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Review of Quantitative Finance and Accounting

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06-02-2017 | Original Research

Earnings quality and the heterogeneous relation between earnings and stock returns

Authors: Helena Isidro, José G. Dias

Published in: Review of Quantitative Finance and Accounting | Issue 4/2017

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Abstract

We adopt a heterogeneous regime switching method to examine the informativeness of accounting earnings for stock returns. We identify two distinct time-series regimes in terms of the relation between earnings and returns. In the low volatility regime (typical of bull markets), earnings are moderately informative for stock returns. But in high volatility market conditions (typical of financial crisis), earnings are strongly related to returns. Our evidence suggests that earnings are more informative to investors when uncertainty and risk is high which is consistent with the idea that during market downturns investors rely more on fundamental information about the firm. Next, we identify groups of firms that follow similar regime dynamics. We find that the importance of accounting earnings for returns in each of the market regimes varies across firms: certain firms spend more time in a regime where their earnings are highly relevant to returns, and other firms spend more time in a regime where earnings are moderately relevant to returns. We also show that firms with poorer accrual quality have a greater probability of belonging to the high volatility regime.

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For a review of earnings-based models, see Penman (2012).

In this paper we take the common view that value relevance is a direct measure of the usefulness of earnings to stock returns (Joos and Lang 1994; Collins et al. 1997; Francis and Schipper 1999; Lev and Zarowin 1999; Barth et al. 2001; Francis et al. 2004). Other ways of assessing the usefulness of earnings include: market reaction to earnings announcements (Ball and Brown 1968; Beaver 1968), correlation between earnings and cash flows (Lev et al. 2010), and reliability of earnings-based models (Dechow et al. 1999; Francis et al. 2000).

For example, Kim et al. (2012) use portfolio tests and find that accounting earnings are not more useful for investors than cash flows or working capital.

A review of the earnings quality metrics is beyond the scope of our study. See for example Dechow et al. (2010) for an extended review of earnings quality and Walker (2013) for accrual based measures.

The earnings variable represents the “stock” element and the earnings change variable represents the “flow” element in the model (see for example Penman (2012) for a revision of earnings-based models). The correlation between the two variables is 0.42.

Regarding the industry and quarter indicators included in the model (not tabulated) we find the following results. In the high volatility regime, industries 1 (agriculture), 4 (transportation and communication) and 7 (services) are significantly different from industry 3 (industrial and electronics), and quarter 2 is significantly different from quarter 1. In the low volatility regime, industries 1 and 6 (finance) are significantly different from industry 3, and quarters 2 and 3 are significantly different from quarter 1.

Results on model selection are available from the authors upon request. We also experimented other solutions in terms of number of regimes and clusters. However, based on the BIC selection criterion, we conclude that a model with two regimes and two clusters is the best. The solution with two regimes is in line with the finance literature that suggests stock markets alternate between boom and downturn periods. This way the two regime solution has the advantage of allowing simple economic interpretation of the results.

To avoid bias due to the use of earnings in the returns regime switching model, we do not estimate measures of earnings quality that rely on stock returns. This way we ensure there is no mechanical relation between the regime switching model and the earnings quality models.

Another relevant firm fundamental that is not included in the model is cash flow volatility (standard deviation of cash flow from operation scaled by total assets over the eight quarter window). We do not include it in the tabulated results because Compustat does not report cash flow from operations for several sample firms and thus including the variable would reduce considerably the number of observations. When we re-estimate the model including cash flow volatility we obtain the same results for earnings quality and find that cash flow volatility is higher for cluster 2 firms but only in the persistence and smoothness models.

Using the mean values yields similar results.

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Title: Earnings quality and the heterogeneous relation between earnings and stock returns
Authors: Helena Isidro
José G. Dias
Publication date: 06-02-2017
Publisher: Springer US
Published in: Review of Quantitative Finance and Accounting / Issue 4/2017
Print ISSN: 0924-865X
Electronic ISSN: 1573-7179
DOI: https://doi.org/10.1007/s11156-017-0619-z

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