Accounting, Auditing &
Vol. 16 No. 1, 2003
# MCB UP Limited
Received June 2002
Revised July 2002
Factors explaining the
inefficient valuation of
Department of Accounting, University of Seville, Seville, Spain
Keywords Intangible assets, Valuations, Financial analysts, Financial forecasting, Ethics
Abstract The inefficient valuation of the intangible determinants of the financial position of
business companies may result in significant damages for both firms and their stakeholders.
Based on the empirical literature in accounting and finance, this paper suggests possible reasons
for the inefficient valuation of intangibles, provides explanations for the existence of biases in
analysts' earnings forecasts and proposes alternative ways for the improvement of the resource
allocation mechanisms in the capital markets.
In recent years, a number of capital markets-based empirical studies have
assessed the extent to which the value relevance of accounting information
has changed over time, finding contradictory results. Whereas the pioneering
studies documented a decline in the degree of association between stock
returns and earnings and between stock prices and both earnings and book
values in US capital markets (Collins et al., 1997; Francis and Schipper, 1999;
Lev and Zarowin, 1999), recent evidence suggests that empirical results are
dependent on the method used (Chang, 1998) and that, once the bias in the
coefficient of scale is adjusted for, there is no significant decrease in the value
relevance of accounting numbers in time (Brown et al., 1998). Moreover, Ely
and Waymire (1998) have shown that the explanatory power of earnings and
book values for prices was not significantly different in the USA in the pre-
This notwithstanding, it seems to be widely accepted nowadays that
accounting information is losing relevance, among other reasons, due to the
increasing importance of intangibles not recognized as assets under current
accounting standards (Wallman, 1995; Lev and Zarowin, 1999). Many
consider this as the main force driving the growing difference between the
market value of companies and their book value equity (Lev, 2001), as,
although intangible investments increase future earnings and cash flows,
they are generally expensed, thus understating current earnings and book
However, it is not reasonable to state that the difference between the market
value of the firm and its book value of equity is entirely due to the existence of
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The author gratefully acknowledges the funding provided by the Spanish Association of
Accounting and Business Administration to the Carlos Cubillo Chair in Accounting and
Auditing, as well as the financial aid of the Spanish Ministry of Education (Project PB98-0415).
intangibles not reflected by the accounting model. First, the book value of
equity may be negatively biased not only due to the lack of recognition of
intangibles, but also because of the undervaluation of tangible and financial
assets. Second, shareholders' equity may not reflect the existence of intangible
liabilities that are likely to be discounted in stock prices but not accounted for
even under GAAP prudent accounting. Third, stock prices may not always be
considered as unbiased estimates of the value of companies. There is an
overwhelming amount of empirical research documenting the existence of
market anomalies such as the size (Banz, 1981), January (Rozeff and Kinney,
1976), E/P (Basu, 1977) and B/M (Fama and French, 1992) effects, and
the underreaction (Ou and Penman, 1998) or overreaction to earnings
announcements followed by a post-announcement drift (Bernard and Thomas,
The significant increase in the stock prices of the so-called new economy
firms during the late 1990s and the subsequent burst of the technological
bubble have resulted in enormous losses for investors and dramatic job slashes.
The question many are posing is whether we could have anticipated the
inefficient valuation of these (presumably intangible-intensive) companies and
to what extent the damages could have been avoided.
In the light of the results reported by recent empirical research in accounting
and finance, this paper identifies the causes of the inefficient valuation of
intangibles in capital markets, discusses the existence of, and the reasons for,
biases in analysts' earnings forecasts, describes some recent efforts undertaken
in order to overcome the problems limiting the efficiency of the resource
allocation mechanisms in financial markets and suggests ways for the
improvement of the resource allocation mechanisms in the capital markets.
The next section discusses the problems arising as a result of the inefficient
valuation of intangibles in capital markets. Section three delves into the causes
of those problems, while section four suggests possible solutions and section
2. The problems
The inefficient valuation of intangibles has significant implications for firms
and their stakeholders. Among the damages that have been thoroughly
discussed in the accounting and financial literature are the following:
Stock price volatility arises as a result of the difficulty to accurately estimate
the future payoffs and the risk associated with the investment in intangible-
The uncertainty regarding the financial position of intangible-intensive
companies increases bid-ask spreads (Boone and Raman, 1999) and raises the
cost of capital (Botosan, 1997; Sengupta, 1998), resulting also in higher interest
rates (Shi, 1999). Information asymmetry increases the opportunities for insider
gains (Aboody and Lev, 2000) causing significant losses for small investors.
The overstatement of the value of companies in the capital markets results
in significant losses for investors when stock prices revert to their fundamental
values. Conversely, undervaluation reduces the ability of the firm to raise
additional capital (Chan et al., 1998; Lev et al., 2000) and increases the risk of
hostile takeovers. This is closely related to the dramatic social and economic
impact of the enormous job slashes resulting from the initial overvaluation of
high-tech companies and the subsequent crash of the stock market.
The last few years have witnessed a growing amount of litigation between
investors and managers as the former find it difficult to evaluate the firm's
performance based on accounting numbers (Lev, 2001). This may be partly due
to managers' propensity to manipulate earnings with intangible investments
(Bushee, 1998) and to cut down R&D before going public in order to increase
earnings and influence investors' expectations (Darrough and Rangan, 2001).
Obviously, all these problems are more likely to appear in growing
companies undertaking important intangible investments to increase their
market share than in mature firms having reached a steady state in which
intangible investments are close to the annual depreciation of both their
recorded and unrecorded intangible assets.
3. The causes
3.1. Quality of financial information
The inefficient valuation of intangibles could stem from the lack of relevant
information in the annual reports of business companies. Based on a survey of
business-reporting practices by US companies, the FASB's Steering Committee
(FASB, 2000) concluded that companies are currently disclosing a large amount
of voluntary useful information on their financial position, although there is a
``general lack of meaningful and useful disclosures about intangible assets''.
The remainder of this section discusses some possible reasons for the
decreasing usefulness that accounting information is experiencing according to
both researchers and practitioners.
Accounting conservatism limits the recognition of intangible investments
as assets in the balance-sheet to those whose cost may be reliably measured,
which are separable from the rest of the assets of the firm and yield future
benefits that are in control of the company. Therefore, firms investing large
amounts in intangibles will report lower book values and will be significantly
affected by the immediate recognition of the costs and the delayed recognition
of the benefits in accounting earnings, particularly if they are small and have
a record of reported losses (Ryan and Zarowin, 2001). In general, managers
fail to satisfy the informational needs of the users of corporate financial
reports because they do not disclose the information that investors and
creditors consider most relevant (PriceWaterhouseCoopers, 2002). This could
be due to the existence of benefits for managers, auditors and leading
financial analysts from the lack of publicly available information on
intangibles (Lev, 2001, p. 87).
Corporate financial reports do not provide investors with an accurate view of
the value creation process within the firm. Specifically, there is a lack of
financial and non-financial information on the firms' value drivers (Amir and
Lev, 1996; Ittner and Larcker, 1998). Also, there appears to be a lack of relevant
information on management's prospects for the future financial position of the
firm. This view is consistent with the claims of the AICPA (1994) for more
forward-looking information in the management report and the suggestion of
the former board of the IASB that firms should be encouraged to disclose more
narrative information on their intangibles.
In sum, there appears to be a growing concern for the lack of usefulness of
accounting statements due to the conservatism of accounting regulation and
the absence of historical and prospective financial and non-financial
information on the intangible determinants of the value of companies.
3.2. Market imperfections
Inefficient valuations may also be the consequence of the inexistence of
markets for intangibles and the imperfections in capital markets. Since there
are no markets for intangibles, their value may not be assessed on the basis of a
consensus as is the case with commodities or other tangible and financial
assets. Moreover, there are no widely accepted valuation models for intangible
assets such as those developed for stocks, bonds or options.
Market imperfections giving rise to information asymmetry allow insider
gains and have negative economic consequences for smaller investors and
stakeholders that do not have the capability to influence management's
decisions because of their small share in the capital of the firm, due to the
incomplete nature of the contracts upon which corporate governance
mechanisms are based or because of their small bargaining power.
The audit function fails to guarantee the necessary transparency in financial
markets and to ensure the disclosure of all the information that is relevant to
understand the financial position of the firm. Furthermore, there are problems
affecting the timeliness in the announcement of the relevant events and the
financial information required by stakeholders.
The lack of international harmonization of accounting standards and
financial markets' regulatory frameworks is also seen by many as the cause of
inefficiencies in the resource allocation mechanisms.
In sum, market imperfections may result in inefficiencies that are likely to
cause greater damage to smaller stakeholders and may only be corrected if
financial markets' regulations are improved and international harmonization is
3.3. Limited capability of financial analysts?
Financial analysts are sophisticated users of accounting information. The
strong competition in the financial markets forces them to exploit all available
knowledge to provide their customers with the most efficient financial
advising services. In order to survive in their competitive environment,
analysts need to have not only the ability to access all value-relevant
information in a timely fashion, but also the capability to understand and
exploit its content. Their capability to predict future earnings accurately has
been extensively documented in the accounting literature (Brown and Rozeff,
1978; Affleck-Graves et al., 1990; Richardson et al., 1999). In fact most
contemporary research studies use analysts' forecasts as a surrogate for the
market's expectations (Liu and Thomas, 2000).
Credibility is another fundamental requisite for financial services companies
in markets nowadays and, consequently, significant or systematic errors in buy
or sell recommendations are likely to undermine the confidence of their
customers and, eventually, result in the loss of a significant part of their
revenues. The results of Mikhail et al. (1999) show that analyst turnover is
greater, the lower their forecast accuracy.
However, there may be significant differences across analysts in the ability
to access relevant and timely information, as well as in their capability to
extract all its value-relevant content to make accurate predictions. Differences
in the ability of market participants to exploit the information content of the
earnings numbers disclosed by companies may explain the existence of over-
and under-reaction to earnings announcements followed by a subsequent
drift in stock prices. If a small subset of market participants are able to
exploit all the value-relevant information conveyed by the earnings figure
disclosed at a given moment, but the rest of the investors fail to fully
understand the impact of current information on the present value of the
future cash flows of the firm, there will be an initial stock price reaction that
does not completely reflect all value-relevant information. Once the leading
investors have adjusted their expectations and reacted accordingly, the rest
of the market participants will slowly move in the direction signalled by the
leading steers and, consequently, prices will show a drift towards the intrinsic
value of the stock.
Analysts' earnings forecasts have become widely used by investors as a
basis for the design of their portfolios and investment strategies. Biases in
earnings forecasts may result in an inefficient valuation of companies. There
are in the empirical literature a large number of studies documenting the
existence of a systematic positive difference between analysts' earnings
forecasts and the actual earnings numbers, which appears to be greater for
smaller companies, is not dependent on the data sources used by the
researcher, and is also present in the case of long horizon growth forecasts
Cognitive biases and analysts' incentives are the two main economic
determinants of forecast biases that have been analyzed by empirical studies.
The potential sources of cognitive biases are related to the anomalous
behaviour of stock markets. DeBondt and Thaler (1985) spawned a stream of
research based on the hypothesis that analysts systematically overreact to the
information (either good or bad) conveyed in earnings. Although the evidence
on overreaction to good news in earnings appears to be consistent, Easterwood
and Nutt (1999) have shown that analysts underreact to bad news. However,
Abarbanell and Lehavy (2000a) have concluded that biases in earnings
forecasts may not be explained by cognitive biases.
Inefficient forecasts could be due to the intense competition between and
within firms that forces analysts to strive for their customers' capital to the
detriment of the rigour in their methods. As shown by Welch (2000), the
recommendations issued by the leading analysts are immediately followed by
the rest (presumably less capable), thus resulting in poorer aggregate
information. Moreover, Cooper et al. (2001) have found that the forecasts of the
leading analysts have a greater impact on stock prices. Taken together, the
findings of these studies suggest that competition among analysts results in
herding behaviour that significantly affects stock prices. Related to this are the
time constraints facing financial analysts, which may lead them to prefer
technical analysis or cheap fundamental analysis, i.e. stock screening (Penman,
2001) instead of a deep fundamental analysis using valuation techniques that
assess the intrinsic value of companies based on estimates of future payoffs
and risk. Although contrary investment strategies aimed at exploiting market
inefficiencies may yield positive abnormal returns, they may also result in
significant losses if the analyst fails to accurately estimate the future payoffs
and the risk associated with the investment and other analysts are able to draw
more efficient estimates of the intrinsic value of the stock.
Functional fixation is another possible source of inefficient earnings
estimates and firm valuations. Analysts may not be able to incorporate
information on intangibles as inputs in their decision processes if the dominant
culture in their investment firms suggests it is not acceptable. Moreover,
analysts may not consider the information voluntarily disclosed by managers
as reliable. Finally, they may fear that investors will not consider information
on intangibles as a consistent basis to sustain their investment decision
Despite the substantial amount of evidence of systematic biases in analysts'
forecasts, the results of recent studies suggest that the magnitude of the bias is
decreasing in time (Brown, 1997, 1998). In fact, Richardson et al. (1999) have
found that the optimism in earnings forecasts has recently turned into
pessimism. Three reasons may explain this change in the pattern documented
by previous studies: analysts are learning from past errors and face negative
consequences when their forecast accuracy is systematically low (Mikhail et al.,
1997); their incentives have changed and, the quality of the data used by
empirical studies of analysts' forecasts has improved significantly in the last
few years (Abarbanell and Lehavy, 2000b); the observed biases could be the
consequence of earnings management practices intended to report earnings
numbers that slightly beat analysts' forecasts.
Amir et al. (1999) have documented that, on average, the information
provided by financial analysts to investors represents a modest contribution
beyond that conveyed by financial statements (12 per cent in adjusted R2
terms), suggesting that analysts mainly react to the observed changes in stock
prices rather than cause them. However, they conclude that the use of the
information provided by analysts in their forecasts mitigates the decrease in
the value relevance of financial statements. The contribution of financial
analysts appears to be greater in high-tech industries and, particularly, for
companies with large investments in R&D. Taken together, their results
suggest that financial analysts are capable of understanding the value
implications of intangibles and provide forecasts and recommendations that
are useful to investors.
We have recently witnessed lamentable events in the capital markets that
have caused huge economic losses to investors and have undermined the
confidence of investors in the financial markets. They have all been the
consequence of the unethical behaviour of managers, auditors and financial
Inefficient valuations may be caused by misleading management practices
such as the disclosure of false information in conference calls or the
manipulation of accounting numbers. Darrough and Rangan (2001) have
shown that managers tend to reduce their R&D investments to increase
earnings in the year of the initial public offering to improve investors'
expectations and Bushee (1998) has also found evidence that firms may
manage their earnings using R&D.
The main role of auditors is to reduce the information asymmetry between
investors and managers. Audit firms providing consulting services to their
clients may be tempted to hide their qualifications as long as it maintains and
increases their customer portfolio. Based on the resulting unreliable
information, investors are likely to overestimate the value of firms and,
subsequently, incur losses when the private information becomes public and
stock prices are adjusted downwards.
Investors may also suffer damages if analysts' behaviour is not ethical.
Biased forecasts will lead investors to allocate resources to overvalued assets
whose price will eventually revert to their fundamental value (Lee et al., 1999).
Besides cognitive limitations, earnings forecast optimism may be driven by the
incentives of financial analysts. An optimistic bias in earnings forecasts issued
by sell-side financial analysts is likely to result in an increase in the
compensation they receive for their services in equity issues, mergers and
acquisitions (Lin and McNichols, 1998). On the other hand, analysts working
for investment banks appear to be more likely to issue optimistic forecasts in
the case of companies to which the bank provides financial services (Michaely
and Womack, 1999). However, it could also be the case that firms choose the
provider of financial services whose analysts issue the most optimistic
earnings forecasts, in the belief that the amount of capital raised in the public
offerings would be greater. Optimistic forecasts may also be a way to improve
analysts' access to corporate information. For issuing positively biased
earnings estimates is likely to improve the relationships between the analyst
and the firm's management, allowing the first to access relevant information
that could be particularly beneficial in the case of significant information
4. Possible solutions
Changes in the regulation are needed in order to improve the market
imperfections that result in economic damages for firms and their stakeholders.
It is necessary to promote efforts aimed at suppressing the arbitrage
opportunities that arise from the differences in the market regulations across
countries. The coordination and integration of financial markets will surely
have positive consequences in this respect.
But, most important, the current accounting model must be improved, issuing
new standards to ensure the disclosure of a greater amount of higher quality
information on the intangible determinants of the value of companies. It is also
necessary to encourage voluntary disclosures including forward-looking
information by management. Managers must use a language that financial
analysts and investors are able to understand. They have to provide explanations
of the value creation process in the firm and make clear links between intangible
investments and future value creation. This will increase the transparency and
reduce the asymmetry limiting the efficiency of capital markets.
The conservative perspective on the recognition of intangible
investments in the balance-sheet adopted by the IASB in IAS 38 (IASC,
1998) will have to be revised in the future because of the new developments
in the accounting standard-setting process in the USA. The FASB has
decided to allow the no amortization of goodwill and prescribe the disclosure
of more information on R&D investments in SFAS 141 and 142. As a result,
fair valuation of tangible and intangible assets becomes a fundamental tool
for managers to provide stakeholders with relevant information on the
financial position of the firm.
The elaboration and implementation of codes of good governance are a
necessary step towards enhancing the credibility of that information. Codes of
ethics in audit and investment firms are also necessary to ensure that audit
reports and analysts' recommendations are considered by investors as reliable
inputs for their investment decision processes. But that is not enough.
Regulatory bodies must enforce controls to ensure that all market participants
respect their provisions and should impose severe sanctions on those who
violate them and cause damage to the system.
However, we must always be aware that managers, auditors and analysts
may have no incentives to trigger changes in the current state of things.
5. Concluding remarks
The inefficient valuation of intangibles has significant negative economic and
social consequences in our economies. High growth rates in GDPs, low interest
rates and excessively optimistic expectations on the potential for future wealth
creation of the so-called new economy businesses have resulted in the
overvaluation of a number of intangible-intensive firms in the capital markets.
Inefficient valuations may be the consequence of low quality financial
information, market imperfections, the insufficient capability of managers,
auditors and analysts or their unethical behaviour.
In recent years, some studies conducted by academics, professional
organizations and standard-setting bodies have suggested that the quality
(usefulness) of accounting information is decreasing and that the users of financial
statements need more forward-looking financial and non-financial information,
particularly on the intangible determinants of the value of companies.
To avoid the inefficient valuation of intangibles in capital markets standard-
setting bodies must improve current accounting regulation so as to ensure the
full disclosure of relevant information on intangibles, increase the transparency
and reduce the asymmetry limiting the efficiency of capital markets. Moreover,
managers should provide more narrative information using a language that
stakeholders and analysts are able to understand, that is, providing a clear
picture of the value creation process within the firm and explanations of the
contribution of intangible investments. Guidelines for the measurement and
voluntary disclosure of relevant information on the intangible determinants of
the value of companies may be useful in this regard.
Although published empirical literature suggests that analysts' forecasts are
systematically biased, recent studies lead us to believe that forecast errors are
not caused by cognitive biases and that analysts actually provide investors
with relevant information beyond that contained in financial statements,
particularly in the case of intangible-intensive companies. Two consequences
may be drawn from these findings: first, analysts seem to be able to obtain
information on intangibles from sources other than the financial statements;
second, the inefficient valuation of intangibles may not be explained by the lack
of ability of analysts to understand the contribution of intangibles to the value
creation process within the firm.
Rather, research points to the unethical behaviour of market participants as
the most suitable source of inefficiencies. Because of the lack of publicly
available information on intangibles, the unethical behaviour of managers,
auditors and financial analysts has resulted in an overvaluation of intangible-
intensive companies followed by a subsequent correction in their stock prices
that caused significant losses for uninformed investors. Managers, auditors
and analysts must now undertake efforts aimed at improving their credibility
in the eyes of investors. Codes of good governance and codes of ethics in audit
and financial firms are not sufficient. Market regulatory frameworks and
accounting standards must be improved to ensure the efficient functioning of
capital markets and guarantee that any conduct causing damage to the
financial system is identified and punished.
I agree with Steven Wallman (1995) that we cannot have financial reporting
and disclosure constraints that slow the pace of progress in capital markets,
decrease the rate of reduction in the cost of capital, or limit innovation. The
next step collectively is ours.
1. In general, an item in the financial statements is considered as relevant if it has the ability
to make a difference to decisions of financial statement users (Barth, 2000). More
specifically, an accounting number is value-relevant if it conveys information that has the
power to modify investors' expectations on the future payoffs or the risk associated with a
given resource allocation. In an efficient market all value-relevant information would be
immediately and completely reflected in stock prices.
2. Kothari (2001) provides an extensive review of the empirical accounting literature and its
implications for the efficient markets hypothesis.
3. See Fama (1998) for a thorough discussion and a critical interpretation of the empirical
evidence on market anomalies.
4. Barth et al. (1999) have found that analyst coverage is directly associated with the
existence of intangibles in the firm, as analysts try to exploit the greater information
asymmetries existing for these companies.
5. Although not mentioned, the underlying reason is that voluntary disclosures are expected
to reduce asymmetries, forecasts errors and bid-ask spreads by helping stakeholders
understand the contribution of intangible investments to the value creation process in the
6. The discussion presented in this section is mainly based on the results of empirical studies
of analysts' earnings forecasts. Case studies based on interviews are only marginally
considered here as they are the focus of Holland (2002).
7. See Kothari (2001) and Brown (1993, 1997) for a thorough discussion of the accuracy of
analysts' earnings forecasts and their possible explanations.
8. Brown (1998) reports that the mean bias has decreased from 2.6 cents per share in 1993 to
0.39 cents in 1997.
9. Bartov et al. (2002) have found that companies beating or meeting analysts' forecasts
experience higher subsequent stock returns.
10. Ely and Waymire (1999) concluded that as early as 1927 (in the pre-SEC era) investors
perceived that managers overstated earnings through earnings capitalization.
11. See Lev (2001) for an interesting discussion of the politics of intangibles disclosures.
12. See www.eu-know.net and www.efs.dk/icaccounts
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