Price and Return Models

EI.
SEVIER Journal of Accounting and Economics 20 (1995) 155-192
Price and return models

S.P. Kothari*, Jerold L. Zimmerman
William E. Simon Graduate School of Business Administration, UniL'ersity of Rochester, Rochester,
NY 14627, USA
(Received March 1993; final version received January 1995)
Abstract
Return models (returns regressed on scaled earnings variables) are commonly ~eferred
to price models (stock price regressed on earnings per share). We provide a framework for
choosing between these models. An econom/cally intuitive rationale suggests that
models are better specified in that the estimated slope coefficients from price models,
but not return models, are unb/ased. Our empirical results confirm that price models"
earnings response coefficients are less biased. However, return models have less serious
econometric problems than price models. In some research contexts the comh;~ed use of
both price and return models may be useful.
Key words: Capital markets; Price-earnings regressions; Earnings response coeffic/ents
J E L classification: MI4; C20
1. Introduction
Researchers in accounting must often choose between return models, in which

returns are regressed on a scaled earnings variable, a n d pr/ce models, in which
* Corresponding author.
We thank Bill Beaver,Andrew Christ/c, N/ck Gonedes, Bob Holthausen, Dave Larcker, John Long,
R/chard Sloan, Charles Trzincka, Mike Rozeff,G. William Schwert, Ross Watts, J~nice Wiltett, and
especially Ray Ball {the editor) for ~.|pfu~ suggestions; Roger Edelen for excellent research a.~st-
ance; and participants at Baruch College CUNY, the Stanford Summer Camp, University of
Glasgow, University of Manchester, Michigan State University, Universityof Pennsylvania,Univer-
sity of Rochester, and SUNY at Buffalo for useful comments. Financ/al support from the Bradk:y
Policy Research Center at the Simon School University of Rochester and from the John M. O~n
Foundation is gratefully acknowledged.
0165-410U95/$09.50 © 1995 Elsev/crSc/cnce B.V. All r/ghtsreserved

SSD/Ol 6 5 4 1 0 1 9 5 0 0 3 9 9 4
156 S.P. Kothari. J.L. Zimmerman / Journal of Accounting and Economics 20 (i 995) 155-192
stock prices are regressed on earnings per share. This paper provides an
economic and econometric framework for assessing whether to use a price
model, a return model, or both. Within the context of a typical valuation model,
we provide an economically intuitive analysis which suggests that the estimated
slope coefficient from the price model, but not the return model, is unbiased. We
then provide empirical evidence on price and return model specifications.
Finally, we draw on previous research to illustrate the contexts in which price
and return models are helpful.
Previous research. Several papers discuss the conceptual advantages and
disadvantages of price and return models. Gonedes and Dopuch (1974) argue
that return models are theoretically superior to price models in the absence of
well-developed theories of valuation. Lev and Orison (1982) describe the two
approaches as complementary, whereas Landsman and Magliolo (1988) argue
that price models dominate return models for certain applications. Christie
(1987) concludes that, while return and price models are economically equiva-
lent, return models are econometrically less problematic. Despite the criticism,
price r,lodels persist (e.g., Bowen, 1981; Olsen, 1985; Landsman, 1986; Barth,
Beaver, and Wolfson, 1990; Barth, 1991; Barth, Beaver, and Landsman, 1992;
Harris, Lang, and Moiler, 1994).
l:~onomic intuition for the return-earnings specification. Both price and return
models begin with a standard valuation model in which price is the discounted
present value of expected net cash flows. Both models also rely on the hypothesis
that current earnings contain information about expected future net cash flows
(e.g., Beaver, 1989, Ch. 4; Watts and Zimmerman, 1986, Ch. 2; Kormendi and
Lipe, 1987; Ohlson, 1991). Since the market's expectations of future cash flows
are unobservable, empirical specifications of the price-earnings relation often
use current earnings as a proxy for the market's expectation.
Current earnings, however, reflect both a surprise to the market and a "staid
component that the market had anticipated in an earlier period. In the return
model, the stale component is irrelevant in explaining current return and thus
constitutes an error in the independent variable, biasing the slope coefficient on
earnings toward zero (e.g., Brown, Griffin, Hagerman, and Zmijewski, 1987). By
contrast, the current stock price in the price model reflects the cumulative effect
of earnings information, and thus varies due to bosh the surprise and stale
components. Therefore, there is no errors-~in-variables bias in price-model re-
gressions. Intuitively, current earnings are uncorrelated with the information
about future earnings contained in the current stock price, the dependent
variable. Econometrically, the price model thus has an uncorrelated omitted
variable, which reduces explanatory power, but the estimated slope coefficient is
unbiased (Maddala, 1990).
Criteria for evaluating alternative models. In evaluating price and return
models, we measure the extent to which the estimated slopes and intercepts
approximate their predicted values. In particular, assuming that earnings follow
S.P. Kothari. J.L. Zimmerman / Journal of Accounting and Economics 20 (1995) 155-192 157
a random walk, the intercept in price- and return-earnings regressions should be

zero. The slope, commonly referred to as the earnings response c o e ~ % n t ,
should be the reciprocal of the firm's expected rate of return, l/r. Its magnitude
should be about 10-12 for the sample of U.S. firms examined over the past 38
years. The second criterion we use to evaluate price and return models is the
extent of misspecification and/or heteroscedasticity as indicated by the White
(1980) statistic. The criteria that we employ to evaluate price and return models
are neither unique nor the only ones that can be used. Depending upon one's
research design and loss function, different criteria will apply.
To keep the analytics tractable and to more confidently assess the degree of
bias in the estimated slopes, we restrict our analysis to a regression with earnings
as the only explanatory variable. Balance sheet and income statement variables
could certainly be examined (e.g., Barth, Beaver, and Landsman, 1992; Barth
and Kallapur, 1994), but there is less agreement among researchers about both
the information content of and the coefficient magnitudes on such variables.
Evaluation of price and return models would, therefore, be more tenuous.
Empirical evidence. Our results indicate that the slope or earnings response
coefficients are substantially less biased in price models than in return models.
Coefficients from the price model, but not the return model, imply cost of capital
estimates that are more in line with those observed in the market. Also, the time
series of implied cost of capital estimates from cross-sectional price models more
closely approximates long-term interest rates plus a risk premium than does the
corresponding time series from return models. Nevertheless, price models do not
unambiguously dominate return models. Price models more frequently reject
tests of heteroscedasticity and/or model misspecification than return models.
Therefore, researchers are confronted with two flawed functional forms: one that
gives more economically sensible earnings response coefficients (price models)
and another with less severe White (1980) specification problems (return models)
but more biased slope coefficients. An obvious implication is that researchers
using price models must exercise more care in drawing statistical inferences, e.g.,
by using White's (1980) heteroscedasticity-consistent standard errors. Since each
functional form has its weakness, researchers should be aware of the econo-
metric limitations in designing their experiments. When possible, using both
functional forms will help ensure that a study's inferences are not sensitive to
functional form.
Limitations. One limitation of our analysis is that we do not explicitly
incorporate the implications of departures from the random walk property of
firms" annual earnings. A coefficient of 1/r is implied by our simple valuation
model that assumes a random walk. However, Be~l and Watts (1979, p. 205)
explain that management's errors in accrual forecasts (e.g., bad debt expense)
reverse themselves, and revenues and costs contain tra~g[tory components (e.g.,
special items, restructuring costs, and other one-time revenues, gains, and losses=:
included in earnings). Consequently, earnings changes will be negatively serially
158 s.P. Kothari, J.L. Zimmerman / Journal of Accounting and Economics 20 (1995) 155-192
correlated. If the earnings variable is not adjusted for this predictable compo-
nent, then the estimated earnings response coefficient is biased towards zero for
both price and return models (see Ali and Zarowin, 1992, and Sections 2 and
5 below).
Another limitation of our analysis is that we do not examine in detail the
economic reasons for and the econometric consequences of nonlinearities in the
price-earnings relation. These issues are beyond the scope of this paper. Basu
(1995) explains how conservatism in accounting induces an asymmetric and
nonlinear price-earnings relation. Hayn (1995) explores the consequences of
losses. Freeman and Tse (1992), Cheng, McKeown, and Hopwood (1992), Das
and Lev (1995), and Beneish and Harvey (1992) are other examples of research
examining the linearity of the price-earnings relation.
Section 2 presents the intuition underlying the argument that the earnings
response coefficient estimates from the price models are unbiased, whereas
return models yield biased estimates. Section 3 describes the data and provides
descriptive statistics, and Section 4 presents the empirical results. Section 5 ex-
plores the sensitivity of the results to several specification tests. Section 6 dis-
cusses implications for other research.
2. Price and return specifications
This section examines alternative price-earnings specifications when the

"nformation set in prices is richer than that in the current and past time series of
earnings, ke., prices lead earnings. We formalize the prices-lead-earnings as-
sumption when earnings follow a random walk.~ Thus~ the market's expectation
of future earnings, conditional on all the information that it has, differs from the
time-series {random-walk) expectation. We further assume that expected rates of
return are constant through time and state a simple valuation model. Condi-
tional on the valuation model, we show that, when prices lead earnings, the price
model yields an unbiased earnings response coefficient, but the return specifica-
tion yields biased estimates. The latter has also been analyzed in Ohlson and
Shroff (1992) and Kothari (1992), among others. Finally, we examine implica-
tions of earnings containing value-irrelevant noise, i.e., there is a component of
earnings that is unrelated to current, past, and future stock returns. The presence
~Theanalyticsare simplifiedby assuminga random walk time-seriesproperty for annual earnings.

However,it is well-knownthat time-seriespropertiesof earningsdeviatemildlyfroma random walk
(e.g., Ball and Watts, 1972; Brooks and Buckmaster, 1976)and that expectedequity rates of return
vary cross-sectionallyand change through time. Implicationsof these violationsof the assumptions
underlyingthe analysisin this section for the various price-earningsspecificationsare discussedin
Section 5. That analysissuggeststhat the tenor of the analyticaland empiricalresultsin the paper is
unaffected.
$.P. Kothari, J.L. Zimmerman / Journal of Accounting and Economics 20 (1995) 155-192 159
of value-irrelevant noise results in biased slope coefficients for all price-earnings

specifications (e.g., Landsman and Magliolo, 1988; Ryan and Zarowin, 1995). All
the assumptions and derivations underlying the analysis in this section are
provided in the Appendix, whereas only the important assumptions and the
intuition behind the results are discussed in this section.
2.1. Alternative price-earninffs specifications under a stylized valuation model
Alternative price-earnings specifications commonly estimated in the ac-

counting literature are:
Price model: P~ = ~ + fiX, + et, (1)
R e t u r n model: P , / P , - i = • + f l X j P , _ 1 + e,, (2)
Differenced-price ,nodel: alP, = ~ + f A X , + e,, (3)
where P, is the ex-dividend price at time t, X, is earnings for period t, 0t and fl are
the intercept and slope coefficients, and e, is an error tenn. The differenced-price
model is included because differencing often yields a stationary," series. Some of
the econometric problems in using the price model can thus be overcome by
using first differences (Christie, 1987).
It is easy to show that all three specifications are equivalent in the sense that
all three models yield a slope coefficient of I/r, where r is the (constant) expected
rate of return (Christie, 1987). T w o critical assumptions are that earnings follow
a random walk and that only the information in the current and past time series
of earnings is used by the market in setting prices, that is, prices do not lead
earnings [see Eqs. (A.1)-(A.6) in the Appendix for details]. Thus, in the context
of a stylized constant price-earnings ratio model, there is no economic difference
between the price, return, and differenced-price specifications. The choice
among the three alternatives must therefore be guided by econometric issues
(Christie, 1987} or because violation of one or more of the underlying assump-
tions has a differential effect across these specifications. 2
2In addition to the return model in Eq. (2},recent research on the price-earnings relation examines
two other return model specifications. While the dependent variable is always stock return,
alternative earnings variablesare earnings change deflated by price, dX,/P,- 1• and earnings change
deflated by last period's earnings, dX,/X,_ x. If the 'price is a constant multiple of earnings"
valuation model is assumed, regressions employing all of these earnings variables yield results
identical to those using Eqs. {1)--{3}.We focus only on the earnings-deflated-by-pricevariable [i.e.,
the return model (2)] because, once prices lead earnings, previous research indicates that return
model (2) outperforms the other two earnings variables in terms of bias in the estimated earnings
response coefficient{e.g.,Ohlson, 1991;Ohlson and Shroff, 1992;Kothari, 1992; Easton and Harris,
1991).
160 S.P. Kothari. J.L. Zimmerman / Journal of Accounting and Economics 20 (1995) 155-192
2.2. Alternative specifications when prices lead earnings
Prices-lead-earnings assumption. Considerable research since Beaver, Lam-

bert, and l~,~orse(1980)demonstrates that prices lead earnings, i.e., the informa-
tion set in stock prices is richer than that in the past time series of accounting
earnings (recent examples include Kothari and Sloan, 1992; Easton, Harris, and
Ohlson, 1992; Wa=field and Wild, 1992; Collins, Kothari, Shanken, and Sloan,
1994). Therefore, even though the time-series properties of annual earnings are
well-approximated by a random walk (e.g., Ball and Watts, 1972; Albrecht,
Lookabill, and McKeown, 1977), the market anticipates a portion of the
time-series earnings surprise or change in earnings. The forecasting power of
prices with respect to future earnings changes arises because historical cost
accounting, with its emphasis on conservatism, objectivity, and revenue-recog-
nition conventions, has a limited ability to reflect the market's expectations of
future earnings.
To formalize the prices-lead-earnings assumption, we begin with a random
walk in earnings:
X, = X,-1 + a X , , (4)
where, conditioning only on the past observations, AX, has a zero mean,
a constant va[iance, and is serially uncorrelated. However, when prices lead
earnings, only a portion of d X is a surprise to the market; the rest is anticipated
during periods t - 1, t - 2, and so on. If we assume that the market anticipates
earnings only two periods ahead, Eq. (4) becomes
X f -= X , - t + St + at.t_ 1 + at . t _2, (5)

where s, + a~.,_ 1 + a,.,-2 = 3X,, st is the component of AX, that is a surprise to
the market in period t, and a,.,_ 1 and a,.,_ 2 are the components of 3X, that the
market anticipates in periods t - 1 and t - 2 (s, a,.,_ 1, and a,.t-2 are assumed
uncorrelated)) The first subscript, t, of a,.,_ t refers to the year of the earnings
X,, and the second subscript, t - 1, refers to the pe,~od in which the market
anticipates a component of the earnings X,. The following numerical example
illustrates the notation. Last year's earnings, X,_ t, were $3 and current earn-
ings, Xt, are $4. The surprise, s,, is $0.30. Last year the market anticipated that
this year's earnings would be up $0.90, and two years ago the market anticipated
a decrease in earnings of $0.20. We decompose the earnings change into:
$4 = $3 + $0.30 + $0.90 - 0.20,
Xt = X t - 1 4" st 4" at.t-t 4" at.t-2.
3The formulation in Eq. (5) is identical to that in Kothari (1992). For related, but conceptually
differentapproaches,see Lipe (1990) and Ohlson (!991, App. B).
S.P. Kothari, J.L. Zimmerman / Journal of Accounting and Economics 20 (1995) 155-192 |6I
Because price reflects anticipated future earnings, the price at time t, P~. will
not be a constant multiple (1it) of current earnings, X,. Pt will exceed X,/r if the
market expects positive ee.rnings changes over the next two years (e.g., a growth
firm), whereas P, will be lower than X,/r if the market expects negative future
earnings changes. Eqs. (A.7)--(A.9)in the Appendix formalize this intuition. The
earnings response coefficient, defined as the coefficient that maps a unit surprise
into stock pric~, will be 1/r even though prices lead earnings because st is
assumed permanent.
Price specification. When prices lead earnings, the current price, in addition
to all the information in current and past earnings, contains information about
future years" earnings that is absent from current earnings. This information (i.e.,
a,+ 1., and a,+2.,) generates variation in price, Pt, but is uncorrelated with X,.
Therefore, price model (1) is missing an independent variable that would explain
the variation in P, due to the anticipated components of future periods" earnings
changes. Econometrically, this is an uncorrelated-omitted-variableproblem that
reduces the price model's explanatory power, but the estimated coefficient on X,
is unbiased (see, for example, Maddala, 1990). Eq. (A.10) in the Appendix shows
the derivation.
Return specification. Previous research shows that when prices contain in-
formation about future years' earnings changes (e.g., Brown, Foster, and
Noreen, 1985; Collins, Kothari, and Rayburn 1987; Freeman, 1987), the esti-
mated earnings response coefficient from the return model (2) is biased toward
zero. While the Appendix contains the derivation [Eqs. (A.11) and (A.12)], the
intuition is as follows. The dependent variable, Rt, in the return model reflects
information about current and future earnings arriving over the current period.
However, the independent variable, Xt, contains information arriving over both
current and past periods. That is, X, contains both the surprise component, s,
and stale components, at.t- 1 and at.,- 2- The stale components are irrelevant in
explaining current returns (which are generated by s,), and newly anticipated
components of future earnings changes (i.e., at+ 1.t and a,+ 2.,). Since Xt's stale
components cannot explain Rt, the independent variable in the return model
measures the variable of interest with error. This errors-in-variables problem
biases the estimate of the return-model earnings response coefficient toward zero.
While we have analyzed the return model using a simple setting of prices
leading earnings, the nature of historical-cost accounting suggests a more com-
plicated structure foi-prices leading ~rnings. Basu (1995) shows that conservatism
in accounting leads to an asymmetric nonlinear return-earn/rigs relation because
earnings are more timely in capturing bad news than good news. The explanatory
power and slope of a linear return model, therefore, are expected to be less than
those from a welbspc:.'.':.~ n,~nlinear me:lel. The nonlinearity analysis within the
context of issues discussed in Basu (1995) are beyond the scope of this study. The
main point, however, is that whether tae prices-lead-earnings phenomenon is
symmetric or not, the return model yields a biased slope.
162 S.P. Kothari, J.L. Zimmerman / Journal of Accounting and Economics ,~0 (1995) i~5-192
Differenced-price specification. The differenced-price specification, Eq. (3),

also yields a biased earnings response coefficient when prices lead earnings. The
intuition behind the result is similar to that described for the return model and,
therefore, is not repeated here.
2.3. Alternative specifications when earnings contain value-irrelevant noise
Considerable research examines the price-earnings relation under the as-

sumption that earnings consist of a value-relevant and a value-irrelevant com-
ponent. The former is typically assumed to be perfectly correlated with stock
prices, whereas the latter is uncorrelated with stock prices. For example, Beaver,
Lambert, and Morse (1980) propose a model in which accounting earnings, Xt,
contain a 'garbling" component, zit, that is uncorrelated with stock returns in all
periods; they model the predictive ability of prices with respect to future
earnings by assuming that the ungarbled component of earnings, x, ( = X, - ut),
follows a first-order integrated moving average process [IMA(1,1)]. Should x,
be observable, then, within the framework of the Beaver, Lambert, and Morse
model, the information set in the time series of x, is identical to that in stock
prices. Choi and Salamon (1990), Landsman and Magliolo (1988, model 3, pp.
598-599), and Ryan and Zarowin (1995) introduce models in which accounting
earnings consist of value-relevant and value-irrelevant components. Finally,
Ramakrishnan and Thomas (1994) also assume that earnings contain a price-
irrelevant component, although they impose a negative serial correlation struc-
ture on it to capture accrual reversals.
Following some of the previous modeling in this area, we consider a simple
formulation:
X~ = x, + u,, (6)
where xt is the value-relevant component and u, is the value- irrelevant compo-
nent of accounting earnings, X~. x~ is assumed to follow a random walk and ut
2
is a zero mean, serially uncorrelated, white noise term with variance o-,.
xt is perfectly correlated with price and ut is uncorrelated with xt and price.
In the p r e ~ n c e of value-irrelevant noise in earnings, all three specifications,
Eqs. (1) to (3), yield downward-biased earnings response coefficient estimates
(see Landsman and Magliolo, 1988; Ryan and Zarowin, 1995; and the Appen-
dix). The intuition behind the result is that the independent variable in all three
specifications measures the "true" variable of interest with error, the value-
irrelevant noise, biasing the estimated slope towards zero? For all three models,
4Obviously, this result hingeson the assumption that the noise is uncorrelatedwith both price and
earnings variables. If opportunistic accruals by managementare the primary soure of noise and if
this noise is assumed to be (perfectly)negatively correlated with the surprise component of
value-relevantearnings,then such noise biases upward the slope coefficientin all three models.To
keep the analysis simple and to focus on the forward-lookingnature of prices to discriminate
between alternative models,we ignore this and other formula,ionsof noise.
S.P. Kothari, J.L. Zimmerman / Journal of Accounting and Economics 20 (1995) 155-192 163
the degree of bias increases in the ratio of the variances of ut and zlx,. An
indication of some researchers" assessment of the relative magnitudes of the
variances of u, and Ax, is given by Ryan and Zarowin (1995). They conclude that
the ratio is about 13, which would imply that, in the price model, the estimated
earnings response coefficient is aboat 7% of the 'true" earnings response coeffi-
cient.
2.4. Summary
All three specifications yield unbiased coefficients (earnings response coeffi-

cients are expected to be 1/r) when prices do not lead earnings and earnings do
not contain noise. The price specification yields an unbiased earnings response
coefficient when prices lead earnings, but it yields a biased coefficient estimate in
the presence of value-irrelevant noise in earnings. The return and differenced-
price specifications, on the other hand, yield biased coefficients when prices lead
earnings and also when earnings contain value-irrelevant noise.
While we provide predictions about the slope coefficient estimate from
various price-earnings specifications, our analysis primarily highlights the
differential implications of prices leading earnings for the price, return, and
differenced-price specifications. Obviously, the predictions critically depend on
the descriptive validity of the simplifying assumptions. In particular, the slope
will be smaller than 1/r if there is negative serial correlation in earnings changes
(e.g., Ball and Watts, 1972; Brooks and Buckmaster, 1976; All and Zarowin,
1992).
3. Data and descril~ive statistics
We use 1952-89 earnings and return data from the Compustat Annual
Industrial tape and the Annual Research tape and the Center for Research in
Security Prices (CRSP) monthly tape. Since we perform time-series, cross-
sectional, and pooled analyses, we construct two samples with different data
availability requirements. For the cross-sectional and pooled analyses, we in-
dude any firm that has at least two consecutive annual earnings and return
obse~ rations. For the time-series analysis we require a minimum of 20 consecut-
ive annual earnings and return observations. The time-series analysis sample is
thus a subset of the pooled and cross-sectional analyses sample. Annual earnings
excluding those from discontinued operations and extraordinary items are used.
Only firms with a December fiscal year-end are included to facilitate inferences
from a cross-sectional analysis (e.g., to test whether the sample mean of slope
coefficient estimates from successive cross-sectional regressions is reliably posi-
tive). This restriction induces a bias in favor of including larger stocks (Smith
and Pourciau, 1988).
We use per-share values of prices and earnings to reduce the presence of

heteroscedastic disturbances (e.g., Barth, Beaver, and Landsman, 1992). The
earnings variable is either earnings per share, X, (price model), ?arnings per
share deflated by price at the beginning of the year, X,/P,_ ~ (return model), or
change in earnings per share, AX, (differenced-price model). The corresponding
price or return variable is price, P,, return, P,/P,_ ~, or change in price, ziP,.
Annual calendar-year (i.e., fiscal-year) buy-and-hold returns, exclusive of divi-
dends, are used. Earnings and price data are adjusted for stock splits, stock
dividends, and stock issues. To avoid any undue influence of extreme observa-
tions, we exclude the largest and smallest 1% of observations for each variable
from the sample (which also affects the time-series analysis sample because
it is a subset of the pooled and cross-sectional analyses sample). While arbitrary,
exclusion of extreme observations is consistent with a similar practice in
previous research, e.g., Easton and Harris (1991) delete observations of
X, deflated by Pt-I that exceed 1.5 in absolute value. The resulting sample
sizes are 38,890 firm-years for the cross-sectional and pooled analyses
and 27,127 firm-years representing 1,017 different firms for the time-series
analysis.
Table 1 reports descriptive statistics for the various price and earnings
variables separately for the two subsamples. Panel A contains descriptive
statistics for the cross-sectional and pooled analysis sample. The minimum and
maximum values of the various variables indicate that degpite exclusion of
extreme 1% of observations, the range of values is substantial. For example, the
minimum value of X,/P,_ ~ is more than 50 standard deviations smaller than its
average value of 0.09.
Comparison of the descriptive statistics for the time-series sample in panel
B with those in panel A suggests that the time-series sample consists of more
successful, surviving firms. The average earnings per share and the average
change in earnings per share are somewhat larger for the time-series analysis
sample compared to the cross-sectional and pooled analyses sample. However,
average returns for the time-series analysis sample are slightly lower than for the
pooled sample.
4. Empirical evidence
This section presents results of estimating the various price--earnings

models. Across all estimations, the results indicate that the price specifi-
cation provides estimates of the earnings response coefficient that are closer
in magnitude to those implied by expected rates of return observed in the
marketplace. Nonetheless, as predicted by Christie (1987), tile price specification
suffers more from heteroscedasticity/misspecification problems than the return
model.
Table I
Descriptive statistics for price and earnings variables used in valuation, return, and differenc~-prk~
specifications of the price-earnings relation; cross-sectional and pooled regression analysis sample
and time-series regression analysis sample; annual data from 1952-1989
Variable Mean Std. dev. Min. Med. Max.
Panel A: Pooled and cross-sectional analyses sample, N = 38,890 firm-years

Xr 1.97 1.81 - 4.61 1.79 9.33
P, 24.41 18.23 0.22 20.25 1~.00
XJP,_ ~ 0.09 0.20 - 10.48 0.09 3.09
P,/P,- t 1.14 0.60 0.06 1.06 48.93
AXt 0.13 1.10 - 11.74 0.15 10.87
dPt 1.77 8.88 - 61.25 0.88 74.92
Panel B: Time-series analysis sample, N = 27,127 firm-years

Xr 2.27 1.79 - 4.61 2.09 9.33
P, 27.77 I8.76 0.25 24.25 106.00
X,/P,_ 1 0.09 0.15 - 8.72 0.09 3.09
P,/P,- 1 1.13 0.56 0.11 1.06 48.93
AX~ 0.15 1.12 -- ! 1.74 0.16 9.66
APt 1.99 9.24 -- 61.25 1.12 74.92
Sample: The cross-sectional and pooled analyses sample includes any firm that has at least two
consecutive annual earnings and return observations. For the time-series analysis sample, a min-
imum of 20 consecutive annual earnings and return observations is required. X, is annual earnings
per share excluding the extraordinary items and earnings from discontinued operations. Price
relatives exclusive of dividends, P,/P,_ 1, are measured over calendar years. Only firms with
a December fiscal year-end are included in both samples. The largest and smallest 1% of observa-
tions for each variable are excluded from both samples. Earnings, X,, and prices, Pt, are adjusted for
stock splits and stock dividends when deflating by P,_ 1 and obtaining differenced variables.
4.1. Pooled time-series and cross-.'-ectional analysis
Results o f p o o l e d time-series cross-sectional e s t i m a t i o n o f '~he v a r i o u s m o d e l s

are r e p o r t e d in T a b l e 2. F o r each specification, the e s t i m a t e d intercept, earnings
r e s p o n s e coefficient, a n d adjusted R 2 o f the m o d e l are reported. O r d i n a r y least
squares (OLS) s t a n d a r d e r r o r s a n d the W h i t e (1980) heteroscedasticity-consis-
tent s t a n d a r d e r r o r s for each p a r a m e t e r e s t i m a t e a n d the W h i t e (1980) chi-
s q u a r e test statistic are also reported. B o t h O L S a n d W h i t e s t a n d a r d e r r o r s
likely u n d e r s t a t e the true s t a n d a r d e r r o r of the e s t i m a t e d coefficients b e c a u s e we
d o not adjust for the positive cross-correlation a m o n g the regression residuals
(Bernard, 1987). T h e r e p o r t e d s t a n d a r d e r r o r s should therefore be viewed o n l y
as descriptive statistics.
Price m o d e l T h e price specification yields a n earnings r e s p o n s e coefficient
estimate o f 6.55, with a W h i t e s t a n d a r d e r r o r o f 0.049. T h e a n n u a l expected
rate o f return implied b y the e s t i m a t e d coefficient is 15.3% l- = 1/6.55]. T h e
166 S.P. Kothari, J.L. Zimmerman / Journal of Accounting and Economics 20 (1995) 155-192
estimated intercept, 11.47, is more than 100 standard errors greater than
zero, although again the standard error is understated because we ignore
positive cross-correlation among the residuals. Recall that all specifications
predict a zero intercept. Within the context of our simple valuation model,
a nonzero intercept implies that the slope coefficient is biased. More generally,
nonzero intercepts indicate either mr~el specification problems or an omitted-
variables problem. As seen from Table 2, all specifications yield highly signifi-
cant intercept estimates, as in previous research (e.g., Barth, Beaver, and Lands-
man, 1992, Table 2; Easton and Harris, 1991, Table 1). Section 5 addresses the
question of model misspecification, including the presence of transitory earn-
ings, nonlinearities due to small-price deflators, and correlated omitted
variables.
The White statistic for the price model, 1,025, indicates severe heteroscedas-
ticity and/or specification problems. 5 The 42.2% adjusted R 2 from the price
model is likely to overstate the information content of contemporaneous earn-
ings because the model is estimated in levels. Scale differences across firms in the
sample and autocorrelatcd errors, because of the use of levels, together can
contribute to the model's explanatory power (Maddala, 1990, pp. 190-d99).
R e t u r n model. Compared to the estimated slope from the price model, the
coefficient from the return model is only 0.45 (White standard error 0.112). The
magnitude of the estimated earnings response coefficient from the return speci-
fication is comparable to the 0.84 (standard error 0.02) that Easton and Harris
(1991, Table 1, first row) report using 19-year data from 1968-86. 6 The estimated
coefficient implies an unreasonably high expected rate of return of over 200%.
The White statistic, 14.2, rejects homoscedasticity of errors at an ~t level of 0.001.
The 2.3% adusted R 2 indicates relatively low information content of current
earnings. It is important to recall, however, that, if prices are forward-looking,
both the slope and the explanatory power of the return model are biased toward
zero. The adjusted R 2 therefore underestimates the information content of
current earnings.
Differenced-price model. The earnings response coefficient estimate from the
differenced-price model is 2.09 (White standard error 0.050), which is higher
than that from the return model but considerably smaller than that from the
price model. The implied expected rate of return is about 50%, which is still too
SThe significantWhite statistic can also occur if the theoretical relation betweenstock prices and
earnings differsfrom the simple valuation model assumed here (White, 1980). Only if the assumed
model is correct does the significantWhitestatistic indicates the presenceof beteroskedasticerrors
alone.
~T~ differencein the coeffmentmagnitudebetween Easton and Harris and this study is attribut-
able to time-perioddifferencesand their use of 12-monthreturns endingin the third month after tbe
fiscal year-end versus our use of returns measuredover the fiscal year.
Table 2
Pooled time-series and cross-sectional estimation of the price, return, differenced-price, and de-
flated-price specifications of the price-earnings relation; sample of 38,890 firm-year observatiom
from 1952-1989
Earnings response coefficient
Standard error Standard error

White
Model Estimate OLS White Estimate OLS White Rz star.
Price 11.47 0.104 0.100 6.55 0.039 0.049 42.2% 1025

Return I. 11 0.003 0.011 0.45 0.015 0.112 2.3 14.2
Diff. price 1.51 C.044 0.043 Z09 0.040 0050 6.7 141.3
Deft. price 4.69 0.037 0.087 9.03 0.062 0.066 37.2 432.6
Price model: Pr = • + ffXt + ~,

Return model: P,/Pt- ,. = ~ + [JX,/P,_ t + e,
Differenced-price model: APt = • + [JAXt + e,
Deflated-price model: P,/X, = a{l/X,) +/~ + ~,
Sample: The sample includes any firm that has at least two consecutive annual earnings and return
observations. X, is annual earnings per share excluding the extraordinary items and earnings from
discontinued operations. Price relatives exclusive of dividends, PdPr- i, are measured over calendar
years. Only firms with a December fiscal year-end are included. The largest and smallest I% of
observations for each variable are excluded from the sample. Earnings, X , and prices, P , are
adjusted for stock splits and stock dividends when deflating by Pt-t and obtaining differenced
variables.
high t o be plausible. T h e W h i t e statistic indicates that, like t h e price m o d e l , t h e

differenced price m o d e l suffers f r o m h e t e r o s c e d a s t i c i t y - r e l a t e d misspecification. 7
D e f l a t e d - p r i c e m o d e l W h i l e the price specification a p p e a r s t o yield a less
biased s l o p e coefficient estimate, t h e r e a r e at least t w o p o t e n t i a l p r o b l e m s . First,
e r r o r s f r o m the price m o d e l are likely t o be h e t e r o s c e d a s t i c b e c a u s e o f scale
TOne interpretation of the relatively small coefficient estimate from the differenced-pri~ model
compared to that from the price model is that the price model is misspecified. If regressions using
first-differenced data yield different results, they frequently indicate misspecification of the undif-
ferenced Ior levels) regression model tPiosser, Schwest, and White, 1982). However, since prices are
forward-looking, the independent variable, X,, is expected to be correlated with lagged errors.
Under these conditions. Plo~ser et aL point out that the slope coefficient from a differenced
regression model is inconsistent and, therefore, results from a differenced regression cannot unam-
biguously indicate misspecification. Ira suitable set of instrumental variables is used to eliminate the
correlation between X, and lagged errors, then the Plosscr et ai. (1982) differencing test can be
applied. However, suitable instrumental variables are not easily obtained and, therefore, we do not
perform the Plosser et al. differencing test of specification.
168 S.P. Kothari. J.L. Zimmerman / Journal of Acco,.mting and Economics 20 (1995) 155--192
differences and cross-sectional variation in the slope coefficient, which the model
assumes to be a constant. Easton (1985) and Christie (1987) recommend deflat-
ing the price model by a variable that is a function of the independent variable
(earnings) to reduce heteroscedasticity.8 Second, there is a danger of obtaining
a significant coefficient on an (economically or theoretically) irrelevant included
variable in a price regression (see Christie, 1987).9 The intuition is that the
significant coefficient on an irrelevant variable might merely be capturing scale
differences across the sample of firms. Use of a suitable deflator in estimating
price models is therefore recommended. We reestimate the price model using X,
as the deflator: ~°
P,/X, = ~(I/X,) + )6 + ~,. (7)

The last row of Table 2 reports results of estimating Eq. (7), the deflated-price
model. The i n t e r c e p t , ~, is an estimate of the earnings response coefficient.
The coefficient, 9.03 (White standard error 0.066), is greater than that from
the price model, reducing the concern that the price models yield spuriously
large coefficients. The White statistic, 432.6, remains significant, however.
The coefficient on 1 i X , , which is an estimate of ~ in the price model, is 4.69
(White standard error 0.087), which is more than 50% smaller than the esti-
mated ~ from the price model, indicating a better-specified model. The 37%
adjusted R 2 of the deflated-price model is only marginally smaller than the
42.2% explanatory power of the price model. Since the regression errors of
individual firms in the sample are likely to be positively autocorrelated, the
explanatory power could be overstated (Maddala, 1990, p. 199) even with the
deflated-price model.
The smaller degree of bias in the coefficients from the price and deflated-price
models in Table 2 is consistent with the prices-lead-earnings phenomenon
contributing to biased coefficients from the return- and differenced-price speci-
fications. Recall that velue-irrelevant noise in earnings biases the estimated
SDeflating by X, also mitigatesheteroscedasticerrors in a price model that may be caused by an

earnings process that followsa multiplicativerandom walk [i.e., X, = X,_ ,(1 + a,), a, is a zero-
mean, constant-varianceshock].
9Christie (1987) points out that time-series regressions in levels are an alternative to mitigate
concern over obtaining a significantcoefficienton an irrelevant variable.
~°Thebook valueof assets is an alternativeto earningsas the deflatorfor the price model.The book
valueof assets as the deflatorhas the advantageofalwaysbeingpositiveand is lesslikelyto generate
outliers than when earnings are used as the deflator.The book-value-deflatedprice model is
P J B V A , _ , = I/BVA,_ l + [3X,/BVA,_ * + error,
whereBVA,_ ~ is the book valueof assetsat the beginningof year t. The earningsresponsecoefficient
estimate from this model is 11.91 (standard error = 0.07) and the adjusted R2 is 44.6%.
S.P. Kothari, J.L. Zimmerman / Journal of Accounting and Economics 20 (199S) 155-192 169
coefficients of all specifications. Empirically, however, only coefficients from the

return and differenced-price specifications appear to he severely biased. Obvi-
ously this conclusion rests on the assumption that coefficients from the price
model are not upward biased. It is possible, however, that this assumption is
violated. If cross-sectional variation in the slope coefficient (which is inversely
related to the expected rate of return) is correlated with the independent variable
(earnings per share) then the estimated slope coefficient is biased (Christie, 1987).
Since empirically both earnings per share and stock price are positively corre-
lated with market capitalization, and market capitalization is well-known to be
inversely related to the expected rate of return (Banz, 1981), a positive correla-
tion between the firm-spedfic earnings response coefficient and earnings per
share is expected. This conclusion will indeed result in upward-biased slope
coefficient estimates. Similar analysis suggests that the coefficient from the
return and differenced-price specifications would he biased downward. There-
fore, we examine whether biases account for observed differences in the earnings
response coefficients reported in Table 2. Howevei-, ~e demonstrate in Section
5 that including finn size and beta in the various models to mitigate the bias has
little effect on the inferences from the price and deflated-price model estimations
described in this section.
Comparing estimated earnings response coefficients to the market price-earn-
ings ratios. While the estiraates of the earnings response coefficient from the
price and deflated-price models are considerably greater than those from the
return or differenced-price specifications, they are somewhat smaller than the
price-earnings ratio of a typical stock in our sample. The ratio of average price
to average earnings per share for the pooled sample (Table 1, panel A) is 12.4
(24.41/1.97). 11 The ratio of medians is 11.3. The coefficients from the various
models range from 0.45 to 9.03 (see Table 2). One reason for the difference
between the estimated coefficients and the average price-earnings ratio of the
sample firms is the presence of transitory components of earnings, violating the
random walk assumption underlying the prediction about the earnings response
coefficient magnitude. Analysis described in Section 5 and previous research
indicate that the presence of transitory components in earnings explains a large
portion of the difl~rence between 1it and the estimated earnings response
coefficient from the price or deflated-price model. The considerably smaller
coefficients frcm the return model, however, are due largely to the effect of prices
leading earnings.
~The ratio of averagepriceto averageearningswouldgenerallybe smiler than the averageof the

firm-specific ratios of prices to earnings because of the Jensen inequality.The average of the
price-earningsratios wouldbe undulyinfluencedby outliersgeneratedby firmsreportingearnings
that are closeto zero.
170 S.P. Kothari. J.L. Zimmerman / Journal of Accounting and Economics '0 (1995) 155-192
4.2. Cross-sectional analysis
Results of 38 annual cross-sectional estimations of the price, return, differ-

enced-price, and deflated-price specifications of the price-earnings relation are
reported in Table 3. For each model, we report sample statistics of the 38
intercept and slope coefficient estimates. One benchmark against which the
estimated slope coefficients can be evaluated is the average or median
price-earnings ratio over the 38 years. The time series of annual price-earnings
ratios, defined as the ratio of average price in year t to average earnings in year
t has an average of 13.1 and a median of 12.9.
Price model. In Table 3, panel A, the average estimated slope coefficient
from the price model is 7.9, with a standard error of 0.41. All 38 coefficient
estimates are positive and range from 3.9 to 14.2. The reported standard error is
likely to understate the true standard error for at least two reasons. First, since
the residuals from a levels regression in year t are likely to be positively
correlated with the residuals in years t + 1 and beyond, the estimated coeffi-
cients are also expected to be positively correlated. The reported standard error
ignores this dependence in the estimated coefficients through time, so it under-
states the true standard error. Second, because the true slope coefficient in year
t is a function of the expected rate of return in year t and expected rates of return
exhibit high positive serial correlation, the estimated coefficients should also
exhibit positive autocorrelation. This too will lead to understated standard
errors.
To incorporate the effect of serial correlation in the estimated coefficients on
the standard errors, we also calculate, but do not report, adjusted standard
errors. The adjustment reflects the Newey and West (1987) correction, with six
lags, for serial dependence in the estimated coefficients. Not surprisingly, these
standard errors are larger (by a factor of about 2) than those reported in Table 3,
but the average slope coefficients are always at least two standard errors away
from zero. The iaferences, thus, are not altered.
The time-series average slope coefficient of 7.9 from the price model implies an
expected rate of retul'n of 12.7%. This is smaller than the 15% expected rate of
return implied by the coefficient from the pooled price model regression re-
ported in Table 2, but still greater than the average expected rate of return of
7.6% implied by the sample firms" average price-earnings ratio of 13.1. Since the
estimated coefficients range from 3.9 to 14.2, the implied expected rates of return
range from 7.0% to 25.6%. While undoubtedly the implied expected rates of
return exaggerate the dispersion in true expected rates of return over this period
because of sampling error in the estimated coefficients, the range of values does
not appear unreasonable.
Return and differenced-price models. The estimated average slope coefficient
from the return model, 1.65, is considerably greater than that obtained from the
pooled regression in Table 2. However, both return and differenced-price model
S.P. Kothari. J.L. Zimmerman / Journal o f Accounting and Economics 20 (1995) 155-192 171
Table 3
Annual cross-sectional estimation of the price, return, differenced-price,and deflated-price specifica-
tions of the price-earnings relation; 38 annual regressions using a sample of 38,890 firm-year
observations from 1952-1989
Coeff. Mean Std. err. Min. QI Med. Q3 Max.
Pane~ A: Price model, P, = :~ +/1Xt + et

:c 10.2 0.58 3.9 7.5 10.0 12.6 19.1
7.9 0.41 3.9 5,9 7.3 9.7 14.2
Adj. R 2 53.1 40.2 47.0 51.1 59.8 67.5
White 23.1 35 significant at 15.4 22.2 33.3
stat. 0.05 p-value
Panel B: Return model, Pr/Pt- i = ~ + 3 X , / P t - 1 + er

1.01 0.04 0.52 0.85 1.01 1.20 1.46
1.65 0.23 - 1.50 0.40 1.45 2.90 4.17
Adj. R z 12.8 0.0 6.2 12.5 17.4 33.9
star. 0.05 p-value
Panel C: Differenced-price model, APt = • +/~AXt + et

1.79 0.78 -- 7.3 -- 0.1 2.14 3.8 15.2
3.24 0.27 0.8 1.8 2.98 4.6 7.8
Adj. R e 13.8 1.6 10.0 12.7 18.4 27.6
star. 0.05 p-value
Panel D: Deflated-price model, P t / X t = {1/Xt) 4- ~ 4- ~,t

5.0 0.30 1.8 3.7 4.9 6.2 10.4
9.6 0.51 4.2 7.1 8.6 12.7 16.7
Adj. R z 38.7 14.4 29.6 40.0 49.1 60.5
stat. 0.05 p-value
On each panel, average value of the estimated coefficients, adjusted RZs, and White (1980) chi-square
statistics from 38 cross-sectional regressions are reported. Standard errors are for the time-series
sample mean coefficients. Qt and Q3 are 25th and 75th fractiles of the distribution of estimated
coefficients, adjusted RZs, or White statistics.
Sample. The sample includes any firm that has at least two consecutive annual earnings and return
ob~rvations. X, is annual earnings per share excluding the extraordinary items and earnings from
discontinued operations. Price relatives exclusive of dividends, P,/P,_ 1, are measured over calendar
years. Only firms with a December fiscal year-end are included. The largest and smallest 1% of
observations for each variable are excluded. Earnings, X,, and prices, P , are adjusted for stock splits
and stock dividends when deflating by Pt- 1 and obtaining differenced variables.
r e g r e s s i o n s (see p a n e l s B a n d C ) y i e l d s l o p e c o e f f i c i e n t s t h a t a r e s u b s t a n t i a l l y
s m a l l e r t h a n t h o s e f r o m t h e p r i c e m o d e l r e g r e s s i o n . T h i s r e s u l t is c o n s i s t e n t w i t h
t h e i n t u i t i v e a n a l y s i s in S e c t i o n 2 a s s u m i n g p r i c e s c o n t a i n i n f o r m a t i o n a b o u t
future earnings.
172 s.P. Kothari. J.L. Zimmerman / Journal of Accounting and Economics 20 (! 995) ! 55- ! 92
Deflated-price model. Panel D reports results of estimating the deflated-price

model. The estimated slope coefficient, 9.6, is greater than that from the price
model. I~ The implied expected rate of return is 10.4%. The 38.7% average
adjusted R 2 of the deflated-price model is considerably less than the 53.1%
average explanatory power of the price model in panel A. The explanatory
power of the return and differenced-price models is considerably lower, consis-
tent with the earlier analysis indicating downward bias in the estimated slope
coefficient and explanatory power of these models,~3
Evaluation of the various models using the results in Table 3 has so far been
based on the closeness of the coefficient estimates to P I E ratios. A related
criterion of interest could be to assess an estimate relative to its standard error
(i.e., power). That is, is the return-model-based coefficient more likely to be
statistically significant, even though it is biased? Using the standard errors
reported in Table 3 as well as those adjusted for serial dependence in the
coefficient estimates, the price and deflated-price models yield coefficient esti-
mates that are about twice as many standard errors away from zero as those
from the return model. The pooled regression analysis results also yield a similar
inference.
4.2.1. Estimated earnings response coefficients and interest rates

We next discuss correlating implied expected rates of return from the annual
estimated slope coefficients with long-term government bond yields as proxies
for the expected rates of return through time. Previous research (e.g., Collins and
Kothari, 1989) indicates that the return-model-based earnings response coeffic-
ient estimates through time exhibit variation that is correlated with the expected
rate of return proxies. Our focus here is on the extent to which the implied
expected rates of return from various models are correlated with long-term
government bond rates.
We estimate the following regression separately for each price-earnings
specification:
Rt = 70 + 7t It + errort, (8)
where Rt is the implied expected rate of return for year t and equals 1/bt, bt is
the estimated earnings response coefficient from one of the four price-earnings
specifications, t covers 1952 to 1989 (38 years), and L is the long-term
government bond rate for year t, taken from Ibbotson and Sinquefield (1989).
ZZTheaverage coefficientestimate using the book value of assets as the deflator is 12.9.
13We also estimated all four models using the smaller time-seriesanalysis sample which includes
only those firmswith a minimumof 20 observationsper firm.The resultsare virtuallyindistinguish-
able from those reported here for the cross-sectionalsample.
S.P. Kothari, J.L. Zimmerman / Journal of Accounting and Economics 20 (I995) 155--I92 173
Assuming that the long-term government bond rates capture variation in the
expected rates of return over time, ?t will be 1 if the implied expected rates of
return from a particular price-earnings specification track the true expected
rates of return over the years. Under these assumptions, ~'o is an estimate of the
market risk premium. 14
OLS parameter estimates of model (8) are reported in columns 2-5 of Table 4.
The estimated 3'o and 71 using the implied expected rates of returns from the
price model are 0.06 (standard error = 0.01) and 1.10 (standard error = 0.16).
There is roughly a one-to-one correspondence between variation in the implied
expected rates of return and the bond yields, and the expected rates of return
estimates are about 6% greater than the bond yields. This fielding is consistent
with the economic intuition that the 6% intercept approximates the market risk
premium and the expected market return equals the sum of the bond yield and
the risk premium.
Since the expected rate of return estimates are autocorrelated, regression
errors of model (8) will be autocorrelated, as confirmed by the Durbin-Watson
statistic. Since under t h e ~ conditions the OLS estimates are unbiased but less
efficient than generalized least squares estimates (Maddala, 1990), we also report
results of estimating the regressions using the Cochrane-Orcutt (1949) pro-
cedure assuming that the OLS residuals follow a first-order autoregressive
process. The results are reported in the last two columns of Table 4. The
estimated 71, 0.98 (standard error = 0.23), is indistinguishable from the OLS
estimate of "/1. In addition, results for the deflated-price model in the last row
are similar to those for the price model. This finding is not surprising given the
similarity in earlier results on earnings response coefficient estimates.
The estimated 71s using the Cochrane-Orcutt procedure for the return and
differenced-price models are 5.73 (standard error = 1.94) and 4.18 (standard
error = 1.60). Is They indicate a positive association between the bond yields
and implied expected rates of return through time. However, since government
14Bycorrelatingthe impliedexpectedrates of return with the governmentbond yields,we implicitly

assume that variation in the pr/ce-earningsratios is related to nominalyields.However,if inflation
has no reaJ effect on valuation,then price-earnings ratios reflect the real discount rates. In the
presence of real effectsof inflation(e.g., Fama, 1981),we expect an association betweenthe implied
expected rates of return and nominalyields.The reason for this associationis that in periodsof high
(unexpected) inflation, because of the adverse effectsof inflation on the economy,earnings (or
dividend)growth is expected to be low.Consequently,price-earningsratioswill be low and nominal
yields will be high, leadingto a positive association between impliedexpected rates of return and
nominal yields.
t sIn estimatingmodel(8) for the return and differencedspecifications,we set Rtequal to 100%if the
impliedexpectedrate of return exceeded 100% or was negative.The impliedexpectedrate of return
was set equal to 100% 17 (2) timesfor the return (differenced)model.If these impliedexpectedrates
of return had not been set equal to 100%, the estimated"/i and Rz for the return model would have
been 30 and 23%, respectively.
174 S.P. Kothari. J.L. Zimmerman / Journal o f Accounting and Economics 20 (1995) 155-192
Table 4
Regressions of expected rates of return thro,lgh time implied by the estimated slope coefficients from
the price, return, differenced-price, and deflated-price models on the long-term government bond
yields: Rt = 7o + ",'l i~ + errort
OLS estimation~ Cochrane-OrcutP
Standard error Standard error
Durbin-
Model 7o 7~ Adj. R" Watson 70 7~
Price 0.06 1.10 54.9% 0.99 b 0.07 0.98

0.01 0.16 0.02 0.23
Return 0.16 7.66 48.2 0.88 b 0.30 5.73
0.10 1.29 0.15 1.94
Diff. pr/ce 0.09 4.62 33.4 0.97 b 0.13 4.18
0.08 1.04 0.12 1.60
Deft. price 0.06 0.81 35.0 0.76 b 0.07 0.71
0.01 0.18 0.02 0.28
Rt = I/(bt) where Rt is the expected rate of return estimate for year t, b, is the estimated earnings
response coefficient from one of the four price-earnings specifications, and 1, is the long-term
government bond rate. If b, is less than 1. then the Rt is set equal to 1 to avoid extreme Rt
observations in a regression. R, is set equal to 1 seventeen times for the return specification, two
times for the differenced-pricespecification, and never for the price and deflated-price specifications.
There are 38 annual expected rate of return estimates from 1952 to 1989. The long-term government
b~,~d y/elds are taken from Ibbotson and Sinquefield (1989).
The price-earnings specifications are:
Price model: Pt = • + fiX, + er
Return model: Pt/Pr- ~ = • + f l X , / P t - ~ + e,
Differenced-price model: 3Pt = • + flzJX, + e,
Deflated-price model: P~/Xt = ~t(l/Xt) + fl + et
Results of ordinary least squares estimation and those from estimating the model after performing
the Cochrane-Orcutt AR~ 1) transformation of the data.
bThe Durbin-Watson statistic is significant at 5%.
bond yields over the sample period ranged from 3% to 14%, with an average of
6 . 8 % , t h e l a r g e c o e f f i c i e n t e s t i m a t e s in T a b l e 5 f o r t h e r e t u r n a n d d i f f e r e n c e d -
p r i c e m o d e ! s ....
~,-~nh,
r-.,. ~, ,,~n~r~lh,
. . . . . . . . .., h i g h .l~',,p!s
... o f e x p e c t e d ,,,at.~,o
"~'"~ ~,J ,,r J~t.,.alai.
,,,,,,,,, •~:,,,.,L.,i
e x a m p l e , if t h e b o n d y i e l d is 6 % , t h e n t h e r e t u r n - m o d e l - b a s e d e x p e c t e d r a t e o f
r e t u r n o n a t y p i c a l s t o c k in o u r s a m p l e will b e 3 4 % . T h e l a r g e 71 e s t i m a t e s a l s o
i m p l y tha~ t h e e x p e c t e d r a t e s o f r e t u r n b a s e d o n t h e p r i c e a n d d i f f e r e n c e d - p r i c e
m o d e l s e x h i b i t a v e r y h i g h d e g r e e o f s e n s i t i v i t y t o c h a n g e s in b o n d y i e l d s .
S.P. Kothari, J.L. Zimmerman / Journal of Accounting and Economics 20 (1995) 155-192 |75
Overall, the results from cross-sectional estimation of the various specifica-

tions of the price-earnings relation indicate that the price-model-based param-
eter estimates assume economically sensible values. The results are consistent
with the analysis in Section 2 under the assumption that prices contain informa-
tion about future ,.., nings changes.
4.3. Time-series analysis
Results of 1,017 firm-specific time-series estimation of the various price-

earnings specifications are reported in Table 5. In panel A, the average estimated
slope coefficient from the price model is 4.6, with a standard error of 0.13.
However, since we ignore cross-correlation among the coefficients' estimation
errors, the repo:~ed ~andard error undL,~.tates the true standard error. The
average explanatory power, 21.8%, is consia,., ably lower than that observed in
cross-sectional price model estimation. White's test is rejected at the 0.05 level
for 95 of the 1,017 firms.
The time-series estimation suffers from at least two problems. First, since
price and earnings levels are serially correlated through time, the regression
errors are autocorrelated. We therefore reestimate the regressions using
the Cochrane-Orcutt procedure (results are not reported). The average esti-
mated slope coefficient increases marginally to 4.9 (standard error = 0.12).
Second, because prices contain information about future earnings, the earnings
variable for period t is likely to be positively correlated with the regression
disturbance terms for periods t - 1 and earlier. [Keim and Stambaugh (1986),
Stambaugh (1986), and Fama and French (1988) discuss this problem, which
is geNaane to many studies.] The positive correlation between the indepen-
dent variable and lagged regression errors induces a finite-sample downward
bias in the estimated coefficient. The bias decreases in the number of time-
series observations and increases in the first-order autoregressive coefficient
on earnings, the independent variable (Stambaugh, 1986). Since the sample size
here is often 20-30 annual observations, and because time-series properties of
annual earnings are we!l-approximated by a random walk, the bias could be
serious.
The average estimated slope coefficient from time-series price-model regres-
sions, 4.6, is considerably smaller than that from cross-sectional estimation, 7.9
(see Table 3). It is not obvious that the difference is due entirely to the downward
bias in the time-series estimate of the average slope coefficient. Differences in the
samples employed in the time-series and cross-sectional analyses are unlikely to
explain the smaller average slope coefficient estimate from the time-series
estimation (see Footnote 10L Moreover, since the time-series sample comprises
r¢iatively large surviving filans, and because previous research indicates that
the expected rate of return on stocks is negatively related to firm size (Banz,
1981), the average slope coefficient for the time-series sample should be larger
176 S.P. Kothari, J.L. Zimmerman / Journal o f Accounting a n d Economics 20 (1995) 155-192
Table 5
Firm-specific time-series estimation of the price, return, differenced-price, and deflated-price speci-
fications of the price-earnings relation; 1,017 firm-specific regressions using a sample of 27,127
firm-year observations from 1952-1989
Coeff. Mean Std. err. Min. QI Med. Q3 Max.
Panel A: Price model, P, = ~t + fiX, + e,

17.3 0.41 - 28.5 8.0 15.0 24.0 85.2
fl 4.6 0.13 - 10.0 2.0 4.1 6.4 30.0
Adj. R 2 21.8 - 32.5 4.0 17.4 34.5 95.3
White 3.03 95 significant at 1.5 2.7 4. I
star. 0.05 p-value
Panel B: Return model, P,/P~_ i = ~ + [3X,/P,_ i + e,

:c 0.90 0.01 - 0.03 0.80 0.90 0.10 2.40
fl 2.3 0.06 -- 14.1 1.3 2.0 3.1 :3.8
Adj. R z 15.5 - 50.0 3.7 12.4 23.5 91.0
star. 0.05 p-value
Panel C: Differenced-price model, ziP, = ~ + f l d X t + e,

1.3 0.05 - 5.8 0.4 1.0 2.1 10.9
fl 3.5 0.13 -- 10.6 1.1 2.5 4.7 34.4
Adj. R 2 9.1 - 11.1 - 1.0 4.9 14.7 82.3
star. 0.05 p-value
Panel D: Deflated-price model, P J X , = ~t(l/X,) + fl + e,

15.6 0.43 - 75.5 6.1 12.3 21.8 78.2
fl 5.0 0.14 - 11.6 2.3 4.7 7.2 39.0
Adj. R z 47.3 - 29.5 23.5 48.6 72.4 98.6
star. 0.05 p-value
In each panel, average value of the estimated coefficients, adjusted R2s, and White (1980) chi-square
statistics from 1,017 time~ries regressions are reported. Standard errors are for the cross-sectional
sample mean coefficients. Qt and Q3 are 25th and 75th fractiles of the distribution of estimated
coefficients, adjusted RZs, or White statistics.
Sample: The sample includes any firm that has at least 20 consecutive annual earnings and return
observations. X, is annual earnings per share excluding the extraordinary items and earnings from
diseontinucd operations. Price relatives exclusive of dividends, P,/P,_ ~, are measured over calendar
years. Only firms with a December fiscal year-end are included. The largest and smallest 1% of
observations for each variable are excluded. Earnings, X , and prices, P,, are adjusted for stock splits
and stock dividends when deflating by P,_ i and obtaining differenced variables.
t h a n t h a t for t h e c r o s s - s e c t i o n a l s a m p l e . T i m e - s e r i e s e s t i m a t i o n m a y t h u s yield
c o n s i d e r a b l y d o w n w a r d - b i a s e d s l o p e coefficient e s t i m a t e s a n d / o r c r o s s - s e c -
t i o n a l e s t i m a t i o n m a y r e s u l t i n u p w a r d - b i a s e d s l o p e coefficient e s t i m a t e s , b u t
a c o m p l e t e r e s o l u t i o n o f t h i s i s s u e is b e y o n d t h e s c o p e o f t h i s p a p e r .
S.P. Kothari, J.L. Zimmerman / Journal of Accounting and Economics 20 (1995) 155-192 [77
Results of the return and differenced-price model estimations are provided in

panels B and C of Table 5. The return model yields an average c ~ t
~timate of 2.3 and the differenced-price model yields 3.5. The average c ~ n t
from the time-series estimation of the return model is larger than that from
cross-sectional estimation. In contrast, both time-series and cross-sectional
estimations of the differenced-price model yield average slope coefficient esti-
mates of similar niagnitudes. Thus, comparison of the cross-sectional and
time-series estimation of the price, return, and differenced-price models does not
reveal a consistent pattern in the estimated slope coefficient magnitudes. There-
fore, one cannot conclude that, because the average coefficient estimate from
time-series estimation of the price model is smaller than cross-sectional estima-
tion, the latter is biased upward.
The deflated-price model results are presented in Table 5, panel D. The
average slope coefficient estimate, 5.0, is close to that obtained from the price
model estimated using the Cochrane-Orcutt procedure (not reported in Table.,
5). ~6 Deflation by Xt, however, is not particularly helpful in reducing the
frequency of White test rejection.
In summary, all specifications yield cost of capital estimates that exceed the
estimate implied by the average price-earnings ratio of 12-13. The cost of
capital estimates from the price model are close to economically sensible values
and they track time-series variation in interest rates. The cost of capital esti-
mates from the price model arc also relatively invariant to using cross-sectional,
time-series, or pooled estimation methods. All of the models have serious
problems of hetcroscedasticity and/or other misspecification, with the price
model being particularly severely affected. The deflated-price model reduces
these problems.
5. Sensitivity of results to ,arious assumptions
This section examines whether the inferences in previous sections are sensitive
to the assumptions underlying the analysis. In particular, we examine whether: i)
transitory components in earnings affect the various models differently and thus
explain the observed differences across models; ii) omitted variables explain the
nonzero intercepts and whether the estimated slope from the price model is
upward biased because of a positive cross-correlation between the earnings
variable and the firm-specific coefficient; and iii) instrumental-variable regres-
sions yield 'better" coefficient estimates.
trAveragecoeff-ic/entfrom the book-va|ue-deflatedmodel,8.91,is comparableto that frompooled

and cross-sectionalestimations.
5.1. Transitory components in earnings and linear regression
5. !. 1. Transitory earnings components" effect on coefficient magnitudes

To assess the degree of bias in the estimated coefficients from the various
models, we use I/r as the benchmark, based on 'earnings following a random
walk" as one of the assumptions. However, earnings changes exhibit mild
negative serial correlation. If this violation of the underlying assumption affects
the various models differently, then we cannot unambiguously conclude that
earnings response coefficient estimates from the price model are less biased. We
briefly discuss the effect of transitory components in earnings on the coefficient
estimates from the various models.
If earnings are a mixture of a random walk and a zero-mean transitory
process, then the coefficient on earnings (i.e., the sum of these two components)
will be a weighted average of the coefficients on the random walk and transitory
components. Since the coefficient on the random walk component is fl = 1/r and
that on the transitory component is 1, the coefficient on earnings in a price
model will be smaller than fl (assuming r < 100%). Specifically, the coefficient
will be k(fl - 1) + 1, where k is the ratio of the variance of the random walk
component of earnings to the sum of variances of the random walk and
transitory components of earnings, i.e., 0 < k _< 1 (proof available on request). If
earnings are entirely permanent, then k = 1 and the coefficient will be ft.
Alternatively, if earnings are entirely transitory, then k = 0 and the coefficient is
1. Note, howe'-:er, that the average-price-to-average-earnings ratio for a sample
of firms will be close to fl precisely because earnings averaged over time and
across firms, by definition, are expected to have a zero transitory component.
Our results in Table 2 and from cross-sectional regressions in Section 4.2 are
consistent with the presence of transitory components: coefficients from the
deflated-price model are 9.0 to 9.6, compared to an average price-earnings ratio
of 12-13. The difference between the estimated slope coefficient and the average
price-earnings ratios indicates that transitory components account for about
25% of the variation in earnings. We also find (but do not report) that, as
expected, including special items and earnings without special items as two
distinct independent variables in the price and deflated-price models yields
a larger earnings response coefficient on earnings without special items.
Transitory earnings components affect the return-model analysis in much the
same way as the price-model analysis. Expectational error in the earnings
variable due to the forward-looking nature of price, however, complicates the
returr~Imodel analysis. In the absence of prices leading earnings, however,
transi,~ory components" effect on the return-model-based earnings response
coefficient estimate will be identical to that for the price model. When prices lead
earnings, to the extent that a portion of the transitory component is also
anticipated, the estimated earnings response coefficient from the return model
will be biased downward.
S.P. Kolhari. J.L. Zimmerman / Journal of Accounting and Economics 20 (1995) 155-192 179
5.1.2. Nonlinearity due to transitory components

Freeman and Tse (1992) argue that the return-earnings change relation is
nonlinear due to transitory earnings components. They argue further that an
earnings change is more likely to be transitory if it is relatively large (e.g., when
current earnings are negative and the earnings change is large and negative).
Thus, the return-earnings change relation will be relatively flat when earnings
changes are negative or large and positive, giving rise to the S-shaped return-
earnings change relation first documented by Beaver, Clarke, and Wright (1979).
A similar intuition underlies the nonlinear return-earnings changes specifica-
tions examined by Cheng, Hopwood, and McKeown (1992), Beneish and Har-
vey (1992), and Das and Lev {1992). Our discussion of transitory components is
applicable even if the importance of transitory components is not uniform
across different magnitudes of earnings changes. The main point of our paper is
that when prices lead earnings, return and differenced-price models yield biased
coefficient estimates, but the price model does not. To keep the analytics simple
in demonstrating this point, ¢¢e do not address nonlinear price-earnings speci-
fications. Nevertheless, to demonstrate nonlinearity in the price-earnings rela-
tion, we estimate various models excluding observations that are dominated by
transitory earnings, namely earnings loss observations. The average earnings
response coefficient from the return model increases from 1.65 in Table 3 to 3.18,
and that from the deflated-price model increases from 9.6 to 11.0.17 Thus,
controlling for the effect of tcansitorj earnings components does not fully
explain the differences in the magnitudes of coefficients from price and return
models.
5.1.3. Nonlinearity due to small-price deflator

Another source of nonlinearity is the use of price as a deflator in the return
model, particularly when the stock price approaches zero. Extremely low-priced
stocks behave more like at-the-money options. For these stocks, even modest
good news in earnings can produce a dramatically high rate of return, thereby
inducing a nonlinear price-earnings relation, is To assess whether the low
coefficient magnitudes from the return model are due to deflating by low prices,
we reestimate all the models using only observations with Pt- i > $3.00 and
using the book value of assets zs the deflator in the return model. There are
relatively small changes in the coefficient estimates relative to those reported
tTHayn (1993) reports similar results for the return model.

tSThe high rate of return is likely to be a consequence of the market revising its cash flow
expectations upward and a decline in the stock's expected rate of return. Very low-pr/ced stocks
typically have an extremely high market-valued leverage ratio, which will likely drop substantially if
good earnings news is reported. This unanticipated change in leverage will be associated with
a decline in the stock's expected rate of rate and therefore a positive stock return will be realized.
180 S.P Kothari. JL. Zimmerman / Journal of Accounting and Economics 20 (1995) 155-192
earlier. For example, the average coefficient from annual cross-sectional price-
model regressions ci~anges from 7.9 in Table 3 to 7.8. The corresponding
numbers for the r~turn model are 1.65 and 2.0.
5.2. Omitted-variables bias
This section investigates whether the nonzero intercepts reported in Section

4 are explained by firm size as a summary proxy for omitted variables from the
various models. We first explain the choice of firm size as a proxy for omitted
variables and then report results. This section also examines whether a corre-
lated-omitted-variables bias explains the observed differences in the earnings
response coefficient magnitudes from the various models. In particular, the
correlated-omitted-variables bias arises because earnings response coefficients
are an inverse function of systematic risk and there is an empirical correlation
between risk and the earnings variables in the various models. Since risk is not
included in the price-earnings models as a separate explanatory variable,
a correlated-omitted-variable bias arises. Our tests suggest that the resulting
bias is too small to explain the large difference between the price- and return-
model earnings response coefficient estimates.
N o n z e r o intercept. Since the intercept is predicted to be zero, the signi-
ficant nonzero estimates reported in the previous section suggest omitted
variables from the model. In the absence of theoretical guidance on possible
omitted variables, we add the natural logarithm of the market value of equity
at the beginning of period t as a second independent variable. Firm size is
known to be correlated with a wide range of variables including expected
stock returns, systematic risk, variance of raw and abnormal returns, stock
price, and dividend yield. Given that firm size is a catch-all proxy, we conjecture
that it would be correlated with the omitted variable(s) as well. In the price
and deflated-price models we also expect size to be useful because it captures
some of the forward-looking information in price (the dependent variable) that
is missing from current earnings. The explanatory power should therefore
increase~
The average estimated intercepts of the price and deflated-price models are
insignificantly different from zero when firm size is included. The earnings
response coefficient estimates remain highly significant, but they decline to 6 for
the price model and 7.7 for the deflated-price model. The coefficients on firm size
are also reliably positive. The average explanatory powers increase by 12% (i.e.,
from 53% to 65%) and 15% ~i.e., from 39% to 54%), consistent with firm size
prox)ing for omitted variabJes.
Unlike the price- and deflated-price model results, the average estimated
intercept from the return model, however, remains reliably positive. In fact, it
increases from 1.01 to 1.14 upon the inclusion of firm size in cross-sectional
regressions. The average estimated coefficient on firm size in the return model is
S.P. Kothari, J.L. Zimmerman / Journal of Accounting and Economics 20 (1995) 155--192 18|
reliably negative, consis:e.nt with a negative relation between firm size and
expected rates of return (e.g., Banz, 1981; Reinganum, 1981),
While firm size is helpful in rendering the average estimated intercept insigni-
ficant in the price model, White's (1980) test continues to indicate heteroscedas-
ticity and/or specification problems for the price, deflated-price, and differ-
enced-price models. More importantly, the White test statistic for the return
model is significant in 33 of the 38 cross-sectional regressions. Without firm s/ze,
it was significant in only six years. Since firm size is negatively correlated with
the variance of returns, the residual variance is correlated with firm size as an
independent variable, causing heteroscedasticity. Consequently, the White test
statistic is frequently significant.
Correlated-omitted-variable bias. Since the earnings response coefficient in all
the models is assumed to be a cross-sectional constant, regression errors include
(fli - fl)Xi,, where fli is firm fs coefficient, (fl~ - r ) is the deviation of firm/'s
coeffic/ent from the cross-sectional average, r, and X~, is earnings per share. In
addition to contributing to heteroscedastic errors, constraining the coefficient to
be a constant creates an upward bias in the coefficient estimate in the price
model because of a positive correlation between (fl~ -- r ) and X~t. To see this,
first note that, ceteris paribus, low-risk stocks have higher eacnings respr, nse
coefficients, i.e., fl~ - ,6 > 0; conversely, fl~ - / / < 0 for high-risk stocks. Thus,
f l i - / / and risk are negatively correlated in the cross-section. Next, as an
empirical matter, earnings per share and stock price are both decreasing func-
tions of risk, because both correlate positively with firm size, which is well-
known to be inversely related to the expected rate of return. 19 The net result is
that f l i - fl and earnings per share are positively correlated. The resulting
upward bias can be viewed as arising from a firm's risk being a positively-
correlated-omitted variable from the regression. A similar analysis indicates that
the coefficient from the return model is likely to be downward-biased.
To assess the degree of bias, we reestimate the price and deflated-price
models with the capital asset pricing model (CAPM) beta included in the
regressions. The C A P M beta is estimated using 60 monthly returns prior to year
t. e° The average coefficient on earnings from 38 cross-sectional price-model
ZgThe analysis is more compl/cated when one accounts for the positive relation betweenearnings
changes and risk changes (Ball, Kothafi, and Watts, 1992).
2°Betas estimated using monthly returns might not adequately capture cross-sectional variation in
expected returns ~e.g., Handa, Kothari, and Wasley, I989: Kothari, Shanken, and Sloan, 1995),
which might inhibit finding the correlated-omitted-variable bias in the price-earnings regressions.
We use betas estimated using monthly returns because for individual firms the use of longer-than-
monthly return observations to estimate betas sacrifices statistical p~'ecision potentially due to
nonstationarity. Another reason is that the effectof inclnding betas estimated from monthly returns
in the price-earnings regressions[s so small that it seemsunlikelythat better estimatesof beta would
alter the tenor of the resu,ts h~ the paper.
regressions is 7.6 (standard error = 0.40) compared to 7.9 reported in Table 3.

The corresponding numbers for the deflated-price model are 9.1 (standard
error = 0.53) and 9.6. As expected, the coefficient on beta is negative. Inclusion
of beta has a negligible effect on the average coefficient on earnings from the
return model: it increases from 1.65 in Table 3 to 1.68.
As a second proxy for risk in the price model to mitigate the upward bias in
the estimated earnings response coefficient, we employ the natural logarithm of
firm size. These results were briefly summarized earlier in this section in the
context of using firm size as a proxy for omitted variables from the
price-earnings models. Overall, results using both beta and firm size to mitigate
the upward bias in the price- and deflated-price models" coefficient estimates
indicate that the bias is small and, perhaps more importantly, the main result of
the paper that price and deflated-price models yield substantially less biased
coefficient estimates is unaffected.
5.3. Instrumental-variable estimation
Since the estimated slope coefficients from the price model are smaller than
the sample firms" average price-earnings ratio, the price-model estimated
slopes are potentially biased downward. Instrumental-variable estimation
is a common approach to obtain less biased slope coefficient estimates. We
use average earnings of all the sample firms belonging to a two-digit SIC
industry as the instrumental variable for earnings on all the firms in that
industry. We obtain an average estimated instrumental-variable earnings
response coefficient of 7.9, which is the same as that obtained from the
OLS estimation of the price model. Alternative interpretations of the results are
that two-digit SIC code membership is not a very good instrumental variable,
and/or the value-irrelevant noise is cross-correlated such that industry-level
regressions are not belpful in mitigating the bias they cause, or there are omitted
variables.
6. lmlflieations for other research
We show that, if earnings follow a random walk and if prices reflect a richer
information set than in the current and past time series of earnings, then price
models (in which stock prices are regressed on earnings per share) yield unbiased
slope or earnings response coefficients. By contrast, return models (in which
stock returns are regressed on earnings per share deflated by beginning-of-year
stock price) and differenced-price models (in which stock price changes are
regressed on changes in earnings per share) yield slope coefficients which are
biased downward. However, price, return, and differenced-price models all yield
significant nonzero intercept coefficient estimates, inconsistent with the theory.
S.P. Kothari. J.L. Zimmerman / Journal of Accounting and Economics 20 ~!995) 155- i 92 | 83
The return model exhibits less serious heteroscedasticity and/or other spec/fica-
tion problems compared to the price and differenced-price models.
The tests indicate that transitory components in earnings explain the fact that
the price model yields coet~cieats that are smaller than average price-earnings
ratios. Transitory components, however, do not explain the observed differences
between the estimated coefficients from the price and return or differenced-price
models. Including size in the price and deflated-price models yields intercepts
that are indistinguishable from zero. Bias due to a correlation between earnings
per share and the expected rate of return appears small. The instrumental-
variable regressions do not yield earnings response coefficient estimates that are
any closer to the price-earnings ratios than those reported earlier. Researchers
should be aware of the econometric limitations of the various models in
designing their tests. Future research should address the issue of nonlinearit/es
in the price-earnings relation.
Our findings have implications for capital market research in accounting.
Currently, much of the research uses the return model as the functional form.
The findings in this paper do not suggest using either price or return models
exclusively, because both have serious econometric problems and both have
impo~_ant deviations from the underlying theoretical model. Future studies can
be enriched by testing for sensitivity to the functional form and by incorporating
the relative strengths and weaknesses of alternative specifications. Using the
price model, perhaps in addition to the return model, could permit more
definitive inferences.
For example, many studies hypothesize that the earnings response coeffcient
will change around or during an information event because of accrual manipula-
tion (e.g., Collins and DeAngelo, ! 990, Collins and Salatka, 1991). Alternatively,
the coefficient also changes if the information content of prices or earnings
changes such that the unexpected earnings proxy used by ~ researcher becomes
more or less noisy over time, e.g., Skinner (1990) studies option-listing and
Rao (1989) studies firms after their initial public offerings. Use of price models,
in addition to return models, in the above research contexts could be useful
in drawing inferences about managemeat's accrual manipulation (via transitory
earnings) or the timeliness of earnings. If accrual manipulation introduces
random noise or transitory earnings, then both price and return regressions
should yield smaller earnings response coefficient estimates. If accrual manip-
ulation biases the earnings per share of all finns by a constant fraction, then,
depending on the upward or downward bias, both price and return models
should yield lower or higher slope coefficient estimates in the event period
compared to coefficients in the nonevent period. Finally, if the earnings
response coefficient is expected to change because prices are forward-looking,
then, unlike the return model, the price model does not predict a change in the
earnings response coefficient (because the forward-looking nature of prices does
not bias the earnings response coefficient estimate from the price model). The
use of both return and price models has the potential to yield more convincing
evidence.
T --ts of information content of accounting earnings and its components are
also" .mmon in the accounting literature. These tests either assess the signifi-
cah~ of estimated slope coefficients or test incremental explanatory power of
a set of variables (e.g., Beaver, Griffin, and Landsman, 1982; Beaver and
Landsman, 1983; Barth, Beaver, and Landsman, 1992). While we analyze only
a simple regression of prices on earnings, the advantage of price studies is that
even in a regression of prices on various revenue and expense items they yield
unbiased (or less biased) slope estimates compared to return studies. One must,
however, be careful in interpreting the coefficients on various revenue and
expense variables from a price regression. The coefficient magnitudes will
depend on the time-series properties of these items and the riskiness of the
various items. In addition, the empirical correlation among the variables can be
important. Therefore, coefficients on various revenue and expense items are not
expected to be equal (Jennings, 1990).
Finally, while price mcdels likely yield less biased slope estimates in in-
formation content studies, it is important to recognize that price models do
not measure information arrival over a period. The dependent variable, price,
is not a measure of the impact of information arriving in the current period.
In an efficient market, the impact of information over a period is measured
by stock returns (i.e., the deflated change in the price level). However, the
explanatory power of return models provides only a lower bound on the
information content of an accounting variable because of the errors-in-
variables problem discussed herein. Stated differently, unless the market's
earnings expectations are proxied accurately, the return model R2s understate
the extent to which current period's accounting numbers reflect the information
affecting security prices. While a significant association between returns
and accounting numbers indicates information content, the low R2s of
the return studies might potentially lead researchers to draw incorrect
inferences, e.g., Lev's (1989) inference that earnings contain "noise' or Shiller's
(1989) conclusion that much of the stock market's volatility reflects investor
irrationality.
Appendix
This appendix describes a stylized valuation model that assumes that prices
are set in the market using only the information in the current and past time
series of earnings. Under such a valuation model, and when earnings follow
a random walk, the price, return, and differenced-price specifications of the
price-earnings relation are equivalent. We then examine alternative models by
allowing prices to reflect a richer information set than the current and past time
series of earnings. Finally, implications of value-irrelevant noise on alternative

specifications are briefly examined.
Alternative specifications under the stylized valuation model. We make the
following assumptions: (i) earnings for a period c o n t e m p o r a n e o u s l y reflect all
the information that is in the return over the period, i.e., prices do not lead
earnings; (ii) the expected rate of return is constant through time; (iii) earnings
follow a r a n d o m walk; and (iv) the dividend p a y o u t ratio is 100% (i.e., earnings
equal dividends). Assuming dividends equal earnings (assumption iv) simplifies
the analytics. We also assume that shareholder wealth is unaffected by the
dividend-payout policy, because the firm's dividend policy per se is assumed not
to signal anything a b o u t the profitability of future investments. Therefore,
implications of the analysis below hold under the m o r e realistic assumption of
a less-than-100% dividend payout. U n d e r the assumptions (i) through (iv), prk:e
is given by Pt = E,(Xt+ t)/r = X J r .
Price specification. The price regression model is
P, = a + / 3 X , + et, (A.I)
where a and/3 are the intercept and slope coefficients, and the error term, e,, is
included because empirically the assumptions underlying the valuation model
may be violated. The estimate of/3 is 21
b = cov(Pt, X , ) / v a r ( X , ) . (A.2)
Eq. (A.2) is simplified by substituting P, = X , / r from the price model (1) to

obtain
b =" cov(Xt/r, X , ) / v a r ( X , } = 1iv =/3. (A.3)
Using (1), {A.2), and (A.3), the estimated intercept can be shown to be zero.
Return specification. T o derive the return specification, we divide Eq. (1) by
price at the beginning of period t:
Pt/Pt- l = (1/r}Et(X,+ l ) / P , - I. (A.4)
zt Since price and earnings follow a random walk, their (time-series) variances are undefined. [We
define b in Eq. (A.2) merely for notational comparability with the expressions for b using other
price-earnings specifications.] However, b is well-defined in the sen~ that it can he estimated as
a projection of P, on X, using the sample observations. If the price and earnings vectors are
cointegrated {i.e..even though the two variables follow a random walk, the errors have a zero mean
and constant variance because movements in the two variables are governed by common factors; see
Engle and Granger, 1987; Maddala. 1990).then there is no econometric difficulty in estimating the
price model (1). To mitigate potential econometric problems in estimating the valuation models, we
also estimate model (I) using a suitable deflator (see estimation of deflated valuation models in
Section 4).
The empirical analog of (A.4), using X, as the time-series expectation proxy for
E , ( X , + l), is
P,/P,_ ~ = • + X,/P,_ t + e.,. (A.5)

Analogous to Eq. (A.3), E(b) =/~ = 1/r, and • is expected to be zero. Therefore,
the price and return models give equivalent estimation of the slope coefficient.
F i r s t - d i f f e r e n c e d - p r i c e s p e c i f i c a t i o n is
P, - E,_ ,(P,) = APt = (1/r)[X, - E,_ ~(X,)] = ( 1 / r ) A X t . (A.6)

By substituting the pricing model (1), the earnings response coefficient esti-
mate from an empirical analog of (A.6) can be shown to have Elb) =/~ = l / r .
A l t e r n a t i v e s p e c i f i c a t i o n s w h e n p r i c e s l e a d e a r n i n g s . Section 2.2 in the text
describes the 'prices-lead-earnings' assumption. The analysis below examines
the effect of prices containing information about two future periods' earnings
changes on the alternative price-earnings specifications. Using Eq. (5) from the
text, the market's expectation of future earnings is
E~(X,+ l) = X , + at+ ,., + at+ l.t- I (A.7)

and
E~{X,+k) = X , + a , + l . t + a , ~ l . , - t t- at+2.t for k >_ 2. (A.8)
Thus, the market expects a perpetuity of X ~ + a t + t . t + a t + t . t - i +at+za,
except that in period t + 1 earnings are expected to be lesser than the perpetuity
by a , + 2 . , . Therefore, P, is given by the present value of the perpetuity minus
a, + 2., discounted over one period:
P, = [(Xt + a , + t . , + a , + t . , - , + a,+2.,)/r] - [a,+2.,/{1 + r)]
~, ( X , + a,~ t., + at+ l.r- 1 + at+ 2 . t ) / r , (A.9)

where the approximation is obtained because a,+ 2 . t / ( l + r) represents a dis-
counted one-period cash flow from the anticipated earnings a,+2.t and thus
makes only a small contribution to P,.
P r i c e s p e c i f i c a t i o n . The earnings response coefficient estimate from a price
regression is
b = cov{P,, X,)/var(X,)
cov[{P,-2 + A P , - I + 3 P t ) , X z - 2 + St--I + a t - t . , - 2 + a t - l . t - 3 + st + at.t- l + ar.t-2]
var[X,-2 + s,-t + a , - t . , - z + a t - t . t - 3 + st + ar,t-t + at.t-2]
coy[P,_ z.{X,-- z + a,_ t.,- 2 + a,_ l.,- 3 + a,.,_ 2 )] + coy[APt ._1.{s,_t + a.... t )] + cov[ AP,, s,]
var[X,_z + a,_ l.,-z + a,_ 1.,-3 + a t . t - 2 ] + var[s, t + a,.~ i] + var[s,]
I l/r)var[X,_ 2 + at- l.,- 2 + a,_ x.z- 3 + at.,- z] + { l/r)var[st _ 1 + a,.,_ t J + { l/r)var[st]
=.
var[X,_ 2 + a,_ t., - z + a,_ i.,- 3 + a,.,_ z] + var [s,_ t + a,.,_ t] + vat[s,]
= l/r. {A.10)
The price specification thus yields an unbiased estimate of the earnings response
coefficiet,,. The intuition, once again, is that the econometric consequence of
prices containing information about future periods' earnings changes is that
there is an uncorrelated-omitted-variables problem that leaves the estimated
slope coefficient unbiased.
Return specb'ication. The earnings response coefficient estimate from a return
model is
coy [{Xt- 1 + st + at.t- l + a t . t - 2 ) / P t - l, P t / P t - l]
b=
var[(Xt_ l + st + at.,- t + at.t- 2 ) l P t - 1]
cov(st/ et - ~, Pt/ P t - a)
(A.11)
= var[{Xt_ ~ + at.t- ~ + a t . t - z ) / P t - l] + v a r [ s t / P , _ 1]"
To simplify the expression for b, first focus on the var[(X,_ ~ + at.t- 1 + at.,-2)~
Pt-1] term in the denominator of Eq. (A.I 1). Since (X,-l + a:.,_ i + at.t-,_ +
at+ l . t - l ) / P t - i] ~ r is a constant [see Eq. (A.9)], ( X t - 1 + at.t- l + a t . , - 2 ) / P t - 1
and a,+ L , - ~ / P t - ~ are (almost) perfectly negatively correlated and, therefore,
var[(Xt_ 1 + at.t- 1 + a t . , - 2 ) / P t - 1] = var(at+ Lt- 1 / P t - 1). To derive the degree
of bias in the earnings response coefficient estimate, we must make assumptions
with respect to the relative magnitudes of the variances of st, a,.t- ~ and a,.t-2- If
the variances of s,, at.t-~, and a,.t-2 are assumed equal, v a r l a t + L , - t / P t - l )
= v a r l s , / P t _ t). Substituting this result in Eq. (A.11),
b = c o v ( s t / P , - l, P t / P t - 1 )/2 * v a r ( s t / P t - l ), (A.12)
which implies E(b) = 0.5 ,(I/r). The return model yields biased slope coefficient
estimates because earnings changes are anticipated. The greater the degree of
earnings anticipation (i.e., larger variances of a,.,_ ~ and at.,-2) relative to the
variance of the surprise component of X,, i.e., s,, the greater the degree of bias in
the earnings response coefficient estimate. Also, the bias will be greater if prices
anticipate earnings changes more than two periods ahead (e.g., Kothari and
Sloan, 1992) because st will then be a relatively smaller component o f A X t . Note,
however, that our objective is not to determine the exact degree of bias, but
merely to demonstrate that the return specification produces a biased coefficient
when prices lead earnings.
Differenced-price specification. We derive the bias in the estimated earnings
response coefficient from the differenced-price specification when prices lead
earnings by one period. We do not explore the bias under the assumption that
prices lead earnings by two periods because the estimated coefficient is biased
even when pi~ce.~ anticipate one-period-ahead earnings changes. Barth, Beaver,
and Landsman (1992), among others, provide an intuitive discussion of bias in the
estimated slope coefficients from a differenced-price model that could arise if
changes in earnings do not accurately proxy the surprise in earnings to the market.
188 S.P. Kothari. J.L. Zimmerman / Journal of Accounting .nd Economics 20 (1995) 155-192
The slope coefficient estimate from the differenced-price regression model is

given by
b = coy [AP t, AXt]/var(Xz)
= coy [(l/r) (st + at + 1.t), (st + at.t - t )]/var [st + at.t - t ]
= (1/r)var{st){var(st) + var(at.t-1)}. (A.13)
Eq. (A.13) indicates that the earnings response coefficient estimate will be biased
because of the vat(at.t- 1) term in the denominator. Once again, the degree of
bias will be an increasing function of the extent to which earnings changes are
anticipated by the market versus they are a surprise.
Alternative specifications when earnings contain value-irrelevant noise. The
notion of a value-irrelevant component in earnings is as formalized in Eq. (6) of
the text. The earnings component without noise, xt, is assumed to follow
a random walk:
xt = xt-1 + ~h, (A14)
where rh has a zero mean and variance of tr2 , and it is serially uncorrelated, u,
is also a zero mean, serially uncorrelated, white noise term with variance a,z.
x, is perfectly correlated with price and u, is uncorrelated with xt as well as price.
The pricing equation is
Pt = (1/r) EtU(xt + l) = ( l/r)xt. ~A.15)

Price specification. The slope coefficient estimate from a price regression
model is (see Landsman and Magliolo, 1988)
b = cov(Xt, Pt)/var(Xt)
= coy [(xt + u,), Pt]/var[xt + ut]

= coy(x,, Pt)/{var(x,) + var(ut)}
= (1/r)[1/{ 1 + var(ut)/var(xt)}], (A.16)
where, given the price equation (A.15), we substitute 1/r for cov(xt, Pt)var(xt).
Eq. (A.16) indicates that, unless var(ut) = 0, b is biased toward zero. The bias
increases in the ratio of the variances of ut and x,.
Return spec!t~cation. The slope coefficient from estimating the return regres-
sion model is
b = coy ( X J P t - a, Pt/Pt- t ) / v a r ( X t / P t - 1)
= coy [-(xt + ut)/Pt-1, PdPt-1]/var['(xt + ut)/P~-t]
= c o v ( x J P t - l, P J P t - 1)/{var(xJPt_ i) + var{uJPt- 1)}
= {1/r)[l/{ 1 + var(ut/Pt- 1)/var{x,/P,- 1)}], (A.17)
S.P. Kothari, 3.L. Zimmerman / Journal 6f ,~.ccounting and Economics 20 (1995) 155-192 189
where we substitute 1/r for cov(xJP,_ 1, Pt/Pt- t)/var(x,/P,- 1). As in case of the
price specification, the return specification also yields a biased slope c ~ t
estimate because earnings contain valuation-irrelevant noise. The degree of bias
is determined by the ratio var(u~/P,_ ~)/var(x,/P,_ ~).
Differenced-price specification. The analysis here is similar to that for the price
specification. Specifically, the estimated slope coefficient is given by
b = (Â/r)[l/{1 + var(Aur)/var(Axt)}]. (A.18)
The degree of bias in Eq. (A.18) depends on the ratio of var(Au,) to var(Axr).
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Price and Return Models

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Price and Return Models

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EI.

SEVIER Journal of Accounting and Economics 20 (1995) 155-192

Price and return models

(Received March 1993; final version received January 1995)

Key words: Capital markets; Price-earnings regressions; Earnings response coeffic/ents

J E L classification: MI4; C20

Researchers in accounting must often choose between return models, in which

0165-410U95/$09.50 © 1995 Elsev/crSc/cnce B.V. All r/ghtsreserved

a random walk, the intercept in price- and return-earnings regressions should be

2. Price and return specifications

This section examines alternative price-earnings specifications when the

~Theanalyticsare simplifiedby assuminga random walk time-seriesproperty for annual earnings.

of value-irrelevant noise results in biased slope coefficients for all price-earnings

2.1. Alternative price-earninffs specifications under a stylized valuation model

Alternative price-earnings specifications commonly estimated in the ac-

Price model: P~ = ~ + fiX, + et, (1)

R e t u r n model: P , / P , - i = • + f l X j P , _ 1 + e,, (2)

Differenced-price ,nodel: alP, = ~ + f A X , + e,, (3)

2.2. Alternative specifications when prices lead earnings

Prices-lead-earnings assumption. Considerable research since Beaver, Lam-

X f -= X , - t + St + at.t_ 1 + at . t _2, (5)

Xt = X t - 1 4" st 4" at.t-t 4" at.t-2.

Differenced-price specification. The differenced-price specification, Eq. (3),

2.3. Alternative specifications when earnings contain value-irrelevant noise

Considerable research examines the price-earnings relation under the as-

All three specifications yield unbiased coefficients (earnings response coeffi-

3. Data and descril~ive statistics

We use per-share values of prices and earnings to reduce the presence of

This section presents results of estimating the various price--earnings

Variable Mean Std. dev. Min. Med. Max.

Panel A: Pooled and cross-sectional analyses sample, N = 38,890 firm-years

Panel B: Time-series analysis sample, N = 27,127 firm-years

4.1. Pooled time-series and cross-.'-ectional analysis

Results o f p o o l e d time-series cross-sectional e s t i m a t i o n o f '~he v a r i o u s m o d e l s

Earnings response coefficient

Standard error Standard error

Price 11.47 0.104 0.100 6.55 0.039 0.049 42.2% 1025

Price model: Pr = • + ffXt + ~,

high t o be plausible. T h e W h i t e statistic indicates that, like t h e price m o d e l , t h e

P,/X, = ~(I/X,) + )6 + ~,. (7)

SDeflating by X, also mitigatesheteroscedasticerrors in a price model that may be caused by an

coefficients of all specifications. Empirically, however, only coefficients from the

~The ratio of averagepriceto averageearningswouldgenerallybe smiler than the averageof the

4.2. Cross-sectional analysis

Results of 38 annual cross-sectional estimations of the price, return, differ-

Coeff. Mean Std. err. Min. QI Med. Q3 Max.

Pane~ A: Price model, P, = :~ +/1Xt + et

Panel B: Return model, Pr/Pt- i = ~ + 3 X , / P t - 1 + er

Panel C: Differenced-price model, APt = • +/~AXt + et

Panel D: Deflated-price model, P t / X t = {1/Xt) 4- ~ 4- ~,t

Deflated-price model. Panel D reports results of estimating the deflated-price

4.2.1. Estimated earnings response coefficients and interest rates

14Bycorrelatingthe impliedexpectedrates of return with the governmentbond yields,we implicitly

OLS estimation~ Cochrane-OrcutP

Standard error Standard error

Price 0.06 1.10 54.9% 0.99 b 0.07 0.98

Overall, the results from cross-sectional estimation of the various specifica-

4.3. Time-series analysis

Results of 1,017 firm-specific time-series estimation of the various price-

Coeff. Mean Std. err. Min. QI Med. Q3 Max.

Panel A: Price model, P, = ~t + fiX, + e,

Panel B: Return model, P,/P~_ i = ~ + [3X,/P,_ i + e,