ERC (Earning Response Coefficient)

Earning Response Coefficient - ERC

The earnings response coefficient, or ERC, is the estimated relationship between equity returns and the unexpected portion of (i.e., new information in) companies' earnings announcements. The ERC is an estimate of the change in a company's stock price due to the information provided in a company's earnings announcement.
The ERC is expressed mathematically as follows:
UR = a + b(ern − u) + e
R = the unexpected return
a = benchmark rate
b = earning response coefficient
(ern-u) = (actual earnings less expected earnings) = unexpected earnings
e = random movement

Good News (GN) firms enjoyed positive abnormal returns, and negative for their Bad News (BN) firms. This raises the question of why the market might respond more strongly to the good or bad news in earnings for some firms than for others. If the answer can be found, accountants can improve their understanding of how accounting information is useful to investors. This, is turn, could lead to the preparation of more useful financial statements.

Consequently, one of the most important directions that empirical financial accounting research took since the BB study is the identification and explanation of differential market response to earnings information. This is called earnings response coefficient (ERC).


“Earnings response coefficient measures the extent of security’s abnormal market return in response to the unexpected component of reported earnings.”


Reasons for differential market response:
 BETA: The more risk related to the firm's expected returns the lower will be the investor's reactions to a given amount of unexpected earnings.
 CAPITAL STRUCTURE
ERC for a highly levered firm is lower than for a firm with little or no debt, Any good news passed on means that the debt holders get this benefit instead of the investors.
(Thus it is important to disclose the nature & magnitude of financial instruments including off-balance sheet)
 PERSISTENCE
Source of increase in current earnings affects the ERC:
- if earnings are expected to persist into the future this will result in a higher ERC
- if the component in the earnings is non-persistent (i.e. unusual, non recurring items) this will result in lower ERC

OR
The earning response coefficient refers to the anticipated relationship between the returns of the equity and the unexpected earnings announcements of a company. Earning response coefficient is also known as ERC.

According to the arbitrage pricing theory of the financial economics, the price of a particular equity shares a theoretical relationship with the information on a particular equity that is available to the market participants. The efficient market hypothesis says that the equity prices are expected to reflect all the necessary and relevant information on the equity at a given point of time. Consequently, if any change in the value of the equity occurs, it is understood that this is due to the change in relevant information. There are market participants who are having superior information and they can exploit that information until the share price is affected by the information.

Hence we can say that depending on the changes in the relevant information on a particular equity, which is available in the market, some changes in price of the shares may occur. It can also be said that the earning response coefficient is actually an estimate of the stock price change of a company because of the changes in information supplied in the earnings announcement of the company.



The use of earning response coefficient is primarily visible in the research of finance and accounting. To be more specific, the earning response coefficient is applied in the positive accounting research. Positive accounting research is a branch of the financial accounting research that is used for the theoretical analysis of the market depending on the various events of information. ERC is used in the finance research to study the activity of the investors depending on the information events.

Securities Markets Efficiency & Accounting Information (증권시장의 효율성과 회계 정보).

Securities Markets Efficiency & Accounting Information. (증권시장의 효율성과 회계 정보).

or

Reasons of Security market inefficiency.

Some people argue that stock market is efficient and some others people argue that stock market is not efficient. News is happening all the time. The capital market is efficient if at any time the security prices fully and correctly reflect all the available information and news at that date.
But market may not respond to information exactly as the efficiency theory predicts. Share prices sometimes take some time to fully react to financial statement information. If the information is not fully and correctly reflect in the market at the right time then we can see securities market anomalies or excess stock volatility or stock market bubbles. So, the security market will be inefficient.
Reasons of Security market inefficiency are as below:
1.Overconfidence: -Psychological evidence suggests that individuals tend to be overconfident. They overestimate the precision of information they collect themselves. If, on average, investors behave this way, share price will overreact.
2. Self-attribution bias:-Self-attribution bias occurs when people feel good decision outcomes due their own skills or abilities, whereas bad outcomes are due to unfortunate realizations of states of nature or unsuccessful outcomes on bad luck, hence not their fault. Suppose that following an overconfident investor’s decision to purchase a firm’s shares, its share price rises (for whatever reason). Then, the investor’s faith in his or her investment ability rises. If share price falls, faith in ability does not fall. If the average investor behaves this way, share price will increase.
3. Post –announcement drift: Once a firm's current earnings become known, the information content should be quickly digested by investors and incorporated into the efficient market price. However, it has long been known that this is not exactly what happens. For firms that report good news in quarterly earnings, their abnormal security returns tend to drift upwards for at least 60 days following their earnings announcement. Similarly, firms that report bad news in earnings tend to have their abnormal security returns drift downwards for a similar period. This phenomenon is called post-announcement drift.
For the post-announcement drift investors can earn arbitrage profits (risk free profit). By buying good news firms on the day announced earnings and selling short shares of bad news firms. But post-announcement drift is workless if a greater portion of a firm’s is held by institutional investors (Sophisticated investors).
4. Buying and short-selling shares based on non earnings financial statement information such as changes in sales, accounts receivable, inventories and capital expenditure.
5. Another possible explanation for the anomalies is transaction costs. The investment strategies required to earn arbitrage profits may be quite costly in terms of investor time and effort, requiring not only brokerage costs but continuous monitoring of earnings announcements, annual reports and market prices, including development of the required expertise. For the transaction costs sometimes investors can’t take advantage of post-announcement drift.
6. Another reason is “jump on the bandwagon”. To take advantage people get involved in something that has recently become very popular. When people see positive feedback then they join the group then increase the stock market volatility.
On the above discussion we can say that securities markets are not fully efficient. Improved financial reporting may be helpful in reducing inefficiencies and security price will be protected. Improved financial reporting, by giving investors more help in predicting fundamental firm value. Indeed, by reducing the costs of rational analysis, better reporting may reduce the extent of investors’ behavioral bias. So, financial accounting information is very important and helpful to investors in securities market to protect securities market inefficiency.