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Review of Accounting Studies

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01-06-2011

Conditional versus unconditional persistence of RNOA components: implications for valuation

Authors: Eli Amir, Itay Kama, Joshua Livnat

Published in: Review of Accounting Studies | Issue 2/2011

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Abstract

Financial analysis often involves decomposing variables into components, emphasizing the structured hierarchy among ratios. We distinguish between unconditional persistence (a variable’s autocorrelation coefficient), and conditional persistence (the power of a variable’s persistence to explain the persistence of a variable higher in the hierarchy). We argue that a variable’s conditional persistence determines the magnitude of its market reaction, allowing us to predict the relative magnitude of the market reaction to a ratio depending on its hierarchal level in the analysis. We examine the market reaction to the DuPont ratios and find that, while the unconditional persistence of asset turnover (ATO) is larger than that of operating profit margin (OPM), the conditional persistence of OPM is larger than that of ATO. Thus, we predict and find that the market’s reaction to OPM is stronger than that to ATO. We further decompose OPM and ATO into their second-order components and show that the market reaction depends on a component’s conditional persistence.

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See also Cottle et al. (1988); Penman (2010); Palepu et al. (2004); White (2003).

Most market reaction studies examine the effects of earnings (Lev and Ohlson 1982; Lev 1989; Kothari 2001; Holthausen and Watts 2001; Dechow and Schrand 2004) and revenues (Jegadeesh and Livnat 2006) on stock returns, but have virtually ignored the effects of financial ratios on short-window returns. This could be because prior databases did not enable researchers to identify the precise line items that were disclosed in the preliminary earnings release as compared with those that became public only through the 10Q/K filings with the Securities and Exchange Commission (SEC). Also, SEC filing dates were largely unavailable to researchers in databases.

We repeated the entire analysis with pre-tax profit instead of after-tax profit and with total assets instead of net operating assets. The results are very similar to those reported here.

In terms of Compustat quarterly item numbers: COI = (#69 + [(#22 − #31 − #32) × (1 − MTR)] − #26)/#2; NOA = #59 + #53 + #45 + #51 + #55 − #36; Net Revenues = #2. GPM = [(#2 − #30) × (1 − MTR)]/#2; WCTO = #2/(#37 + #38 + #39 − #46 − #48 − #47); FATO = #2/#42; MTR = is the annual federal and state tax rate.

See related discussions and a description of the Charter Oak database in Jegadeesh and Livnat (2006).

The unconditional persistence measures are larger for the high market value of equity sub-sample (significant at the 0.05 level for all variables except for P(UOPM) and P(UWCTO)).

We repeated the analysis using firm-by-firm time series regressions. The results are qualitatively the same.

This argument is similar to that raised by Ohlson and Penman (1992), although they argue that absent measurement error, each component of earnings should be valued the same.

The average coefficient on SUE is significantly higher (at the 0.01 level) than that on SURG in the long window (Panel A) but the difference between the average coefficients is not significant in the short window.

We also used a window starting 2 days after the current SEC filing date until 1 day after the next preliminary earnings announcement date (if the next preliminary earnings announcement date was unavailable, we used a window of 90 days after the current preliminary announcement date) obtaining very similar results.

The importance of unexpected changes in asset turnover in predicting stock returns is related to the finding that changes in NOA predict stock returns (Fairfield et al. 2003; Hirshleifer et al. 2004; Penman and Zhang 2006).

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Title: Conditional versus unconditional persistence of RNOA components: implications for valuation
Authors: Eli Amir
Itay Kama
Joshua Livnat
Publication date: 01-06-2011
Publisher: Springer US
Published in: Review of Accounting Studies / Issue 2/2011
Print ISSN: 1380-6653
Electronic ISSN: 1573-7136
DOI: https://doi.org/10.1007/s11142-010-9138-z

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