Wall Street Loves to Round Up

Last week, the WSJ highlighted a fascinating study. Two academics looked thousands of earnings reports down to the tenth of a cent. They found an unusual dearth of earnings-per-share that fell on the 0.4 cent level. This implies that a larger-than-expected amount of companies were trying to round up their EPS to the next whole cent.

(T)he overall effect is striking. In theory, each digit should appear in the 10ths place 10% of the time. After reviewing nearly 489,000 quarterly results for 22,000 companies from 1980 to 2006, however, the authors found that “4” appeared in the 10ths place only 8.5% of the time. Both “2” and “3” also are underrepresented in the 10ths place; all other digits show up more frequently than expected by chance.
Companies tracked by Wall Street analysts are less likely to report “4s” in the 10ths place of an earnings-per-share figure particularly when their results are close to analysts’ predictions. Companies with high price-to-earnings ratios also report fewer “4s.”
In their most intriguing finding, the authors found that companies that later restate earnings or are charged with accounting violations report significantly fewer 4s. The pattern “appears to be a leading indicator of a company that’s going to have an accounting issue,” Mr. Grundfest said.

Missing earnings can be a big deal. As is often the case, the scandal isn’t that people are breaking the rules. The scandal is what the rules allow. Companies have enormous latitude with their earnings reports. This is one of the reasons why I stress investing in high-quality companies. I have much greater faith that companies like AFLAC (AFL) or Johnson & Johnson (JNJ) won’t abuse the rules.

Posted by on February 22nd, 2010 at 9:44 am


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