Question

There are two identical firms (A and B with the same total market value of equity (MVEt-1 = $20,000), total earnings (Et-1 = $1,000), same discount rate, same earnings persistence, etc. There is only one difference. Firm A has twice the number of shares outstanding (2,000 vs. 1,000) because A declared one 2:1 stock split in the past and B has never split its shares. Thus, B’s earnings per share (EPS) and stock price (P) is twice that of A’s. Given the MVE and shares outstanding, Pa, t-1 = $10 and Pb, t-1 = $20; and from other facts, EPSa,t-1 = $0.50 and EPSb,t-1 = $1.00.

Next assume that each firm reports the same total earning Et = $1,700 at their respective quarter t earnings announcements, each has MVE just after the earnings announcement window of $26,000, and each has MVE just prior to the earnings announcement window of $22,000.

show the announcement-related ERC is 5.71 for quarter t’s earnings announcement for A and B with three below method, and verify each method.

ERC = 5.71 for both firms and for all three calculation methods.

explain

(a) the unexpected change in market value of equity (MVE) divided by the unexpected total earnings,

(b) the unexpected change in stock price divided by the unexpected EPS, or

(c) the unexpected stock return, divided by the unexpected EPS scaled by stock price.

Note: MVE = share price x common shares outstanding.

Answer 1

It is important to first understand that ERC implies the level of change in the stock returns caused by any earnings announcements.

It measures the impact caused by the announcement of unexpected earnings on the stock prices or returns.

ERC(Earnings response coefficient)= where UR is unexpected return, e is random error, a is benchmark return. ern-u is the unexpected earnings increase(decrease).

a) the unexpected change in market value of equity (MVE) divided by the unexpected total earnings,

unexpected change in market value of equity (MVE)= $26000-$22000=$4000

unexpected total earnings()=

$1700-$1000=$700

ERC=

Hence, proved

(b) the unexpected change in stock price divided by the unexpected EPS, or

unexpected change in stock price=

unexpected EPS= = $0.35

ERC=

Hence,proved

(c) the unexpected stock return, divided by the unexpected EPS scaled by stock price.

unexpected stock return=

unexpected EPS scaled by stock price.=

ERC =

Hence,proved