Recall from the previous section that earnings at extreme levels, both high and low, tend to revert to normal levels over time, a phenomenon called mean reversion. This is a typical characteristic of competitive markets. When a company realizes low earnings, it will abandon its harmful value projects, resulting in improved earnings. Conversely, when it realizes abnormally high profits, it attracts competition leading to a reduction in prices.
Because of mean reversion, analysts should not expect severe earnings (high or low) to continue indefinitely. Earnings comprise of cash flows and accruals. They are more sustainable and persistent when the cash flows dominate earnings. Additionally, when earnings have a significant accruals component, mean reversion occurs faster—and even more so when the accruals are mostly discretionary.
Elodie Juliet, a research analyst, is analyzing the earnings quality for ABC Ltd. She compares ABC’s financial statements with those of a peer competitor. Both companies have similar, above-average returns on equity (ROE), although ABC Ltd. has a higher cash flow component of earnings. Juliet applies the mean reversion concept in her forecasts of the two firms’ future ROE.
Juliet should forecast that the return on equity (ROE) for ABC Ltd. is most likely to decrease:
A. Faster than that of the peer competitor.
B. At the same rate as the peer competitor.
C. Slower than that of the peer competitor.
The correct answer is C.
According to the mean reversion phenomena, the high ROE for both firms should revert towards the average (mean). ABC Ltd. has a higher cash flow to its earnings (returns) than the peer company. This implies that its high return on common equity is likely to persist longer than that of the peer company.
A and B are incorrect. The peer company has a higher accruals component, so it is likely to revert more quickly than ABC Ltd.
Reading 15: Evaluating Quality of Financial Reports
LOS 15 (g) Explain mean reversion in earnings and how the accruals component of earnings affects the speed of mean reversion.
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