An examination of the association between equity undervaluation and information risk: the signaling role of earnings quality

The purpose of this thesis is twofold. First it empirically examines the association between the level of undervaluation of a firm’s equity and three information risk proxies including earnings quality, analysts following and dispersion of analysts’ forecasts. Second, given that earnings quality has implications for equity pricing; the thesis examines the association between the level of equity undervaluation and earnings quality in the year post-undervaluation. The empirical evidence provided for the first test clearly indicates that lower earning quality, fewer analysts following and higher dispersion of analysts’ forecast are having a significant and negative impact on the level of equity undervaluation. This is consistent with the proposition that investors are expected to be willing to pay less for a stock that is perceived to have higher information risk, due to increased information asymmetry and agency costs. Unlike the existing literature, these findings indicate that investors price earnings quality, proxied by the absolute magnitude of abnormal accruals, and they are not fooled by reporting higher levels of earnings, as a result of greater earnings management practices. In addition, the empirical findings provided for the second test suggest that greater improvement in earnings quality in the current year (reduction in earnings management practices) is explained by the higher level of equity undervaluation in the preceding year. This result is consistent with the notion that managers of undervalued firms will subsequently improve earnings quality as a signaling mechanism to reduce information risk and change the investors’ perception of their firm’s equity value. Additional tests compare the results of undervalued sample with the results of a control sample (non-undervalued sample), and suggest that the managerial tendency to improve earnings quality in the following year is unique only to undervalued sample. Additional tests were also conducted to capture the impact of the Sarbanes-Oxley Act (SOX) on the final results. Fundamentally, this thesis suggests that higher information risk is expected to provide a tangible detriment for managers in the form of lower equity valuation. In order to mitigate information risk associated with lower earnings quality, the managers of undervalued firms should utilize their discretion over accounting accruals to improve earnings quality, and therefore change investors’ perceptions of their equity value.