The dark side of earnings response coefficient : the role of ERC in future stock crash risk prediction

Abstract

This study tries to explain individual crash risk from the perspective of valuation theory. We find that a higher Earnings Response Coefficient (ERC) predicts a higher probability of price crash than a lower ERC. This finding can be explained by investors' misevaluation of earnings persistence and systematic risk of the firm, which is also related to the bad news hoarding hypothesis. If managers hold back the bad news, this would prevent the investors from correcting their valuation of the systematic risk, hence resulting in a higher ERC and higher crash risk. Consistent with prior literature on earnings opacity, we find that the valuation theory could explain the increasing crash risk, which is further supported by cross-sectional analyses.