Earnings beta
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Earnings beta Atif Ellahie 1 # Springer Science+Business Media, LLC, part of Springer Nature 2020
Abstract The literature on cash flow or earnings beta is theoretically well-motivated in its use of fundamentals, instead of returns, to measure systematic risk. However, empirical measures of earnings beta based on either log-linearizing the return equation or log-linearizing the clean-surplus accounting identity are often difficult to construct. I construct simple earnings betas based on various measures of realized and expected earnings and find that an earnings beta based on pricescaled expectations shocks performs consistently well in explaining the crosssection of returns over 1981–2017. I also examine the relation between different measures of beta and several firm characteristics that are either theoretically connected to systematic risk or are empirically associated with returns and find evidence in support of the construct validity of an earnings beta based on pricescaled expectations shocks. Overall, the findings suggest that this easy-toconstruct earnings beta can be suitable for future researchers requiring a measure of systematic risk. Keywords Cash flow beta . Earnings beta . Systematic risk . Expected returns . Aggregate
earnings JEL classifications G10 . G12 . M41
1 Introduction The search for a measure of systematic risk that is priced in the cross-section of returns is an important objective of asset pricing research. Motivated by the failure of returns-based market betas to explain the cross-section of returns, recent research has examined cash flow betas. These betas are theoretically appealing, * Atif Ellahie [email protected]
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David Eccles School of Business, University of Utah, 1655 E Campus Center Drive, Salt Lake City, UT 84112, USA
A. Ellahie
as they allow for a direct link between cash flow fundamentals and systematic risk. Most studies measure the cash flow fundamentals needed to estimate betas by either log-linearizing the return equation, following Campbell and Shiller (1988), or log-linearizing the clean surplus accounting identity, following Vuolteenaho (2002). However, the empirical implementation of these two approaches to construct measures of beta presents challenges. Instead, motivated by the positive empirical relation between returns and earnings at the firm level, I consider accounting earnings as a summary measure of cash flow fundamentals. I construct simple earnings betas based on various measures of realized and expected earnings using different scalars and empirically examine their relative performance in explaining the cross-section of portfolio-level and firm-level returns. I also examine the relation between these beta estimates and firm characteristics that are either theoretically connected to systematic risk or are empirically associated with returns, to assess the construct validity of the different earnings betas and illuminate whether certain characteristics explain returns because they indirectly reflect systematic risk. Studies use one of two
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