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Weekly UpdatesAbstract This paper examines the valuation effects of earnings and two nonearnings-based measurements (book values and operating cash flow) on security prices of airline companies under two different market structures: regulated and deregulated. The literature lacks empirical evidence in examining the relative importance of earnings and nonearnings accounting-based measurements in regulated and deregulated markets, especially in the airlines industry. We compare coefficient estimates of regressing stock prices on earnings, book value, and cash flow from operations of airline companies during regulated and deregulated times. A control sample of manufacturing companies is also used for supporting inferences from the airline sample's findings. In a typical regulated market, using cost recovery plus an adequate rate of return on assets, security prices are highly aligned with nonearnings measurements such as the book value. In the airline industry, regulation took the form of guaranteed routes and subsidies to service rural areas, giving rise to a differential effect of both earnings and nonearnings measurements. Under deregulation, airline firms operate in highly competitive markets with large airline firms enjoying the benefits of economy of scale and service diversification. Thus, the asset capitalization (book value), cash flow, and operational efficiencies (earnings) would be major indicators in the market assessment of the firm's future profitability and security price. This paper finds that nonearnings measures have higher explanatory power of security prices in regulated times for the airline firms. In deregulated times, although earnings have a stronger relationship with prices, nonearnings measures continued to influence stock price levels, reflecting airline specific economics.
Keywords Regulated markets * Valuation relevance. Earnings and nonearnings information. Airline industry
Introduction
Investors use accounting reports and disclosures, among other publicly available information, to assess the risk and value of firms. Prior research has indicated that the value relevance of specific accounting information may vary depending upon the industry's regulatory environment. For example, regulated industries do not exhibit the same reaction to earnings announcements as do nonregulated ones (Teets 1992). The operating risk of a firm in a regulated industry is reduced compared to those in nonregulated industries where earnings are more stable and predictable. We examine the valuation importance of earnings and non-earnings accounting measures in the airline industry between two different economic environment periods: regulated and deregulated. The two alternative nonearnings measures we use are book value and cash flow from operations.
The airline industry was regulated through guaranteed routes and fares until 1976 when the Civil Aeronautics Board (CAB) began to voluntarily relax its control over the industry. This phase-out period ended with the passage of the Airline Deregulation Act in 1978. The emergence of this industry from regulation to non-regulation provides a unique opportunity to test the value relevance of accounting information within the same industry but between two different economies. This is a more accurate test than prior research which uses random samples of non-regulated firms to assess the differential effect of accounting information. This random sample approach may subject the results to industry and size effects which are known to affect firm value.
Prior Research
Firms in regulated industries generally enjoy rates that insure achieving a normal rate of return on their assets based on an appropriate cost of capital. They enjoy some degree of certainty because of guaranteed markets and rates of return. As a result, a regulated firm's operating risk would normally be lower than that of a firm in a nonregulated industry. Teets (1992) compares the earnings response coefficients (ERC's) for electric utilities with a random sample of nonregulated firms drawn from a sample of firms identified by Brown et al. (1987). He finds that the ERC for the utilities are more tightly clustered than for nonregulated firms and have a much smaller average ERC than for nonregulated firms. This result is consistent with the notion that the effects of unexpected earnings are less permanent for utilities.
Nwaeze (1998) studies the relative contribution of income statement items to the valuation of electric utilities using a matched sample (by size) of manufacturing firms to highlight the effect of regulation. Among his findings are: 1) there is considerable alignment between market value and book value for electric utilities, 2) the contribution of earnings levels in explaining market value diminishes significantly in the presence of book values for electric utilities, whereas 3) earnings levels compliment book values in explaining market valuation of manufacturing firms, and 4) earnings change compliments earnings levels in explaining market values of manufacturing firms. Therefore, balance sheet book value is more closely aligned with utilities than with manufacturing firms whereas earnings levels and earnings changes are important in explaining the market value of manufacturing firms. These results are explained by the fact that in regulated industries, rates of return and guaranteed markets are assured.
In addition to book values, there are other nonearnings accounting information that can be value relevant. For example, in a study to assess the relative valuation importance of earnings and cash flow, DeFond and Hung (2003) document that financial analysts place more weight on cash flow than earnings for firms with higher capital intensity and poorer financial health. Firms with higher capital intensity rely more on cash flows for routine maintenance and asset replacement. Investors are more likely to place emphasis on information about liquidity for capital-intensive firms because their assets are less liquid and their probability of financial distress is higher. When a company becomes financially distressed, its cash flows become more important, and its earnings less important in assessing firm value. This is consistent with cash flows providing information about solvency and liquidity, and with operating cash flows being a traditional measure in evaluating credit and bankruptcy risks (e.g., Previts et al. 1994; Beaver 1966). This is particularly relevant to the airline industry as discussed below.
The airline industry was, until 1978, a regulated industry where both airline prices and airline routes were subject to approval of the CAB. The first signs of congressional interest in deregulating the airline industry began in 1970. Reaction to attempts at deregulation of the airline industry was generally greeted negatively by most airlines. Predictions of adverse consequences of deregulation included the creation of inefficiencies as new and inexperienced airlines entered the field creating excess capacity leading to increased costs, heightened price competition, and decreased profitability. This was particularly true of the small and weaker airlines who were concerned, once the industry was deregulated, about their ability to compete on price and routes with the larger more financially able firms.
Concern that deregulation would negatively impact share prices was also evident in the transformation of interstate trucking from regulation to deregulation. Schipper et al. (1987) studies the effect of regulatory changes on shareholder wealth resulting from the Motor Carrier Act of 1980. This act had the effect of making truck-operating rights easier to secure and thereby allowing entry into new markets, which changed the rate setting practices of the past. The results of Schipper et al. (1987) demonstrates that several of the regulatory changes made prior to enactment of the Motor Carrier Act of 1980 resulted in negative share price reactions and reduced shareholder wealth owing to fear that deregulation will lead to increased competition in both routes and pricing.
Events and hearings on deregulating the airline industry continued for 8 years and through two political administrations before the Deregulation Act was signed on October 10, 1978. Industry profits at the time deregulation became law were approximately $1.4 billion and tumbled to a loss of approximately $225 million in 1980 (Davidson et al. 1984). The immediate post deregulation period was also characterized by an increase in capacity that peaked in the early 1980's. The resultant overcapacity and financial losses led to a period of active merger activity (Kyle et al. 1992). From 1985--1987, fourteen mergers of airlines were completed in an attempt to restructure the airline industry. The extensive merger activity resulted in positive abnormal returns for both the target (14.5%) and the bidding firm (3.7%) over the 3 day period surrounding the merger announcement date (Kyle et al. 1992).
The transformation of the airline industry from being regulated to deregulated provides a unique setting to test hypotheses concerning the impact of earnings announcements on market valuations in a specific industry. E1-Gazzar et al. (2003) test the impact of earnings announcements in three distinct economic environments as the airline industry went from regulation to partial regulation (transition period) to full deregulation. Using both a revaluation index (RI) and a standardized revaluation index (SRI) they conclude that earnings announcements do contain information content during each period and that the relevance of accounting information increases as the industry goes from regulation to deregulation. This supports the notion that in a deregulated environment there is greater competition resulting in more risk and uncertainty for the investor in valuing securities. According to the authors, earnings have more value relevance in competitive markets than in regulated ones.
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