Previous study suggest that accruals principle gives the managers space to do the earning management, so they argue that earnings will become less reliable and cash flow could be preferable. Recently, FCF becomes an important firm performance index. Therefore, this paper wants to investigate EPS and FCF which has better explanatory power on firm performance. The results suggest that both EPS and FCF are positive and significant on accounting-based firm performance, ROA, no matter by countries and growth. However, only simply to compare R2 does not provide statistically reliable evidence that EPS is superior to FCF on firm performance. Therefore, we use the method provided by Vuong (1989), and the result shows EPS has better explanatory power for firm performance no matter by countries or growth.
We also find that in low-growth opportunity firms, the larger the firm size may cause lower firm performance, Tobin’s Q, which is market-based of firm performance. This indicated that when firm go in to low-growth, it already be in a mature stage and the opportunity for future growth will relatively lower. Besides, when the firm size larger the demand of external fund may increase. It may cause ownership incline towards dispersion,
and the managers may acquire some shares, which will make agency problem appear easier (Lee and Chuang, 2009). Additionally, we find that EPS and FCF do not have significant relationship on market-based firm performance in low-growth opportunity firms.
From both the effects of EPS and FCF on firm performance, we find the effects on firm performance have different results between countries, cross-country variations in firm performance are not driven only not only by financial statement factors, but it may cause by the country-level corporate governance factors, and previous study documents that corporate valuation may driven by corporate governance (LLSV, 2002; Claessens and
Fan
, 2002;Lemmon and Lins 2003; Brown and Caylor, 2006; Chua, Eun et al. , 2007; Bhagat and Bolton, 2008). Therefore, we add the country-level corporate governance factor, like corporate board, corruption, country risk, rule of law and shareholder’s right to discuss. The results suggest that both EPS and FCF are positive on Tobin’s Q and ROA, but only EPS is significant on both. Overall, EPS is consistent on the explanatory power of firm performance. Our study also suggest that firm in countries with higher corruption will have higher firm performance, but it is not consistent with Lee and Ng (2003) and Chua, Eun et al. (2007). We argue that comparing to the other well-developed five countries china is with highly potentiality and growth. Therefore, we exclude china to examine the regression analysis of top five world economic markets in Panel B, and the corruption index is not significant with firm performance when drop out the samples of China. This is the first paper attempt to examine the relationship between EPS、FCF、country corporate governance and firm performance.
From the results, we find that EPS has more positive explanatory power for firm performance than FCF, and our finding suggest that firm in lower country risk, higher legality, higher shareholder’s right country will have positive relationship with firm performance. Therefore, U.S. is the country which has the highest shareholder’s right, the best quality of law enforcement, the lowest country risk and the best firm performance in the six economic markets.
Reference
1. Ahn, S., D. J. Denis and D. K. Denis (2006). "Leverage and investment in diversified firms." Journal of Financial Economics 79(2): 317-337.
2. Amess, K. and S. Girma (2009). "Do Stock Markets Value Efficiency?" Scottish Journal of Political Economy 56(3): 321-331.
3. Anderson, R. C., A. Duru, and D. M. Reeb (2009). "Founders, heirs, and corporate opacity in the United States." Journal of Financial Economics 92(2): 205-222.
4. Anderson, R. C. and D. M. Reeb (2003). "Founding-Family Ownership and Firm
Performance: Evidence from the S&P 500." The Journal of Finance 58(3): 1301-1328.
5. Banker, R. D., R. Huang, R. Natarjan (2009). "Incentive Contracting and Value-Relevance of Earnings and Cash Flows." Journal of Accounting Research, Vol. 47, No. 3, pp.
647-678, June 2009.
6. Beiner, S., W. Drobetz, M. M. Schmid and H. Zimmermann (2006). "An integrated framework of corporate governance and firm valuation." European Financial Management 12(2): 249-283.
7. Bhagat, S. and B. Bolton (2008). "Corporate governance and firm performance." Journal of Corporate Finance 14(3): 257-273.
8. Brown, L. D. and K. Sivakumar (2003). "Comparing the value relevance of two operating income measures." Review of Accounting Studies 8(4): 561-572.
9. Brown, L. D. and M. L. Caylor (2006). "Corporate governance and firm valuation." Journal of Accounting and Public Policy 25(4): 409-434.
10. Brush, T. H., P. Bromiley and M. Hendrickx (2000). "The free cash flow hypothesis for sales growth and firm performance." Strategic Management Journal 21(4): 455-472.
11. Chan, K., Louis K. C. Chan, N Jegadeesh and J Lakonishok (2006). "Earnings Quality and Stock Returns." The Journal of Business 79(3): 1041-1082.
12. Chen, S. S., R. K. Chou and S. F. Chou (2009). "The Impact of Investment Opportunities and Free Cash Flow on Financial Liberalization: A Cross-Firm Analysis of Emerging Economies." Financial Management 38(3): 543-566.
13. Chen, S. S., K. W. Ho, C. F. Lee and G. H. H. Yeo (2000). "Investment opportunities, free cash flow and market reaction to international joint ventures." Journal of Banking &
Finance 24(11): 1747-1765.
14. Chua, C. T., C. S. Eun and S. Lai (2007). "Corporate valuation around the world: The effects of governance, growth, and openness." Journal of Banking & Finance 31(1):
35-56.
15. Claessens, S. and P. H. J. P. Fan (2003). "Corporate Governance in Asia: A Survey."
SSRN eLibrary.
16. Collins, D. and P. Hribar (2000). " Earnings-based and accrual-based market anomalies:
one effect or two?" Journal of Accounting and Economics 29 :101–123.
17. Dechow, P. M. (1994). "Accounting Earnings and Cash Flows as Measures of Firm Performance - the Role of Accounting Accruals." Journal of Accounting & Economics
18(1): 3-42.
18. Faccio, M. and M. Lasfer (1999). "Managerial Ownership, Board Structure and Firm Value: The UK Evidence." SSRN eLibrary.
19. Gabrielsen, G., J.D. Gramlich and T. Plenborg (2002). " Managerial Ownership, Information Content of Earnings and Discretionary Accruals in Non-US Setting." Journal of Business Finance and Accounting 29: 967-988.
20. Gompers, P., J. Ishii and A. Metrick (2003). "Corporate Governance and Equity Prices*."
Quarterly Journal of Economics 118(1): 107-155.
21. Gottesman, A. A., M. R. Morey, E. D. Baker III and B. Godridge (2008). "Does Better Corporate Governance Result in Higher Valuations in Emerging Markets? Another Examination Using a New Data Set." SSRN eLibrary.
22. Gregory, A. (2005). "The Long Run Abnormal Performance of UK Acquirers and the Free Cash Flow Hypothesis." Journal of Business Finance & Accounting 32(5-6): 777-814.
23. Gul, F. A., J. S. Tsui and C. J. Chen (1997). "Agency Costs and Audit Pricing: Evidence on Discretionary Accruals." SSRN eLibrary.
24. Healy, Paul M.(1985)."The effect of bonus schemes on accounting decisions." Journal of Accounting and Economics 7:85–107.
25. Healy, Paul M. and Krishna G. Palepu (1993)."The effect of firm's financial disclosure strategies on stock price."Accounting Horizons 7:1-11
26. Holthausen, R. W. and R. W. Leftwich (1983). "The economic consequences of accounting choice implications of costly contracting and monitoring." Journal of Accounting and Economics 5: 77-117.
27. Holthausen, V. (1990). "The Effect of Informedness and Consensus on Price and Volume Behavior " The Accounting Review 65(1): 191-208
28. Jensen, M. C. (1986). "Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers." The American Economic Review 76(2): 323-329.
29. Jensen, M. C. (1989). "Active Investors, LBOS, and the Privatization of Bankruptcy."
Journal of Applied Corporate Finance, Vol. 2, No. 1, pp. 35-44, Spring 1989.
30. Klapper, L. F. and I. Love (2004). "Corporate governance, investor protection, and performance in emerging markets." Journal of Corporate Finance 10(5): 703-728.
31. Korczak, A. and P. Korczak (2009). "Corporate ownership and the information content of earnings in Poland." Applied Financial Economics 19(9): 703 - 717.
32. Krishnan, G. (2003). "Audit Quality and the Pricing of Discretionary Accruals." SSRN eLibrary.
33. La Porta, R., F. Lopez-De-Silanes, A. Shleifer and R. Vishny (2002)."Investor protection and corporate valuation." Journal of Finance 57(3): 1147-1170.
34. Lee, Charles M.C., Ng, David T. (2003)." Corruption and international valuation: Does
virtue pay?" Working Paper, Cornell University.
35. Lee, Shin-Ping, T. H. Chuang (2009), " The determinants of corporate performance:
A viewpoint from insider ownership and institutional ownership." Managerial Auditing Journal 24(3):233-247.
36. Lemmon, M. L. and K. V. Lins (2003). "Ownership structure, corporate governance, and firm value: Evidence from the East Asian financial crisis." Journal of Finance 58(4):
1445-1468.
37. Liu, Q. and Z. Lu (2007). "Corporate governance and earnings management in the Chinese listed companies: A tunneling perspective." Journal of Corporate Finance
13(5): 881-906.
38. Maury, B. (2006). "Family ownership and firm performance: Empirical evidence from Western European corporations." Journal of Corporate Finance 12(2): 321-341.
39. Majumdar, S.K. and P. Chhibber (1999)." Capital structure and performance: evidence from a transition economy on an aspect of corporate governance." Public Choice 98 : 287–305.
40. McConnell, J.J. and H. Servaes (1995). " Equity ownership and the two faces of debt."
Journal of Financial Economics 39:131–157.
41. Morey, M., A. Gottesman, E. Baker and B. Godridge (2009). "Does better corporate governance result in higher valuations in emerging markets? Another examination using a new data set." Journal of Banking & Finance 33(2): 254-262.
42. Myers, Stewart C. and Nicholas S. Majluf (1984)‚Corporate financing and investment decisions when firms have information that investors do not have,‛Journal of Financial Economics 13, 187-221.
43. Opler, T. C. and S. Titman (1994). "Financial Distress and Corporate Performance." The Journal of Finance 49(3): 1015-1040.
44. Patel, S. A., A. Balic and L. Bwakira (2002). "Measuring transparency and disclosure at firm-level in emerging markets." Emerging Markets Review 3(4): 325-337.
45. Richardson, S. (2006). "Over-investment of free cash flow." Review of Accounting Studies 11(2-3): 159-189.
46. Shivakumar, L., 2000. Do firms mislead investors by overstating earnings before seasoned equity offerings? Journal of Accounting and Economics 29, 339–371.
47. Shuto, A. (2007). "Executive compensation and earnings management: Empirical evidence from Japan." Journal of International Accounting, Auditing and Taxation
16(1): 1-26.
48. Sloan, R. G. (1996). "Do stock prices fully reflect information in accruals and cash flows about future earnings?" Accounting Review 71(3): 289-315.
49. Stulz, R. (1990). "Managerial discretion and optimal financing policies." Journal of Financial Economics 26(1): 3-27.
50. Tehranian, H., M. M. Cornett, A. J. Marcus and A. Saunders (2006). "Earnings
Management, Corporate Governance, and True Financial Performance." SSRN eLibrary.
51. Teoh, S. H., I. Welch and T. Wong (1998)." Earnings management and the long-run market performance of initial public offerings." Journal of Finance 53:1935-1974.
52. Vuong, Q. H. (1989). "Likelihood Ratio Tests for Model Selection and Non-Nested Hypotheses." Econometrica 57(2): 307-333.
53. Warfirld, T. D., J. J. Wild and K. L. Wild (1995) "Managerial Ownership, Accounting Choices, and Informativeness of Earnings."Journal of Accounting and Economics
20:61-91.
54. Watts, Ross L. and Jerold L. Zimmerman (1986). "Positive accounting theory" (Prentice Hall, Englewood Cliffs, NJ).
55. Weill, L. (2008). "Leverage and Corporate Performance: Does Institutional Environment Matter?" Small Business Economics 30(3): 251-265.
56. Wright, P., M. Kroll, A. Mukherji and M. Pettus, (2009). "Do the contingencies of external monitoring, ownership incentives, or free cash flow explain opposing firm performance expectations?" Journal of Management and Governance 13(3): 215-243.
Appendix: Vuong’s test
With both EPS and FCF are positive and significant with firm performance, ROA. So we want to find EPS and FCF which is a better estimate for valuing firm performance as firm ROA. For this purpose, both are set up as a competing model to explain firm ROA. This paper use a recent development in model selection techniques, previous studies (Dechow, 1994;
Brown and Sivakumar 2003; Shuto, 2007) also use the method is provided by Vuong (1989).
Vuong has provided a likelihood ratio test for model selection, and the test is suitable for any non-nested, overlapping, and nested competing model. The null hypothesis of Vuong’s test is the two models are equally close to explaining the true data generating process, and the alternative is one model has more explaining ability. Therefore, Vuong’s test statistic may produce the result that both models have explanatory power, but provides the direction of choosing the more explanatory model.
The first model is regressing firm ROA on EPS, and excluding time subscripts:
) (1) The second model is regressing firm ROA on FCF, and excluding time subscripts:
) (2)
1. Assume are independent and normally distribution, and the joint density of the first model observations is:
(3)
2. The log likelihood function of the first model is:
log
(4) When L be maximizing, the maximum likelihood estimators of and are the
same as the least squares estimators of and . Therefore, using the least squares estimators to substitute. For each observation i, we can get:
(5)
3. is the maximum likelihood estimate of , where is the residual sum of squares from the regression of firm ROA on earnings per share.
4. The log likelihood function of the second model can be obtained by above process:
log
(6)
5. is the maximum likelihood estimate of , where is the residual sum of squares from the regression of firm ROA on free cash flow per share. And for each observation i, we can get:
(7)
6. In Eq.(4), we substitute for , and substituting for in Eq.(6) . Therefore, we can obtain estimates of and .
By the likelihood ratio test, we can compare which the two models explains more of the firm ROA.
(8) 7. is the estimate of variance of LR, represented by following function:
(9)
8. The statistic is formed by:
(10)
This test has the mean of direction, if the Z-statistic is positive and significant, that indicated the first model is the better choice, whereas if the Z-statistic is negative and significant, that indicated the second model is the better one.
9. Except for above process, there is a simpler approach to estimate the Z-statistic. To substitute Eq.(4)and Eq.(6) into Eq.(8), for each observation i, we can obtain:
(11)
To Simplify the above function, for each observation i, we can obtain :
(12)
If we summed for each observation i, the results will equal to the LR in Eq.(8), finally we estimate the standard deviation of LR, the Z-statistic will be obtained. Vuong(1989) also provided another method that regressing on unity to calculate the Z-statistic instead of estimating the standard deviation of LR. The Z-statistic can be obtained from multiplying the t-statistic of the regression by . The positive and significant Z- statistic indicates that the first model is the model of choice, because the residuals of the second model are larger than the first model.
Table 1 The top six world economic markets
This table provided the top six world economic markets selected by annual Gross Domestic Product (GDP), and the six economic markets are USA、Japan、Germany、UK、France、China. The GDP of top six world economic markets are reported annual in billion dollars during the sample period, 2003-2007. USA is the top 1 economic market in the world selected by annual GDP, and its annual GDP is larger than other countries. Japan and Germany are world top 2 and 3, and the others are 4 to 6. Panel B provided the ratio of sum of top six economic markets' GDP to sum of all countries' GDP in the world. Total_six means sum of top six economic markets' GDP in each year, and Total_world means sum of 57 world main countries’ GDP in each year. The top six world economic markets' GDP are almost above 60% of world total GDP, so that the top six world economic markets can be a proxy for the whole world.
US$ billions
Panel A: Ranking of the top six economy markets bases on GDP
2003 Rank 2004 Rank 2005 Rank 2006 Rank 2007 Rank
USA 10,960.80 1 11,685.90 1 12,421.90 1 13,178.40 1 13,807.60 1 Japan 4,230.32 2 4,609.88 2 4,557.08 2 4,358.80 2 4,380.51 2 Germany 2,442.21 3 2,745.10 3 2,789.70 3 2,912.43 3 3,316.32 3
UK 1,862.34 4 2,198.90 4 2,277.27 4 2,434.44 5 2,804.40 5
France 1,800.00 5 2,061.34 5 2,146.58 6 2,267.55 6 2,589.98 6 China 1,640.97 6 1,931.64 6 2,235.91 5 2,657.88 4 3,280.05 4 Panel B: The proportion of sum of the top six world economy markets' GDP to sum of all countries' GDP in the world
2003 2004 2005 2006 2007
Total_six 22,936.64 25,232.76 26,428.45 27,809.50 30,178.86
Total_world 35,411.20 39,788.48 42,773.06 46,063.57 51,576.67
Proportion 0.65 0.63 0.62 0.60 0.59
Table 2 Description of variables
This table shows the description of variables used in this study. The full sample period is from 2003 to 2007.
Variables Proxy Definition
Tobin’s Q Market-based firm performance (Market value of equity＋Book value of liability )
／Book value of assets.
Size Firm size The natural log of book value of assets at fiscal year end.
EPS Earnings per share (Income before extraordinary items－Preferred dividends) ／Common shares outstanding . FCF Free cash flow per share (Operating activities net cash flow－Cash
dividends－Capital expenditures)／Common shares outstanding.
Leverage Firm leverage (Book value of liability－Divided by common stock) ／Book value of equity.
Corporate boards Corporate boards The natural log of corporate boards index; corporate boards index is from IMD World Competitiveness Online. It do supervise the management of companies effectively, and the index is from 0 to 10(best).
Corruption Corruption The natural log of corruption index; corruption index is from Transparency International, and ranges between 0 (highly corrupt) and 10.
Country risk Country risk The natural log of country risk; country risk is from Euromoney. The measure is taken from the
September issues of Euromoney, and ranges between 0 (highly risk) and 100.
Rule of law Rule of law The natural log of legal and regulatory framework measure; legal and regulatory framework is from
IMD World Competitiveness Online, and the index is from 0 to 10(best).
Shareholder's right Shareholder's right The natural log of shareholder's right index;
shareholder's right index is from IMD World Competitiveness Online. The index is from 0 to
10(best).
Table 3 Mean statistics by variables
Table 3 reports some descriptive statistics on the world six economic markets sample of market value、
book value of debt、book value of asset、Tobin’s Q and some variables of financial statement and corporate governance, averages over 2003-2007. The number of samples (N) for each economic market is also reported in the table. There are 9,320 samples for USA, 12,465 for Japan, 1,515 for Germany, 2,335 for UK, 1,325 for France and 1,805 for China. The total samples contain 28,765 observations.
USA Japan Germany UK France China Total
N 9320 12465 1515 2335 1325 1805 28765
Market value of equity($M) 5183.74 1112.34 2690.40 3144.52 3738.99 2129.96 2864.41 Book value of debt($M) 2783.43 1233.29 3878.46 1682.55 3575.81 891.12 1997.76 Book value of assets($M) 4528.36 1952.60 5253.73 3031.89 5243.54 1744.19 3187.15
Tobin's Q 2.03 1.15 1.49 1.71 1.52 1.87 1.56
ROA 0.04 0.02 0.00 0.03 0.03 0.03 0.03
EPS($) 0.95 0.47 0.99 0.30 2.41 0.03 0.70
EPS/P0 0.02 0.04 -0.01 0.03 0.05 0.04 0.03
FCF($) 0.56 0.18 0.40 0.28 0.59 -0.03 0.33
FCF/P0 0.04 0.03 0.02 0.06 0.03 -0.06 0.03
Leverage 0.44 0.31 0.34 0.24 0.41 0.17 0.35
Corporate boards 5.63 5.02 5.07 5.85 5.29 5.67 5.34
Corruption 7.42 7.26 7.98 8.58 7.24 3.36 7.21
Country risk 95.99 90.55 90.97 93.30 90.81 61.44 90.74
Rule of law 6.03 4.48 3.59 4.74 3.53 5.67 4.99
Shareholders' rights 7.38 5.11 7.33 7.07 6.47 5.15 6.19
Table 4 Earnings Per Share and Firm Performance
The table reports the effect of EPS on firm performance for the period 2003 to 2007. The results are based on panel regressions. The dependent variable in Panel A is ln(Tobin’s Q), and Tobin’s Q is defined as the market value of equity plus the book value of debt divided by book value of assets. The dependent variable in Panel B is return on assets (ROA), which is defined as income before extraordinary items minus preferred dividends plus share capital dividends divided by book value of asset. Firm size is the natural log of book value of assets.
Leverage is debt to equity ratio. T statistics are in parentheses; *, **, and *** indicate significance at 10%, 5%, and 1% respectively.
Table 5 Free Cash Flow Per Share and Firm Performance
Panel A and B shows the effect of FCF on firm performance for the period 2003 to 2007. The results are based on panel regressions. The dependent variable in Panel A is ln(Tobin’s Q), and Tobin’s Q is defined as the market value of equity plus the book value of debt divided by book value of assets. The dependent variable in Panel B is return on assets (ROA), which is defined as income before extraordinary items minus preferred dividends plus share capital dividends divided by book value of asset. T statistics are in parentheses; *, **, and
*** indicate significance at 10%, 5%, and 1% respectively.
Dependent variable : Ln(Tobin's Q)
Table 6 EPS, FCF, Growth and Firm performance
Table 6 reports the effect of EPS, FCF and Growth on firm performance for the period 2003 to 2007. The results are based on panel regressions. We use the method provided by McConnell & Servaes（1995）to separate low and high-growth opportunities firms, it ranks by P/E ratio. The 1/3 of all sample high P/E firms defined as high-growth opportunities firms; 1/3 of all sample low P/E firms defined as low-growth opportunities firms. The samples in Panel A are low-growth, and have 9,590 observations; the samples in panel B are high-growth, there are also 9,590 observations at high-growth. There are two dependent variables, one is ln(Tobin’s Q), and Tobin’s Q is defined as the market value of equity plus the book value of debt divided by book value of assets; one is return on assets (ROA), which is defined as income before extraordinary items minus preferred dividends plus share capital dividends divided by book value of asset. Firm size is the natural log of book value of assets.
Leverage is debt to equity ratio. T statistics are in parentheses; *, **, and *** indicate significance at 10%, 5%, and 1% respectively.
Table 7 Test the explanatory power of EPS and FCF
Table 7 is the results of using the method provided by Vuong to examine whether the explanatory power of EPS and FCF have difference or not. The number of observations in the panel regression is 9,320 for USA, 12,465 for Japan, 1,515 for Germany, 2,335 for UK, 1,325 for France, 1,805 for China. There are 28,765 observations for Total (sum of the top six world economic markets’ samples). The sample period is over 2003-2007. We use the method provided by McConnell & Servaes（1995）to separate low and high-growth opportunities firms, it ranks by P/E ratio. The 1/3 of all sample high P/E firms defined as high-growth opportunities firms; 1/3 of all sample low P/E firms defined as low-growth opportunities firms. The number of observations in the panel regression is 9,590 observations for low-growth and also high-growth group.
Table 7 is the results of using the method provided by Vuong to examine whether the explanatory power of EPS and FCF have difference or not. The number of observations in the panel regression is 9,320 for USA, 12,465 for Japan, 1,515 for Germany, 2,335 for UK, 1,325 for France, 1,805 for China. There are 28,765 observations for Total (sum of the top six world economic markets’ samples). The sample period is over 2003-2007. We use the method provided by McConnell & Servaes（1995）to separate low and high-growth opportunities firms, it ranks by P/E ratio. The 1/3 of all sample high P/E firms defined as high-growth opportunities firms; 1/3 of all sample low P/E firms defined as low-growth opportunities firms. The number of observations in the panel regression is 9,590 observations for low-growth and also high-growth group.