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In a recent study, published in European Accounting Review (EAR), Niklas Kreilkamp, Sophie Teichmann and Arnt Wöhrmann examine the effect of cost stickiness on corporate valuation using peer-based valuation.
Peer-based valuation is a popular method —particularly from a practitioner's perspective— to derive an estimate of firm value. This is achieved by multiplying a value indicator (such as the target’s EBITDA) with the corresponding pricing multiple derived from a peer group. It is assumed that if the law of one price holds, i.e., if identical goods are traded at the same price, the firm’s intrinsic value is sufficiently well approximated.
Researchers have made multiple suggestions on how to improve peer-based valuation, for example by considering accounting comparability or fundamental value drivers during the peer group selection process. Taking a management accounting perspective, our study adds to this stream of research by investigating the effect of cost management strategies on peer-based valuation. More precisely, we examine how asymmetric cost behavior (also termed ‘cost stickiness’) affects valuation.
Cost stickiness describes the empirical phenomenon that costs increase more with increasing activity than they decrease with decreasing activity. This cost behavior contradicts the traditional model in accounting assuming that variable costs change proportionally with the level of business activity while fixed costs do not. One explanation why cost stickiness materializes is that if sales decrease, managers must decide whether to keep capacity levels constant and incur the costs of unutilized resources or reduce capacity and accept both, immediate retrenchment costs as well as future restoration costs. If managers believe that the decrease in sales is temporary, they delay capacity reductions.
Using a sample of 20,132 firm-quarter observations of U.S. firms from 2000 to 2016 we find that the higher the level of the target’s cost stickiness compared to its peer group, the more is the target’s market value underestimated if the peer-based valuation method is used. We provide two reasons for this finding. First, while cost stickiness results in a lower value indicator (such as EBITDA) and thus lower firm value estimates, it does not necessarily reduce the firm’s market value. This is because investors understand that cost stickiness signals management’s positive expectations concerning future firm performance. Second, if future expectations are more positive for the target firm compared to the peer group using the market value of peer group firms to estimate the intrinsic value of the target again results in underestimation. Our study also shows that when cost stickiness is driven by non-value-orientated reasons (i.e., agency motives), the level of underestimation is reduced.
Interestingly, our study does not only show that cost stickiness results in biased value estimates but also that in many cases incorporating information about cost management strategies in peer-based valuation models improves peer-based valuation.
To read the full paper, visit https://www.tandfonline.com/doi/full/10.1080/09638180.2021.1976662