Abnormal Earnings and Economic Value Added Research Proposal - 1

Abnormal Earnings and Economic Value Added - Research Proposal Example When a company reports lower earnings in its financial statements than investor-anticipated earnings, it can induce the stock prices to drop significantly. Whereas in case if a company reports more earnings than anticipated by the investors, it boosts up the company's stock prices. This motivates the managers to report discretionary results or earnings so as to live up to the expectations of the shareholders and investors leading to earnings manipulation. The companies report abnormal earnings that misrepresent their financial position and to artificially evaluate the stock. Another metric used to gauge a company's performance and position is known as Economic value added that compares earnings with the cost of capital. Stewart (1991) has presented several arguments that go in favor of using economic value added concept for valuation purpose. The major reason behind using the economic value added as a basis for stock valuation is to analyze the worth a company returns to its shareholders as a reward for their risk and investment. Stewart (1991) shows that the economic value added is calculated by subtracting the cost of capital from the after-tax profit of a company. ... plies that a company should be able to drive that many returns to the shareholders, as they would otherwise get out of another investment opportunity. If the company fails to provide that value, it implies that it actually incurring the loss and is unable to provide sufficient returns to the shareholders. Therefore, it can be said that the ability of a company to procure returns for its shareholders greater than the capital costs can eventually increase or decrease its value. The studies conducted by researchers Stewart (1991), and Lehn and Makhija (1996) prove that economic value added concept bears a strong relationship with company's stock and therefore, has a great capability to influence its stock value. It is, however, to be noted that Topkis (1996) shows that economic value added could only be used as a basis for valuation of a company's future share price and cash flow expectations, but it can not be used to value current stock prices. .