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Economic determinants of the relation between earnings changes and stock returns

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Financial Markets and Investment Strategies Corporate Finance and Governance Financial Analysis and Corporate Governance

Abstract

SYNOPSIS AND INTRODUCTION: In competitive product markets, product prices and thus firms' revenues incorporate the cost of equity capital. In a competitive capital market, the cost of equity capital (the expected return on equity) increases with the risk of firms' investments. Because accounting earnings are calculated without deducting the cost of equity capital, they are expected to be an increasing function of firms' investment risks. This simple competitive equilibrium analysis predicts a positive relation between changes in investment risk and expected earnings. The presence of corporate debt complicates the analysis because leverage effects seem likely to affect the relation between changes in investment risk and expected earnings. Using annual earnings and return data from 1950 to 1988, we document a statistically significant positive association between changes in equities' relative risks and in earnings. However, on average, only a small proportion of changes in earnings can be attributed to changes in risk. A much larger proportion is attributable to changes in economic rents (windfall gains and losses). The observed positive association between changes in earnings and changes in equities' risks suggests that leverage effects do not fully offset the effect of changes in investment risks. This

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References

1968An Empirical Evaluation of Accounting Income Numbers 1992The investment opportunity set and corporate financing, dividend, and compensation policies 2011The effects of bonus schemes on accounting decisions 1983Size-related anomalies and stock return seasonality 1975Price performance of common stock new issues 1976Capital market seasonality: The case of stock returns 1990Data-Snooping Biases in Tests of Financial Asset Pricing Models 1987Earnings Innovations, Earnings Persistence, and Stock Returns

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