The Risk-Relevance of Street Earnings

Abstract

Risk is an important earnings attribute in valuation models and the FASB’s conceptual framework identifies providing information about risk as a primary objective for earnings. Managers and analysts, however, state that they provide non-GAAP earnings to produce numbers that are more focused on core or cash-based earnings components. They do not discuss risk-relevance as a motivation. We ask whether, by focusing on one earnings attribute (core earnings), non-GAAP earnings sacrifice another important earnings attribute (risk-relevance). We find that non-GAAP earnings capture the more risk-relevant components of GAAP earnings, although non-GAAP exclusions are not risk-irrelevant. Further, not only do non-GAAP earnings better capture information about current risk, they also provide more information about future firm risk. Finally, when comparing exclusion types, we find that special item exclusions contain more risk-relevant information than other item exclusions. Overall, we conclude that in constructing non-GAAP earnings to better capture core earnings, non-GAAP earnings also provide investors with a more risk-focused earnings construct.