| dc.description |
We hypothesize that when confronted with a loss, investors price earnings conditional on the expected probability
of the firm's return to profitability. We show a parsimonious model of one year-ahead loss reversal is useful in
predicting the firm's return to profitability. Using the estimated probabilities of loss reversal to define samples of
persistent (low probability of reversal) and transitory (high probability of reversal) losses, we show the pricing of
losses, as well as their characteristics, varies as a function of their expected probability of reversal. We document a
more pronounced stock price response to a transitory loss consistent with investors assessing the likelihood of
exercising the abandonment option to be smaller. We also find the market responds negatively to persistent losses,
especially in the latter part of the sample period. We also show the results are consistent with investors pricing the
components of losses differently depending on the type of loss: they value only the aggregate accruals component
of persistent losses and only the aggregate cash flow component of transitory losses. Further analysis shows the
result for persistent losses relates to the presence of an increasingly larger R&D component that investors price
negatively as if rewarding firms that make larger R&D outlays with larger returns. One consequence of the
presence of a growing R&D component implies persistent losses become a weaker indicator of the likelihood of
exercising the abandonment option. |
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