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.