Article Analysis

Importance of the Research Questions

This paper will be analyzing the article written by Ching-Lih Jan and Jane A. Ou, “Negative-Book-Value Firms and Their Valuation”. The article states the negative earnings of an organization/firm and its consequences that lead towards negative book value which is not a good sign for any firm working in an industry. This study provides an explanation for the anomalous significantly negative price-earnings relation using the simple earnings capitalization model for firms that report losses. We hypothesize and find that including book value of equity in the valuation specification eliminates the negative relation. This suggests that the simple earnings capitalization model is mis-specified and the negative coefficient on earnings for loss firms is a manifestation of that misspecification.

Furthermore, we provide evidence on three competing explanations for the role that book value of equity plays in valuing loss firms. Specifically, we investigate whether the importance of book value in cross-sectional valuation models stems from its role as (1) a control for scale differences, (2) a proxy for expected future normal earnings, or (3) a proxy for loss firms' abandonment option. Our results do not support the conjecture that the importance of book value in cross-sectional valuation stems primarily from its role as a control for scale differences. Rather, the results are consistent with book value serving as a value-relevant proxy for expected future normal earnings for loss firms in general, and as a proxy for abandonment option for loss firms most likely to cease operations and liquidate.

Theoretical Underpinnings

A firm can have a bad year in terms of earnings, but the problems may be isolated to that firm, and be short-term in nature. If the loss can be attributed to a specific event - a strike or a lawsuit judgment, for instance - and the accounting statements report the cost associated with the event, the solution is fairly simple. Estimation should be based on the earnings prior to these costs and use these earnings not only for estimating cash flows but also for computing fundamentals such as return on capital. In making these estimates, though, note that you should remove not just the expense but all of the tax benefits created by the expense as well, assuming that it is tax deductible. If the cause of the loss is more diffuse or if the cost of the event causing the loss is not separated out from other expenses, you face a tougher task. First, you have to ensure that the loss is in fact temporary and not the symptom of long term problems at the firm. Next, you have to estimate the normal earnings of the firm.

The simplest and most direct way of doing this is to compare each expense item for the firm for the current year with the same item in previous years, scaled to revenues. Any item that looks abnormally high, relative to prior years, should be normalized (by using an average from previous years). Alternatively, you could apply the operating margin that the firm earned in prior years to the current year's revenues and estimate an operating income to use in the valuation. In general, you will have ...