Foreseeing risk of a stock price crash

By Alistair Jones

SMU Office of Research & Tech Transfer– The company reporting season can be a minefield for unwary investors as firms strive to present their recent performance in the best possible light. It can be difficult to get a true picture, much less an estimation of how a company may perform in the future.

Official financial statements are accurate, if complex to decipher. In the US, it is legally required by the Securities and Exchange Commission (SEC) that such reports are prepared according to Generally Accepted Accounting Principles (GAAP) which have their origins in the 1930s aftermath of the 1929 stock market crash.

“GAAP refers to a common set of accounting principles, standards, and procedures issued by the accounting standard setters,” says Rencheng Wang, an Associate Professor of Accounting at Singapore Management University (SMU).

“Publicly listed companies in the US must follow US GAAP when their accountants compile their financial statements.”

But aside from official financial statements, companies increasingly supplement their reporting communications with alternative earnings metrics of their own devising to buoy up market sentiment – and price – for their stock. These alternative figures are known as non-GAAP earnings.

“Non-GAAP earnings are an alternative method used to measure the earnings of a company,” says Professor Wang.

“Many companies report non-GAAP earnings in addition to their GAAP earnings as calculated through GAAP because they believe non-GAAP earnings reflect more about the true financial performance of a company than GAAP earnings.”

Non-GAAP earnings reports are not standardised and their contents vary from firm to firm, making comparisons difficult. They may indeed be helpful to investors but can also be misleading.

The potential of non-GAAP earnings reports to increase the risk of a stock price crash is the basis of a recent research paper co-authored by Professor Wang.

A rosier view

Stock price crashes represent an extreme decline in stock price. Extant research has identified several firm characteristics that predict a higher likelihood of stock price crashes, such as reporting opacity and less conservative accounting. 

The increased likelihood of crashes is often attributed to managers exploiting their information advantage over investors by withholding bad news required to be disclosed in GAAP-based financial reporting.

A traditional way of presenting a more positive picture of a company's prospects has been the use of earnings management – a tactic that manipulates a company's earnings so that figures match a pre-determined target. Excessive earnings management can lead to fines from the SEC.

Professor Wang and his co-authors have found that some managers are using non-GAAP earnings as a substitute for earnings management.

“One potential explanation is that earnings management could be associated with more litigation risk while there are no or fewer regulations around non-GAAP earnings,” he says.

“When used appropriately, non-GAAP earnings can help companies provide a more meaningful picture of the company's performance. However, due to information asymmetry between managers and investors, investors have no way of knowing whether non-GAAP earnings figures are genuine or misled,” Professor Wang says.

“It is possible that misled non-GAAP earnings can, for example, deceive the automated news-watching trading algorithms [used] nowadays into taking action as the non-GAAP earnings are often published in headlines, which will lead to mis-pricing. Once such mis-pricing is going on, the risk of a stock price crash increases over time.”

Future prospects

One of the criticisms of GAAP reporting is that it is a measure of past performance, making it less useful in an age of dominant technology companies, where tech start-ups, for example, can have a promising future despite making initial losses.

“[That] could be one of the motivations for companies to highlight non-GAAP earnings more than GAAP earnings,” Professor Wang says.

“However, it is more than start-up tech companies. Non-GAAP earnings normally exclude large one-off costs, such as asset write-downs or organisational restructuring, which should not be considered normal operational costs.

“Non-GAAP earnings largely result from the shortcomings of GAAP earnings, which could provide retrospective and not future-oriented information. Managers revise and adjust [their] GAAP earnings in an attempt to convert historical performance measures into forward-looking information.

“In this vein, items of the income statement which are extraordinary and non-recurring may be adjusted in an attempt to predict future performance, reduce information asymmetry and communicate the managers’ informed view of the transitory nature of these elements,” says Professor Wang.

Something for investors to consider is that company motives affect the usefulness of non-GAAP figures.

“Our findings suggest that investors should be more alerted when managers have a greater incentive to use non-GAAP earnings to mislead investors – for example, when market sentiment is higher, insider trading incentives are higher, executive pay is more sensitive to stock prices, and managers are constrained to manage GAAP earnings,” Professor Wang says.

“[And] a company's quality of earnings is important, so investors need to consider the validity of non-GAAP exclusions on a case-by-case basis to avoid being misled.”

Red flags

Overall, the researchers find evidence consistent with some non-GAAP disclosures exposing investors to risks of large and sudden price declines.

A warning sign could be a consistently aggressive approach to making non-GAAP earnings contain income increasing exclusions.

“Our findings suggest that [the frequency of non-GAAP disclosures] could be a potential red flag especially when non-GAAP earnings are always greater than GAAP earnings,” Professor Wang says.

“Investors need to be wary of a company's potential for misleading reporting which excludes items that have a negative effect on GAAP earnings, quarter after quarter.”

It takes time for investors to over-value a firm to a point where a subsequent price correction is large enough to meet the definition of a crash. Accordingly, the researchers investigated the relationship between the frequency of income-increasing non-GAAP reporting during a fiscal year and crash risk in the subsequent year. 

They found the likelihood of a crash significantly increases with the firm’s non-GAAP reporting frequency during the prior year. Also that the negative stock price implications of crashes for non-GAAP reporting firms can extend at least two years after the crash week.

Non-GAAP metrics have become increasingly common in capital markets during the past decade and the researchers provide evidence consistent with SEC concerns about their potential to mislead investors. They also reveal the types of exclusions and settings that are, and are not, particularly worrisome.

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