How do Investors Value IT ?

An Empirical Investigation

of the

Value Relevance of

IT Capability

and

IT Spending Across Industries

MFC, DFS, UDSC

Presented by :

Group No. 1

1. SAI ABHISHEK BHARADWAJ V. (2601)

2. MANIK MADAN (2626)

3. VARUNN KAUSHIK (2642)

4. NITIN (2653)

5. RAHUL JASORIA (2663)

Resource-based theory of the firm

Drawing on

Ohlson’s1995 residual income

valuation framework

This paper investigates the relationships between IT capability

and IT Spending, & Market Value.

INTRODUCTION

Our basis for doing this investigation takes care of following important measures :

1) Industry type ( whether high tech. etc. )

2) Publicly available ratings

3) Firm specific determinants

4) Industry fixed effects

The results are shown to hold using two unique archival data sets :

5) The immediate pre-Internet 1992–1994.

6) The post-Internet Commercialization 1999–2006.

Both are remarkably robust to variations in the control sample, sampling

method, and model specifications.

While going through the presentation : kindly base your thoughts around .....

Keywords:

1) Business value of IT;

2) IT capability;

3) IT spending;

4) Resource-based theory;

5) Market valuation.

Understanding the impact of information technology (IT) on firm performance is a central theme in :

1) Contemporary Information Systems (IS) ; &

2) Accounting Information Systems (AIS).

Important definition to start off :

A firm’s IT capability refers to the firm’s capacity to leverage the potential of information technology by effectively deploying IT

resources in combination or co-present with other resources in the organization;

Thus, it focuses on how IT is used, rather than on, how much the firm spends on IT.

Thus , what is it that makes our research article different from earlier

ones:

A key distinguishing factor of our study is the inclusion of comparative analysis; i.e. simultaneously examine diff. Effects of value relevance of IT Cap. & IT spending on mkt. Values.

Whereas prior studies have included effects of these in isolation from each other.

Also, several problems were associated with earlier studies, viz.:1) Not risk adjusted2) Only captured tangible value component of IT resources3) Based on accounting based data, not always correct.

Framework followed

Identify links between IT capability and IT spending by performing three

related sets of analysis using 2 archival data sets “___________”

1. Using Ohlson’s model and publicly available ratings

2. By adjusting relevant book values, earnings, net dividends, expenses (advertising, R & D) .

3. Derive results and conclusions.

So, let’s move forward.....

1. Theory and Hypotheses

2. Research & Methodology

3. Results

4. Conclusions

5. Bibliography

THEORY AND HYPOTHESES

- The research here investigates here whether investor reward firms with higher IT spending or superior IT capability through increased market valuations.

What is Resource based theory ?

- The resource-based view is the contemporary theory of competition in the strategy literature, and it seeks to explain sources of competitive advantage, sustained or otherwise.

What are the resources taken into considerations?

- The theory ascribes competitive advantage to a firm’s idiosyncratic resources the tangible and intangible assets and capabilities that are used to implement firm strategies

How RBV logic differentiate firms resources ?

- RBV differentiate resources on competitive parity, temporary competitive Advantage and competitive advantage.

- Recently, IS scholars have turned to the RBV to reason about and seek better answers to the question of IT business value and competitive advantage from IT .

- RBV theory, therefore, seems well positioned to inform examinations of the relationship between IT capability and market value.

- A firm’s IT capability tends to be tacit, firm-specific, and developed over a long period of time, and it is often path-dependent and socially complex.

What are the hypothesis drawn Using RBV?

- IT capability value relevant i.e positively related to market value

- IT capability is positively associated with future earnings.

- IT spending related is not value relevant.

- IT spending is not associated with Future earning.

- The value of relevance of IT capability will be greater when the firm is in a high tech industry.

Research and Methodology

The main research question lies in the association between IT capability and IT spending on one hand and market valuation on other.

Two aspects of Data requisition:

1) Categorizing the organizations according IT capability.

2) Devising model focused on explaining the determinants of market value.

Measurement of IT capability

• The IT capability data is based on Information Week special issue IW 500.

• Information Week (IW), a weekly technology magazine based in San Francisco.

• Two time frames of data:

1992 – 1994 (Pre commercialization of internet).

1999 – 2006 (Post commercialization of Internet)

IW’s criterion

• 1992 – 1994 : Forty IT leaders were selected out of 500 companies. The selection was based on the nominations by IT executives with select group Industry analysts and Information systems researchers

• 1999 – 2006 : IW developed a ranking based on ‘quality of companies IT innovations’ acting as a proxy for IT capability.

Market valuation model

• The model devised for research is Residual valuation model (RVM).

• RVM is an approach to equity valuation that formally accounts for the cost of capital.

• RVM is based on basic premise that asset pricing represent the present value of all future dividends.

• The model as represented in the equation

• The model can be

MVEjt =

b0 + b1BVEjt + b2Earningsjt + b3Net_Dividendsjt + Value_relevant_information + e jt.

• The comparative analysis, as the theme of the research, IT related variables are introduced, giving rise to a new model;

• MVEjt = b0 + b1BVEjt + b2Earningsjt + b3Net_Dividendsjt + b4IT_Capabilityjt + b5IT_Spendjt + industry dummies + year dummies + e jt .

• To provide stronger test, the paper included advertising and R & D expenditures potentially value relevant intangible assets.

• A performance halo effect is said to exist when well-performing firms are selected as IT leaders based on their performance rather than on their capabilities.

Performance HALO effect

• Halo effect : The halo effect or halo error is a cognitive bias in which our judgments of a person’s character can be influenced by our overall impression of him or her.

• It is addressed in the paper by conservative approach is to assume that a halo effect does exist, and then determine the impact of IT capability on financial performance, after adjusting for the halo effect.

Adjustment to Halo effect

• Inclusion of return-on-asset of prior year ROAjt−1 to control for the possible halo effect of prior performance.

• Paper includes Sales S to control for firm size.

• Additionally, it includes the one-year sales growth rate SG as a proxy for future.

• Earnings growth and book-to-market value ratio BM as an additional control for future growth potential.

• The final model is as follows:

• MVEjt = b0 + b1BVEjt + b2Earningsjt + b3Net_Dividendsjt + b4IT_Capabilityjt + b5IT_Spendjt + b6ADVjt + b7R&Djt + b8ROAjt−1 + b9Sjt + b10SGjt + b11BMjt + industry dummies + year dummies + ejt .

Accounting Earnings Models

• This model on examinations of the time-series properties of annual earnings, suggests that earnings follow a random walk.

• Combining these two models:

• Future Earningsjt = b0 + b1ADVjt + b2R&Djt + b3BMjt + b4ROAjt−1 + b5Sjt + b6SGjt + b7IT_Capabilityjt + b8IT_Spendjt + industry dummies + year dummies + ejt .

Sample selection and data

• Correlation table (1992-94)

Cont.….

• Correlation table (1999-2006)

Description

The description of variables

Results

The Value Relevance of IT Capability and IT Spending - 1

Examining the association between IT capability and spending and market value

Pre-Internet period Results on basis of accounting books, IT capability added- Higher market value for companies with IT

capability IT spending portrayed separately - significant when included

separately IT spending coupled with IT capability- IT spending becomes

insignificant when IT capability is added.

IT spending, IT capability with controls- No qualitative change after adding controls to companies already considered for IT spending and IT capability.

This result further increases our confidence that IT capability is value relevant

Hypothesis 1a is therefore strongly supported.

Fact that proves it - $1.6 Billion in additional market valuation is due to superior IT capabilities

The Value Relevance of IT Capability and IT Spending- 2

Post Internet Period IT capability is statistically(p<0.01) and economically value relevant

even after controlling for IT spending and other relevant controls. the coefficient on IT spending is not statistically significant even

when IT capability is not included in the model. The results are consistent with the earlier findings of the pre internet

period.

These results prove that while actual hardware and software may have become cheaper and commodity-like, superior IT capability continues to be a source of distinctive advantage.

Robustness Checks

• Deflate variables by size related metric or add a control to the size?• Net income for predicting future earnings?• Results driven by outliers?

To check the sensitivity of the model to the above issues:

I. the specifications were altered while the variables are scaled by two size related metric(shares and assets)

II. Use operating income instead of net income

III. To check the issue of outliers trimming of each sample by the top and bottom 1 percent to rerun the analysis

End Result- with the altered specifications the results were found to be in coherence with the actual results. Also,

a) the coefficient of IT capability remained positive and statistically significant.

b) the coefficient on IT spending remaining insignificant.

Association of IT (Capability and Spending) with Future Earnings

1. For both time periods, the results indicate that IT capability is a significant predictor of positive future earnings, while IT spending is not.

2. In order to mitigate concerns that these results might be driven by outliers, we trimmed the top and bottom 1 percent of the observations based on the dependent variable and reran the models. Results of estimation using the trimmed sample were qualitatively similar to those presented earlier.

3. These results provide strong support for H1b regarding the association of IT capability and future earnings, and the results regarding IT spending are also consistent with expectationsH2b.

Valuation of IT Capability Across Industries

• Introduce dummy variable (High_Tech) and make it interact with (IT_Capability) and (IT_Spend)

• Results- the coefficient on the interaction term between High_Tech and IT_Spend is not significant.

• coefficient on the interaction term between High_Techand IT_Capability is positive:

a) insignificant for the pre internet period

b) significant for the 1999–2006 sample

Results show that IT capability is valued significantly higher for high-

tech firms during the post-Internet period.

With the rise of the internet, the transformative role of IT and hence value of superior IT capability is likely to have become even more pronounced in the increasingly dynamic and turbulent high-technology industries.

Sample composition appears to have changed overtime, with high-technology firms making up a larger proportion of the sample in the post-Internet “new economy” period compared to the pre-Internet period(29 percent versus 24 percent)

Conclusions

Objectives of the paper

• To argue that IT spending and IT capability must be considered while examining the business value of IT at firm level.

• To test that IT capability is intangible asset while IT spending is not

• To test whether the type of industry matters

First Limitation

• Study is based on the Perceptual rating.

• Even after control on Halo effect it still creates a recognizable halo effect.

Second Limitation

• Sustainability of IT capability

• What Sustainability is?

• Factor on which Sustainability depend.

• Are the advantages we have Studied Sustained?

Highlights of the Paper

• Importance of IT in management.

• IT capability is superior to IT spending.

• IT capability is related to future earnings of the firm.

ANY QUESTIONS ???

Hope you had enough of ‘IT’ for today ....