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Earnings Volatility and Market Valuation: An Empirical Investigation

This study investigates whether there is a systematic relationship between a firm's market value (as measured by its market to book ratio) and the variability of its quarterly earnings stream. Using data from the Compustat full coverage, industrial and research quarterly files from 1973 to 1998 inclusive I find that, after controlling for firm size, leverage, current profitability, the level of current investment and sales growth, there is a significantly negative relationship between the market to book ratio and earnings volatility (defined as the coefficient of variation of various earnings measures). I further find that this negative relationship remains even after controlling for operating cash flow volatility, indicating that "accounting-driven" earnings volatility does indeed have an economic impact as has long been claimed. My results are robust to various specifications (including fixed effects, the inclusion of industry dummies, the inclusion of year-quarter dummies and adjusting all variables relative to the relevant industry year median) and to the inclusion of additional control variables such as future cash flow volatility and future profitability. In addition to being statistically significant, my results also have economic significance. For example, there is on average a 0.04 difference in market to book ratios between a firm whose earnings volatility is in the 5th percentile and one in the 95th percentile. If we compare the 1st and 99th percentiles, we obtain a difference in market to book ratios of 0.23, approximately 15% of the median.