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Investors Use Strategies Such As Fundamental Ratio Analysis, Accruals ...

Investors use strategies such as fundamental ratio analysis, accruals analysis and fundamental value analysis, to account for their decisions and treatment of investment portfolios. However, Daniela, Hirshleifer and Teohb (2001) are of the view that these strategies are not effective predictors of future stock returns. They write:
"Earnings reported on firms' financial statements differ from cash flows by accounting adjustments known as accruals. These are designed in principle to reflect better economic circumstances...high accruals predict negative long-run future returns." (Daniela, Hirshleifer and Teohb 2001)
This strategy is affected by the discretionary working capital accrual and new equity. This is so because investors are fixated by earnings numbers. Consequently they tend to underestimate other accrual factors.
Similarly, the authors also note that the fundamental value analysis strategy to predict future stock returns, "relies on stock prices from an imputed value based on a fundamental value model" (Daniela, Hirshleifer and Teohb 2001). Even in this model the discounted value of expected future residual earnings are defined in the context of normal return employed in future years. In reality, earnings prediction depends on the value of the index as well as the incremental book/market returns. Frank and Lee (1999) in their research indicate that internationally such a model, when applied to cross-country firms such as Enron or WorldCom tend to produce abnormal returns, resulting in inadequate strategy for comparing stock prices or its performance prediction. In such a condition misevaluations can occur and so does manipulation. This is known as timing. Timing is used to mislead stock events to influence when and whether buying actions (Legoria, Cagwin and Sellers 2000). Legoria, Cagwin and Sellers (2000) note that when firms engage in timing of discretionary accruals they are motivated by opportunities for new debts, creditor confidence, and favourable reversals during the period of debt issuance, especially in firms where earnings are volatile they are viewed as risky. Reporting volatile earnings reduce stock attractiveness for investors. For this reason accounting principles allow managers to smooth earnings conducive to positive investment decisions.
Another author Mcmenamin (1999) points out that weaknesses in asset-based valuation methods on the other hand ignores earnings or cash flow generating potential of the firm. Instead investors adopt the price/earnings (P/E) method to predict future earnings to overcome the weakness mentioned above. P/E ratio is a popular method for share valuation amongst investment analysts, managers and shareholders. It gauges the earnings potential of the company's earnings per share (EPS) and compares it with the share's market price. P/E is determined by dividing the market price of the company's ordinary share by EPS.


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