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Familiarity bias and earnings-based equity valuation

March 2021
Review of Quantitative Finance and Accounting 57(2):1-24

Authors:

Shanghai University of Finance and Economics

This study examines whether investors’ familiarity bias affects their earnings-based equity valuation. Building on theoretical and empirical findings from prior studies, we hypothesize that familiarity bias may reduce the earnings-based equity valuation of foreign firms. We also hypothesize that the perceived link between current earnings surprises and future operating cash flows is one channel through which familiarity bias affects earnings-based equity valuation. Using the setting of the earnings announcements of U.S.-listed non-U.S. firms and U.S. firms matched by industry, year, and firm characteristics, we find that U.S. investors discount the earnings response coefficient of non-U.S. firms relative to that of U.S. firms by 46%. Using analysts’ earnings forecast revisions immediately following the earnings announcements as the proxy for the market-perceived link between current earnings surprises and future operating cash flows, we find that analysts significantly discount the link for non-U.S. firms relative to U.S. firms. Both discounts exist only in the subsamples of non-U.S. firms toward which U.S. investors have a higher degree of familiarity bias. Thus, we provide empirical evidence of the effect of the familiarity bias on earnings-based equity valuation and the channel through which it affects equity valuation.

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Vol.:(0123456789)

Review of Quantitative Finance and Accounting (2021) 57:795–818

https://doi.org/10.1007/s11156-020-00949-y

1 3

ORIGINAL RESEARCH

Familiarity bias andearnings‑based equity valuation

YashuDong1· DanqingYoung2· YingleiZhang2

Accepted: 20 November 2020 / Published online: 2 March 2021

Abstract

This study examines whether investors’ familiarity bias aﬀects their earnings-based equity

valuation. Building on theoretical and empirical ﬁndings from prior studies, we hypoth-

esize that familiarity bias may reduce the earnings-based equity valuation of foreign ﬁrms.

We also hypothesize that the perceived link between current earnings surprises and future

operating cash ﬂows is one channel through which familiarity bias aﬀects earnings-based

equity valuation. Using the setting of the earnings announcements of U.S.-listed non-U.S.

ﬁrms and U.S. ﬁrms matched by industry, year, and ﬁrm characteristics, we ﬁnd that U.S.

investors discount the earnings response coeﬃcient of non-U.S. ﬁrms relative to that of

U.S. ﬁrms by 46%. Using analysts’ earnings forecast revisions immediately following the

earnings announcements as the proxy for the market-perceived link between current earn-

ings surprises and future operating cash ﬂows, we ﬁnd that analysts signiﬁcantly discount

the link for non-U.S. ﬁrms relative to U.S. ﬁrms. Both discounts exist only in the subsam-

ples of non-U.S. ﬁrms toward which U.S. investors have a higher degree of familiarity bias.

Thus, we provide empirical evidence of the eﬀect of the familiarity bias on earnings-based

equity valuation and the channel through which it aﬀects equity valuation.

Keywords Familiarity bias· Earnings-based equity valuation· Earnings response

coeﬃcients· Analyst earnings forecast revisions

JEL Classiﬁcation G12· G14· G41· M41

We thank conference participants at the 2014 American Accounting Association (AAA) Annual

meeting, and workshop participants at The Chinese University of Hong Kong, Tsinghua University

for helpful comments.Yashu Dong acknowledgesthe ﬁnancial support from the MOE project of Key

Research Institute of Humanities and Social Science in University (No.18JJD790010).

* Yinglei Zhang

yinglei@cuhk.edu.hk

Yashu Dong

dong.yashu@mail.shufe.edu.cn

Danqing Young

dyoung@cuhk.edu.hk

1 Shanghai University ofFinance andEconomics, Shanghai, China

2 The Chinese University ofHong Kong, ShaTin, HongKong

Content courtesy of Springer Nature, terms of use apply. Rights reserved.

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