Content area
Full text
SYNOPSIS: We document a phenomenon that, along with the increasing trend of negative earnings, the frequency and the magnitude of negative book value of equity have also grown substantially over time. Although negative-book-value firms are commonly perceived as financially distressed, we find that the majority of these firms survive for a long time, and that many continue to report negative book value for several years. Over the most recent decade of our 30-year test period, 1976-2005, we find that based on per-dollar of assets, the market, on average, prices negative-book-value firms higher than positive-book-value firms. In addition, we discover that the correlation between market value and book value for negative-book-value firms is negative. Searching for explanations of these phenomena, we examine R&D expenditures of negative-book-value firms. Our results indicate that R&D, especially R&D accumulated over time, not only contributes to the increasing trend of negative-book-value incidences, but also plays an important role in the market's valuation of firms that concurrently report negative earnings and negative book value.
Keywords: book value of equity; negative book value; valuation; losses; R&D; accounting conservatism.
Data Availability: The authors will make their data available for use by others in extending or replicating results reported in this article.
The accounting literature well documents that the frequency of reported losses has increased significantly over recent decades.1 Existing studies show that traditional earnings-based valuation models cannot explain equity value when earnings are negative or extremely low. In such cases, book value of equity replaces earnings to play a pivotal role in equity valuation (e.g., Jan and Ou 1995; Collins et al. 1999; Burgstahler and Dichev 1997; Barth et al. 1998). These studies suggest that when earnings are negative, these earnings do not reflect future earnings expectations. Instead, in such cases, book value of equity becomes an important indicator of value, because it proxies for the abandonment/adaptation value of loss firms that are in distress and provides information about future normal earnings of loss firms whose earnings are only temporarily low.
In this paper, we show that along with an increasing trend of negative earnings in income statements, the frequency of negative book value of equity reported on balance sheets grows substantially over a three-decade period (1976-2005), especially among firms that report losses....