The Wall Street Journal reported over the weekend on a fascinating new study by Professor Joseph Grundfest of Stanford Law School and doctoral student Nadya Malenko of Stanford Business School. The authors studied 27 years worth of earnings reports (489,000 quarterly earnings reports). They examined earnings not just to the penny, as usually reported, but actually looked to the tenth of a cent. Of course, each digit should appear in the tenths place 10% of the time. However, these scholars found that an earnings report that ended with a "4" in the tenths place tended to occur less often that statistically expected (only 8.5% of the time, in fact). the numbers "2" and "3" also occurred less than expected by chance. The scholars coined the term "quadrophobia" to describe this phenomenon!
What about firms that later restated results or were found to have irregularities in their financial statements? It turns out that their earnings end with a "4" in the tenths place more than expected by chance. Hmmm... What's going on? It appears that companies may be edging up their earnings to the point where a "5" ends up in the tenths place, so that then they can round up to the next cent. That may not seem substantial, but consider for a moment how stock prices rise and fall significantly when a company misses earnings estimates by just a penny, or beats expectations by a cent.
What I find truly amazing is how much attention continues to focus on earnings, when all those finance professors around the world preach that cash flow, not earnings, should be the focus of investor analysis. Still, journalists report extensively on EPS results, and many companies appear to spend a great deal of time "massaging" those numbers.
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