Do price-earnings multiples for firms with patterns of increasing earnings vary with the quality of the earnings pattern?

Abstract

ABSTRACT Prior research finds that firms with patterns of consecutive earnings increases are rewarded by market participants with higher Price-Earnings (P/E) multiples, and that some firms manage earnings to sustain the earnings stream. We propose several fast and inexpensive heuristics to classify firms as suspect or non-suspect of maintaining the stream through earnings management and examine whether market rewards differ for suspect and non-suspect firms. We find higher P/E multiples for firms with a pattern of increasing earnings supported by the same pattern of increasing cash flows (non-suspect). This is an important result as it shows that cash flows can be used to assess the quality of earnings in scenarios prone to earnings management, where earnings quality is expected to be low. We also find lower price-earnings multiples for firms suspected of using accrual-based earnings management, sales manipulation, and overproduction to achieve the earnings pattern.