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

Although several studies have examined how investors value domestic versus foreign earnings, the results are inconsistent. We reexamine this question employing a variance decomposition model, which in contrast to extant 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 number of institutional owners or the percentage of institutional holdings. These 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, and with the agency explanation offered by Denis, Denis and Yost (2002) for the dominance of domestic earnings. Our results also supplement the literature on the role of sophisticated investors which shows that these investors are better able to analyze and incorporate information pertaining to firms' operations than other investors.