Economic persistence, earnings informativeness, and stock return regularities
- PDF / 903,932 Bytes
- 38 Pages / 439.642 x 666.49 pts Page_size
- 91 Downloads / 235 Views
Economic persistence, earnings informativeness, and stock return regularities Kai Du1
· Steven Huddart1
© Springer Science+Business Media, LLC, part of Springer Nature 2020
Abstract We propose a simple framework for understanding accounting-based stock return regularities. A firm’s accounting reports provide noisy information about hidden economic states that evolve according to a Markov process. In response to the accounting reports, a representative Bayesian investor forms beliefs about the underlying state and hence the value of the firm. For a population of such firms, the model provides predictions consistent with two sets of well-documented regularities: (i) the market reaction to an earnings announcement that ends a string of consecutive earnings increases and (ii) the return predictabilities based on accruals and book-tax differences. The model also yields novel cross-sectional predictions about the distinct roles of economic persistence and earnings informativeness. We confirm these predictions through empirical tests. Keywords Economic persistence · Earnings informativeness · Earnings strings · Accruals anomaly · Book-tax differences anomaly JEL Classification G12 · M41
1 Introduction Empirical research in accounting and finance identifies a number of regularities in the relation between stock prices and earnings reports (Kothari 2001; Richardson et al. 2010). Even though researchers have attributed these regularities to various economic, behavioral, and institutional factors, the causes are still debated. Two concepts
Kai Du
[email protected] Steven Huddart [email protected] 1
Smeal College of Business, Pennsylvania State University, University Park, PA, USA
Kai Du, Steven Huddart
underlie many explanations: economic persistence (i.e., the process driving the firm’s economic profitability) and earnings informativeness (i.e., the information about the underlying state of the firm contained in its earnings reports). We propose a simple model of a firm and its reporting system that parsimoniously captures both economic persistence and earnings informativeness. The firm is in one of two underlying states (“high” or “low”), and the accounting system reports one of two possible signals each period. From the history of accounting signals, a representative investor forms a belief that the firm is in a certain state. The stock price is set by this belief because the value of the firm is determined solely by its present state. Given that the earnings signals imperfectly indicate the firm’s underlying state and that its state can change from one period to the next, the stock price does not stabilize or settle down. Instead, there is typically a price change in response to each new signal. Though the model features a single firm and a representative investor, we apply it in a way that resembles how an empiricist detects patterns based on a large number of idiosyncratic firms. This “frequentist” perspective has also been adopted in prior theories that attempt to explain empirical regularities through a represent
Data Loading...
