Research Insights

Crunching numbers is essential to investment success, but often times the role of accounting is left behind. Professor Guochang Zhang, Head of Accounting at HKU Business School, wants to see a change in the way investors view company valuation, by bringing accounting to the centre stage of valuation theory.

“In the past few decades academics have neglected the role of accounting in valuation theory, but it is absolutely essential: ‘we need to map out the path of value generation through a firm’s decisions that rely on accounting information,” says Professor Zhang. Studying the relationship between accounting data and firm value has been one of Professor Zhang’s passions, “we are in a world where accounting information and financial reporting events greatly impact stock prices and returns, along with other market activities.

Professor Zhang published his first theoretical models on this subject in 2000, as he felt the issue of effectively processing information was crucial to the overall health of the capital market. “People use accounting information for many economic decisions, and it is considered the language of business. I observed the theories we had been using were mostly coming from finance, which generally ignore accounting information, and to me this is puzzling,” he says. Without connecting to this language of business, these theories tend to lack power to explain observed stock prices and returns

Driving knowledge from an accounting point of view

Professor Zhang has believed throughout his career that there is plenty of room for developing accounting-based theory. “People are using the information, watching companies’ performance releases, and prices react. Investors can benefit from having a more carefully thought-through model or theoretical framework, so they would be able to think and analyse data in a more systematic way, rather than using simple heuristics or getting fixated on a single performance measure like earnings,” he says.

When investors open a financial report, they can be easily overwhelmed by the vast amount of data items, and this had motivated Professor Zhang to develop a more holistic view by taking into consideration the different aspects of the financial report, not just earnings. “We are basically interested in how investors should extract and use information. While investors indeed look at accounting data very closely, the techniques they conventionally use are not most scientific for mapping financial data to firm value. And it’s a daunting task to deal with so many numbers and touch points,” says Professor Zhang. “Users need to process data efficiently, by extracting core information, and to gain a thorough understanding of the underlying operation that the financial report portrays,” he adds.

Proper functioning of capital markets depends heavily on investors’ ability to obtain information, and the financial reporting that firms regularly perform conveys a vital source of company information—which directly speaks to business activities. Researchers previously discovered that accounting information did indeed have an immediate impact on stock prices. Despite this, it was not so well understood how investors sift through reporting data to discover prices and in particular what constitutes the core set of information. Professor Zhang’s research demonstrates why it is inadequate to rely on a single performance metric like earnings. A comprehensive view of a business operation requires information along five dimensions: earnings, profitability (efficiency), capital investment, growth, and risk.

Studies have shown that accounting information plays an important role in reflecting the stock price.

“The theory can be useful in terms of offering a common understanding, and providing a structured way to process financial reporting data. There are numerous investors in capital markets; for serious investors, they need to go through the numbers and figure out the state of the business. Conventional techniques can be crude and inaccurate, such as treating companies in the same industry as “comparable”, says Professor Zhang.

Getting down to the nitty gritty

Take any industry as an example such as e-commerce. There are a multitude of firms, and we cannot assume that firms in the same industry generate similar returns from their investment. Firms have different efficiency levels, and the returns they earn can vary widely, so a theory that internalises the effects of operational efficiency and other firm-specific characteristics will enable investors to better identify “comparable firms”, leading to more well-justified, and more accurate, valuations. The conventional techniques which investors rely on are susceptible to large errors.

Realistically, accounting information also has limitations. “Financial numbers do not automatically speak for the future, especially when firms are expected to growth or are operating in volatile environments. At times of huge uncertainties such as the public health crisis we are facing now and with political and international relations, it’s a big challenge to figure out growth opportunities and future prospects,” says Professor Zhang.

Many people in the profession have thus asked: how important is financial reporting information in driving stock price changes? Fundamentals are always important, but observers will have to take into account other factors. One is the slowness of markets in processing the entire set of core fundamental information — pertaining to all five dimensions of operations, as discovered by Professor Zhang and his collaborators. This puts into doubt the validity of the efficient-market hypothesis (EMH) which has predicted that asset prices reflect all available information quickly and accurately. There thus needs to be a rethinking of EMH as a conceptual benchmark — whether it is realistic. Looking more closely at how markets operate, we realise that the types of information that firms disclose pertain to either operational activities or events that affect operations. Although such information is useful for valuation, it is not a close proxy for firm value as was assumed by EMH.

“Financial forecasting combines both internal characteristics, which can be conveyed by financial reporting information, and the external environment and outlook, which is not well captured by this information. When the external condition gets volatile, the challenge is amplified and investors get jittery, so you see sudden market movements and drastic fluctuations. In this situation the mood regarding the future is unreliable and can be easily pushed around by little bits of information,” says Professor Zhang.

Data accuracy also plays a part. “When examining a specific company, we should be very careful in interpreting data, as there are many possibilities of distortion and manipulation in reported numbers—these numbers also happen to affect managers’ pay package and reputation. Nonetheless, when we do large sample analysis, the general trends will emerge, so on average you can still capture the broad trends,” says Professor Zhang. “We generate results that speak to the overall market, and in the end we can demonstrate general relationships,” he adds.

“There are many possibilities to distort or manipulate numbers as it affects their pay package and reputation”

For the future, Professor Zhang seeks to contribute to the accounting field by offering more conceptual understanding beyond bookkeeping. He would like to see a wider recognition and appreciation of the importance of accounting for the real economy and financial markets. “The academic field could be lifted by developing a more unified framework for valuation, contracting, and other uses of accounting information, and by bridging the fields of finance and accounting,” says Professor Zhang.