The Valuation of Domestic and Foreign Earnings and the Impact of Investor Sophistication

Abstract

Although several studies have examined how investors value domestic versus foreign earnings, the results are inconsistent. We re-examine this question employing a variance decomposition model which, in contrast to previous research, explicitly considers expectation models for domestic and foreign earnings and allows for time varying discount rates. We document that investors value domestic earnings significantly higher than foreign earnings. We further find that the relative valuation of foreign earnings is an increasing function of the degree of investor sophistication, measured as either the percentage of institutional holdings or the number of institutional owners. Finally, when we classify institutional investors as short-term and long-term following Bushee (1998), we find that the relative valuation of foreign earnings increases with the level of investment by long-term investors. In contrast, there is no significant relation between the degree of ownership by short-term (or transient) investors and the relative valuation of domestic and foreign earnings. Overall, our results are consistent with Thomas' (1999) finding that investors on average underestimate the persistence of foreign earnings due to lack of understanding of firms' foreign operations caused in part by poor disclosure.

Keywords: Foreign earnings, valuation, investor sophistication

JEL Classification: M41, G12, G14, G23