Fundmentals To Market

Accounting Research Center, Booth School of Business, University of Chicago
Accounting Earnings and Security Valuation: Empirical Evidence of the Fundamental Links
Author(s): Peter D. Easton
Source: Journal of Accounting Research, Vol. 23, Studies on Accounting Earnings and
Security Valuation: Current Research Issues (1985), pp. 54-77
Published by: Wiley on behalf of Accounting Research Center, Booth School of Business,
University of Chicago
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Journal of Accounting Research

Vol. 23 Supplement 1985
Printed in U.S.A.
Accounting Earnings and Security
Valuation: Empirical Evidence of

the Fundamental Links
PETER D. EASTON*
1. Introduction
Considerable accounting research has been devoted to analyzing the
relation between accounting data and contemporaneous security prices.

A conceptual framework that explains this relation is provided by the
information perspective on accounting. This framework involves an
information link, between accounting data and the future stream of

benefits from an equity investment, and a valuation link, between the
future benefits and security price.1 The aim of this paper is to provide
empirical evidence of these fundamental links.
In a world with rational wealth-maximizing investors, security price is
generally regarded as being tautologically equal to the present value of
expected future benefits of share ownership. The contemporaneous as-
sociation between accounting earnings and security price is therefore a

* University of Chicago. This paper is based on my Ph.D. thesis at the University of
California, Berkeley. I wish to thank James Ohlson and Stephen Penman for their help
and encouragement at various stages in the development of my dissertation. The generous
financial support of the Ernst and Whinney Foundation, Arthur Young and Co., and the
Professional Accounting Program at the University of California, Berkeley is gratefully
acknowledged. I am indebted to the faculties at the University of British Columbia, the
University of Chicago, and Massachusetts Institute of Technology, where an earlier version
of this paper was presented. Special thanks are due to Bruce Grundy, David Hsieh, Richard
Leftwich, Katherine Schipper, and Mark Zmijewski for many helpful discussions.
1 This conceptual framework is formally presented in Ohlson [1979] and Garman and
Ohlson [1980]. These studies examine the implications of the nature of the information
and valuation links for the form of the contemporaneous link.
54
Copyright (?, Institute of Professional Accounting 1986
ACCOUNTING EARNINGS AND SECURITY VALUATION 55
"reduced-form" characterization of the information link between accounting earnings and future benefits. Since security prices are observ-
able variables while the fundamental variables-expected future benefits-are unobservable, it is not surprising that tests of the information
content of accounting data have relied on market-based measures of

information. The equivalence of security price and the present value of
expected future benefits justifies the use of market-based measures of

information content. However, tests of the form of the link between
accounting earnings and security prices require some consideration of
the expected future benefits themselves. In this paper, ex post dividend

realizations are used as a measure of expected future benefits. This paper
is an empirical study of the relation between accounting earnings and
future dividend realizations, and between security price and future divi-
dend realizations. Dividends are chosen as the valued future attribute for
two reasons: (i) authoritative accounting statements explicitly identify
future cash receipts as the variable about which accounting data should
provide information;2 and (ii) the risk-adjusted dividend capitalization

formula is a widely used theoretical construct relating future benefits
from equity investment to security price.
The empirical tests begin (in section 3) with a test of the risk-adjusted
dividend capitalization formula. This formula expresses the value of a

security at time t as the discounted sum of the expected future stream of
dividends from time t to infinity, with discount factors equal to the
expected return on the security. In this paper, the expected future
dividend stream is represented by the actual stream of dividend realizations following the date of the financial report. The price of the security
at the end of the period of available data is used to represent the dividend
stream from the end of the sample period to infinity. Estimates of the
expected return on the security are used as the discount weightings. The
empirical tests are based on a cross-sectional regression of the present
value of the future dividend stream (calculated according to the risk-
adjusted dividend capitalization formula) on security price. The results

demonstrate a strong valuation link between security price and the
present value of future dividends.
If dividends are the valued future attribute, then information variables
will be related to security price because they are related to future
dividends. In this paper, accounting earnings are used as the information
variable for two reasons. First, accounting earnings are a readily available
summary information variable, and second, accounting earnings are the
financial statement datum that is most frequently analyzed in both the
2For example, the FASB Statement of Accounting Standards No. 1 [1978] states:
"Financial reporting should provide information that is useful to present and potential
investors and creditors in assessing the amounts, timing and uncertainty of prospective
cash receipts."
56 ACCOUNTING EARNINGS AND SECURITY VALUATION: 1985
popular press and the academic literature. The cross-sectional correlations between accounting earnings and the present value of the future
dividend realizations are used (in section 4) as an indication of the
information content of accounting earnings with respect to future divi-
dends. The correlation between security price and the present value of
the future dividend realizations is used as a benchmark against which to
compare information content. The analyses are based on cross-sectional

regressions of present value on accounting earnings and cross-sectional
regressions of present value on both accounting earnings and security
price.
The association between accounting earnings and present value has
strong statistical significance, indicating that accounting earnings are a

useful summary of the available information about the future cash
receipts from an equity investment. On the other hand, security price
provides a statistically significant increase in the explanation of the
cross-sectional variation in present value in addition to that provided by

accounting earnings. Thus, there appears to be significant information
regarding the future stream of dividends that is not captured by accounting earnings.
The primary focus of this paper is on the information link between
accounting earnings and the present value of expected future dividends.

Since an explanation for this link is that accounting earnings are a
readily available summary information number, it is pertinent to ask
whether the nonaccounting (but certainly as readily available) information number, current dividends, is also such a summary datum. This
question is addressed in section 5. In a multiple regression of the present
value of future dividends (dependent variable) on accounting earnings
and current dividends, the coefficient on accounting earnings is highly
significant. This result demonstrates that accounting earnings summa-
rize significant information in addition to that implicit in current dividends. The coefficient on dividends in this multiple regression is negative
and significant at the 5% level. That is, conditional on the level of
accounting earnings, the higher the dividend payment in the current
year, the lower the dividend payments in the future. However, in the
simple regression of present value on current dividends, the coefficient
on dividends is positive. In other words, if all other information is ignored,

higher current dividends imply higher future dividends, but for a given
level of accounting earnings higher current dividends imply lower future
dividends. Thus, the information in accounting earnings appears to be

useful in interpreting the information in current dividends.
In summary, the results in this paper provide empirical evidence of an
information link between accounting earnings and future dividends and
a valuation link between future dividends and security price. These
associations provide an explanation for the contemporaneous association
between accounting earnings and security prices that is reported in the
extant literature.
2. Data and Sample Selection

The results reported in this paper are based on the period 1962-80.
Accounting earnings for fiscal year 19623 and security prices three
months after the end of 19624 are evaluated as predictors of dividend
payments and the capital gain over the next 19 years. The empirical
estimation procedures are also conducted for samples 1962 through 1971,
1962 through 1979, 1963 through 1979, 1963 through 1980, and 1972
through 1980. For these latter samples, only those results that are
qualitatively different from the 1962 through 1980 sample are reported.
The source of the accounting earnings and annual dividend data is the
Standard and Poor's Compustat Annual Industrial File. Security prices

and the amounts and dates of dividend payments are obtained from the
Center for Research in Security Prices (CRSP) Monthly Stock Master
File. Securities for which there is a missing record of any one of the
required variables over the respective sample periods are excluded from
the sample. Security return data are obtained from the CRSP Monthly
Stock Return File. Securities that do not have a complete record of
returns on the file for the entire five-year period ending fiscal year 1962
are excluded.5 These selection criteria result in a sample of 349 firms.6
Market return data are obtained from the CRSP Monthly Stock Index
File.
3. The Descriptive Validity of the Dividend Capitalization

Formula
This section focuses on the valuation link between security prices and
future dividend realizations. The valuation link is represented by the
risk-adjusted dividend capitalization formula which expresses the value
of a security at time t as the sum of the expected future stream of
dividends from time t to infinity. In a world with rational wealthmaximizing investors, this value will be equal to security price. The
empirical tests in this section examine the relation between security price
and the present value of future dividend realizations. The tests simulta'The sample includes firms with fiscal year-ends other than December 31.
4 Security prices were taken three months after the end of the fiscal year in order to
ensure that they reflect the information conveyed by accounting earnings. Securities
Exchange Commission requirements ensure that accounting earnings will be announced
within three months of the end of the fiscal year. Chambers and Penman [1984] showed
that only 3% of annual reports are released later than 12 weeks after fiscal year-end.
5 Financial and insurance companies and utilities are also excluded from the sample.
Regulation and the nature of the assets of these companies may result in noticeably
different valuation and information relationships from those of other types of companies.
6 Since the sample includes only large and stable firms, the results may not be generalizable to a wider sample. However, the aim of this paper is to provide empirical evidence
of the fundamental links associated with the contemporaneous link between accounting
earnings and security price that has been observed in the information content studies. It is
appropriate, therefore, to use this limited sample.
58 PETER D. EASTON
neously seek evidence of security market rationality and of the descriptive
validity of the risk-adjusted dividend capitalization formula.

The risk-adjusted dividend capitalization formula, discussed in Beja
[1967], Garman [1978], Rubinstein [1976], and Ross [1976], may be
written as follows:
T-1
Pj*t= E E[djs I Zt]/ f (1 + E[rjT I ZJ)

S=t
T=t
(1)
T
+ E[d1TI Zt]/ 11 (1 + E[rjT I Zt])

T=t
where Pj*t denotes the present value of the dividend stream at time t,
E[djs I Zt] is the expected dividend for security j at time s conditional on
the vector of available information Zt, E[rjT I Zt] is the conditional
expectation of the T period return, and E[dT I Zt] is the conditional
expectation of the liquidating dividend at the end of the holding period.
In this paper, the actual ex post dividend payments (djs) are used as
surrogates for dividend expectations E[djs I ZJ.7 The date of the dividend
payment s is taken as the date on which the check was mailed. The
expected liquidating dividend E[d]T I Zt] is represented by the security

price at time T. The expected return on the security E[rjT I Zt] is determined according to the Fama [1977] and Bar-Yosef and Leland [1982]
formulation of the multiperiod capital asset pricing model as the sum of
the risk-free rate and the product of "beta" and the expected market
premium. That is, expected return is estimated using the following
formula:
rjT = rfT + fijt(im - rfT) (2)
where r T is the estimate of expected security return over the time period
t to T, -fT and rmT are, respectively, estimates of the risk-free rate and the
expected return on the market over time period t to T, and fjt is the firmspecific estimate of systematic risk (beta) at time t.8 The term structure
of the risk-free rate is estimated from available riskless investments9 at
7 It is inconceivable (and contrary to the model being tested) that a good model of
dividend expectations would not rely on security prices, accounting earnings, and/or current
dividends (as predictors). However, the use of these predictors in this paper would be
circular.
8 A shortcoming in the estimation of the expected return on the security is reliance on

the capital asset pricing model with the associated problems of estimating beta and the
market premium. Although this model has been analyzed extensively in the theoretical
finance literature, empirical tests have generally shown significant deviations from the
predicted relationships. Obviously, Pjt is measured with an error that is difficult to define.
This error in measurement has a considerable impact on the empirical estimation procedures in this paper, and some sensitivity analyses are conducted to examine the potential
effect of this measurement error.
'These investments include U.S. government and governmental agency bonds. The term
structure estimation employs an optimization procedure that minimizes both the effect of
the time of the announcement of accounting earnings. Estimates of beta

are based on security return data for the 60 months prior to the time of
the announcement of accounting earnings. The average monthly market
premium between January 1926 and the time of the announcement of
accounting earnings is used as the estimate of the expected market
premium.s
In contrast with beta and the risk-free rate, there has been little
research on estimating the expected return on the market. Merton [1980]
observes that estimating expected return on the market by taking the

current expected market premium and adding to it the expected risk-free
rate does not take account of the level of risk associated with the market.
Confronting this problem is, however, beyond the scope of this paper. As
an attempt to avoid the problem the sensitivity of the results to the
estimate of the return on the market (and implicitly the sensitivity to

the choice of discount rate) is examined by repeating each empirical
estimation procedure using estimates of Pj*t based on eight different

estimates of expected market premium. The a priori best estimate of the
market premium is the historical average market premium. The other
estimates are based on seven different multiples (1.6, 1.4, 1.2, 0.8, 0.6,
0.4, and 0) of the historical average market premium.
The estimate of Pj*) may be written as follows:

T-1
Pi~t = E disl H ( 1 + j )+ Pi TI 1 ( 1 + Aj (3)

s=t
T=t
Tt
Pj}t is the ex post rational price of the security at time t. A number of
studies (for example, LeRoy and Porter [1981], Shiller [1981], and
Grossman and Shiller [1981]) have constructed tests of market ration-
ality/efficiency based on estimates of Pj*t for portfolios of common stocks.

All of these studies observe that, if prices are rational, then:
Pit = E [Pjnt I zt] (4)

that is:1"
Pj*t = Pi t + bi t (5)
and hence:
Var(Pj*t) > Var(Pjt). (6)

bond heterogeneity and the errors in measurement resulting from the interpolation between
observations. An algorithm developed by Hoag [1982] is used to calculate the term structure.
10 Ibbotson and Sinquefield [1979] provide historical return data from January 1926December 1978. Based on this data, the average (compound) monthly return on long-term
government bonds over the period January 1926-March 1963 was 0.00269, and the average
monthly return on the CRSP-value-weighted market return index was 0.00780. The average
market premium, therefore, was 0.00511. This average market premium is the estimate of
the expected market premium used in the calculation of expected security returns for firms
with December fiscal year-ends. The expected market premium is calculated similarly for
firms with fiscal years ending in months other than December.
" See Shiller [1981, p. 422] for a detailed discussion of this step.
60 PETER D. EASTON
In each of these papers, the empirical evidence reveals that security
prices violate the variance inequality specified in equation (6), leading to

conclusions of market irrationality and inefficiency. Subsequently Copeland [1983], Kleidon [1983], and Marsh and Merton [1984] provide
several reasons that the conclusion of market irrationality is not justified
in these "variance bound" studies.
In this paper, market rationality, as defined by equations (4) and (5),

is tested via cross-sectional regressions of the form:
Pt= aot + a1tpjt + 'it (7)
(where aot and ait are regression coefficients and cjt is the regression
disturbance term.)12
The disturbance term ejt in regression (7) includes the difference (bjt)
between the ex post rational price (Pjt) and the security market price
(Pjt). The difference may be interpreted as error in measurement of Pat.
This error arises due to errors in measurement of each of the components
of Pitt (the risk-free rate, the market return, beta, expected dividend
payments, and the expected liquidating dividend). The disturbance term
ejt is assumed to have zero mean but is unlikely to have constant variance.
To overcome this problem the regression parameter covariance matrix
estimator is calculated according to the method described by White

[1980] .13
All regressions reported in this paper are conducted on a cross-section
of observations. Also, all regressions are conducted in "levels" form (for

example, price per share on present value per share) rather than in
"change" form (for example, change in price per share on change on
present value per share).14 These choices are a result of the method of
estimation of P>. The effect of error in measurement of Pitt will be less

12In regression (7), Pat is used as the dependent variable in order to minimize the
problems associated with error in measurement of Plt13 White's procedure may be briefly summarized as follows. Consider the model:
yi= xi + ei (i = 1, ..., n)
where (xi, ei) is a sequence of independent, not (necessarily) identically distributed random
vectors such that xi (a 1 x k vector) and ci (a scalar) satisfy E(x 'ei) = 0. ,0 is a finite
unknown k x 1 parameter vector to be estimated. Under additional assumptions that
essentially ensure that the (X'X/n) matrix (where X is the k x n matrix made up of the
xi vectors) is nonsingular and finite, White proves that the following covariance estimator
is consistent:
n
Var(3) = (X'X/n)_ E [eZ2(xixi)]/n(X'X/n)-1.

i=1
The regression results reported in the paper are OLS estimates of the regression coefficients
with the t-statistics based on White's consistent variance-covariance estimator.
14 All regressions reported in this paper use "per share" data. The "per share" specification is not motivated by a need to choose a common "deflator" of "whole firm" data. Rather
the motivation is that an equity share is the fundamental unit of value to the shareholder.
in the cross-sectional levels regression than in a change formulation. If
the investment period is short, the cash received when the security is
liquidated will be by far the largest cash receipt to the shareholdererrors in the estimate of the price at which the security can be sold at
the end of the holding period will be a primary source of error in the
estimate of present value. With a longer holding period, there will be
other errors-particularly errors in estimation of dividend realizations

over the holding period. These errors will tend to cancel one another
(though some error remains). For example, an overestimate of expected
dividends in the near future may be associated with an underestimate of

dividend realizations in the long-run future. However, any regression
formulation that is based on changes in Pj*t will tend to emphasize errors

in measurement of Pj*, and reduce the benefits obtained from calculating
P, over a long period. For example, suppose Pj*t is the present value of
cash receipts"5 to an investor who holds security j for the period 196279, while P t+l is the present value of cash receipts over the period 1963-
80. The difference between P~t+l and Pjt (implicitly, if not explicitly,
used in a time-series or returns regression formulation) will be dominated

by the change in security price during 1980 because dividend realizations
over the holding period are common to both P)*t+l and P~t.
The null hypotheses based on regression (7) are aot = 0 and alt = 1.
Rejection of these null hypotheses leads to the conclusion that the
estimate of present value is not equal to security price. There are a

number of possible explanations of rejection of the null, including that
ex post dividend realizations are a poor surrogate for ex ante dividend
expectations; the discount factors used as weights in the summation of

dividend realizations to a present value are too high or too low; the riskadjusted dividend capitalization formula does not accurately reflect inves-
tor behavior; dividends are not the valued future attribute; or the securities market is not rational.
Attempts (in the extant literature) to predict various components of

the present value of expected future dividends (for example, beta, the
risk-free rate, the return on the market and expected dividends) have
had only limited success. Combining estimates of each of these variables
into an estimate of present value and attempting to examine the exact
specification of the valuation link between security price and present
value (specifically aot = 0 and alt = 1) may be too ambitious. For this
reason the alternate hypothesis alt = 0 is also tested. Tests of this

hypothesis examine only the significance of the relation between security
price and a weighted sum of the future dividend realizations (where the
weights are an attempt to reflect an appropriate discount rate).
Using equation (3), the present value of cash receipts over six different
holding periods (1962-71, 1962-79, 1962-80, 1963-79, 1963-80, and 197115 The price of the security at the end of the holding period is the cash receipt associated
with the liquidation of the investment.
62 PETER D. EASTON
80) are determined for each security satisfying the selection criteria
identified in section 2.
The results for the analyses based on regression (7) are reported in
table 1. Although there were some differences across the six sample
periods (1962-71, 1962-79, 1962-80, 1963-79, 1963-80, and 1971-80),
only the results based on the 1962-80 sample are reported in the table
because the differences do not affect the overall conclusions. Since the
data in each of the samples are not independent, we would expect similar
results. On the other hand, the coefficients from cross-sectional regressions of this form have been shown to be unstable over time, and some
instability was evident across the samples. This instability has been
interpreted as a manifestation of cross-sectional dependence in the
disturbance term.16 Qualitative differences in the results across the six
sample periods are reported in the text. When reading the results in this
table note that rA4j is the a priori best estimate of expected return,
discount rates ri3j, through rljr are progressively higher than r4jr, while
discount rates rP5j through ri8j, are progressively lower. Discount rate ri8jr
is the estimate of the risk-free rate.
Consider the results for tests of the null hypothesis ait = 1.17 The
discount rate for which the null hypothesis at = 1 is not rejected (F41r)
is the discount rate based on the a priori best estimate of market return.18
As the discount rate increases from the best estimate, the coefficient ait
becomes increasingly significantly less than one, and as the discount rate
decreases further from the best estimate, the coefficient at becomes

increasingly significantly greater than one. These results suggest that
the risk-adjusted dividend capitalization formula is a valid description of

investor behavior. However, the null hypothesis aot = 0 is rejected (see
table 1) when Pj*) is based on high discount rates, and more particularly,
the null aot = 0 is rejected when the estimate Pj*] is based on the a priori
best estimate of expected return. Rejection of the null aot = 0 when the
estimate of Pj*) is based on discount rate r'4j, may be interpreted as

evidence against market rationality. However, like all tests of market
rationality, the tests of the nulls aot = 0 and ait = 1 are tests of both
market rationality and of the model of market equilibrium. In this study
the model of market equilibrium is the capital asset pricing model.

Although this model has been extensively analyzed in the theoretical
finance literature, empirical tests have generally shown significant devia16 See, for example, Schwert [1981]. Cross-sectional dependence in the error term in
regression (7) may be caused by excessive optimism or pessimism within particular
industries and even across the whole economy. In other words, dividend expectations may
be higher or lower than dividend realizations due to an unanticipated change within an

industry or across industries.
17 t-statistics for tests of the null hypothesis alt = 1 are reported in square brackets.
18 In each sample period, the discount rate for which alt was closest to one was based on
the a priori best estimate of the return on the market or a small digression from it (K =
1.2 or K = 0.8).

TABLE 1
Results from the Regression of the Present Value of the Ex Post Dividend Stream(Pi) on
Security Price (PjJ
ait
Discount
rij,
(K
Rate
tart)
12.96
1.6)
(6.03)**
(t
0.52
1)
0.55
(28.45)**
[-26.18]**
r2jT
12.96
0.64
0.58
(K = 1.4) (5.07)** (24.02)**

[-13.72]**
r3jT
(K
12.73
1.2)
(4.07)**
0.78
0.59
(20.67)**
[-5.93]**
r4jT
(K=
1)
12.12
(3.14)**
0.95
0.60
(18.19)**
[-1.03]
r5jT
10.95
1.15
0.61
(K = 0.8) (2.29)* (16.33)**

[2.13]*
r61T
(K
0.6)
9.04
1.39
(1.53)
(14.90)**
6.22
1.67
0.62
[4.19]**
r7jT
0.63
(K = 0.4) (0.85) (13.76)**

[5.54]**
r81T
(K=
0)
rfT
(-0.25)
-2.74
2.37
0.64
(12.09)**
[6.99]**
PJ*t = aot + aitPit + fjt. (7)

Security price data for 1962 and future dividend realizations over the period 1962 through 1980
discounted to a present value according to the risk-adjusted dividend capitalization formula.
The estimates of the discount rates used in the present value calculation are based on:
rj. = if, + fljt(?,,- ,%). (2)

Discount rates f1j, to F8i, differ according to the estimate of the market premium (Q,, - rf,) which is
based on eight different multiples (K = 1.6, 1.4, 1.2, 1.0, 0.8, 0.6, 0.4, 0) of the historical average market
premium.
* Significant at the 0.05 level.

** Significant at the 0.01 level.
(to1t) is the t-statistic for the test of the null hypothesis a1t = 0.
[t,1,I is the t-statistic for the test of the null hypothesis ait = 1.
tions from the predicted relationships. Furthermore, each of the components of expected return (beta, the riskless rate, and the market premium)
are estimated with error. Thus there are several reasons (in addition to
market irrationality) why the null aot = 0 may be rejected. Section 4
provides evidence that measurement error in Jat is a probable explanation

for rejection of the null aot = 0.
In table 1, the t-statistics for the test of the null hypothesis that ait =
0 are highly significant for every method of calculation of Pjtt. Evidently,
64 PETER D. EASTON
there is a strong statistical association between security price and present

value. The strength of this association is also demonstrated by the high
R2 statistic for every method of calculating Pj*). The high correlation

between Pjt and Pjt, despite the errors in the estimate of expected return
used in the calculation of Pj*t, is evidence of the valuation link between
security prices and future dividends.
In summary, the results in this section provide evidence of a valuation

link between security prices and future dividends. In testing this link,
future dividends are aggregated into a present value using the riskadjusted dividend capitalization formula. Errors in estimating the ex-
pected security returns that are used as the discount rate in this formula
prohibit further conclusions regarding the form of this valuation link.
4. Accounting Earnings as Parsimonious Predictors of

Future Dividend Streams
This section focuses on the fundamental information link between
accounting earnings and the future stream of cash receipts from an equity
investment. The objective is to seek empirical evidence on whether the
contemporaneous association between accounting earnings and security

price is a consequence of this fundamental link. If accounting earnings
may be used by investors as parsimonious and efficient predictors of

future dividends, then there will be a valuation relationship between
accounting earnings and contemporaneous security prices. This paper
does not purport to establish that investors used the information contained in the accounting report, rather it has the objective of determining
whether accounting data (particularly accounting earnings) are a reasonable representation of the future attributes of the firm. To this extent,
in the absence of other sources of information, accounting earnings could
have been used by investors in forming (or revising) their expectations
about the future of the firm.
The cross-sectional correlations between accounting earnings at a
given time and the present value of future cash receipts are, in this
section, used as indications of the information link between accounting
earnings and future benefits from an equity investment. The following

regression forms the basis of the test of the information link between
accounting earnings and these dividend realizations:
Pj*t = bot + b1tEjt + ejt (8)

where Ejt is the accounting earnings per share of firm j at time t, bot and
bit are the regression coefficients, and ejt is the regression disturbance
term assumed to have the normal properties."9 The significance of the
"9The disturbance term in regression (8) is expected to be heteroscedastic for two
reasons. First, the disturbance term includes the error in measurement of P5j* which will
have nonconstant variance. Second, there is no reason to expect that the coefficient relating
earnings to present value is constant across firms. Consider the extreme case where
information relationship between accounting earnings and future divi-
dends is shown by the t-statistic for tests of the null hypothesis, b1t = 0.
The relation between accounting earnings and the future stream of
dividends, depicted in regression (8), may not necessarily represent the
information mapping implicitly used by investors. Since accounting
earnings are fundamentally undefined as intrinsic economic variables,
the form of the "true" relationship between accounting earnings and the
future dividend stream is unknown. Unlike the valuation link examined
in section 3, there is no theoretical foundation which suggests the form
of the information link examined in this section. Note, however, that the
purpose of this section is to determine whether accounting earnings are
a readily available summary of the future dividends that an investor can

expect to obtain from an equity investment. If, as the results indicate,
there is a high correlation between accounting earnings and the future
stream of dividends, then accounting earnings are such a summary datum.
If security price is equal to the present value of expected future cash
receipts, then it may be viewed as an alternative single variable that
summarizes the total information set available to investors. Hence the
correlation between security price and the present value of future cash
receipts is an appropriate benchmark against which to compare the
information content of accounting earnings. The following regression is
used for this purpose:
Pj*t = Cot + CltEjt + C2tPjt + Aj t (9)

where cot, cit, and C2t are the regression coefficients, and Hit is the
regression disturbance term assumed to have the normal properties.20
Note that regression (9) is not used to test any notion of a "true"
economic model underlying the relation between accounting earnings
and the present value of the future dividend stream or between security
price and the present value of the future dividend stream. If this were
the case, this equation would be misspecified, because the theory of

accounting earnings capture all the information about future dividends. Then present value
will be a multiple of earnings. That is:
Pj*t =bljtEjt.
Forcing bljt to be constant cross-sectionally (as in regression (8)) will result in an error
term with variance equal to u2Elt, where a2 is the variance of b1jt. (A similar point is made
by Christie [1984].) The appropriate procedure to overcome this second form of heteroscedasticity is to replace regression (8) with:
PjtlEjt = bot/Ejt + bit + eft (8a)

where eft = ejtEjt. The heteroscedasticity due to measurement error remains (and is
significant according to the test proposed by White [1980]). As a result, the consistent
variance-covariance estimator proposed by White (and used for regression (7)) was also
used for hypothesis tests based on regression (8).
20 Again, White's consistent variance-covariance estimator was used in the hypothesis
testing.
66 PETER D. EASTON
market rationality suggests that the appropriate model relating security

price to future dividends is captured in regression (7). The purpose of
regression (9) is simply to compare accounting earnings and the security
price as predictors of the present value of future cash receipts.
A priori, the coefficient cit will not be significantly different from

zero,21 but C2t will be significantly positive. A significant C2t coefficient
suggests that there is information about the future stream of cash receipts
that is not captured by accounting earnings.
Table 2 summarizes the results of regressions (8) and (9). The regressions were repeated for each of the six sample periods identified in section
2. The results were qualitatively equivalent to the results based on the
1962-80 sample period reported here.22 The t-statistics for tests of sig-
nificance of the bit coefficient are all very significant, showing that
earnings are significantly correlated with present value. The significance
of the bit coefficient declines as the discount rate decreases, suggesting

that accounting earnings are a better predictor of dividend realizations
in the near future than of realizations in the longer-run future. (This
suggestion is examined more closely later in the paper.) The correlations
between accounting earnings and present value are of the same order of
magnitude as the correlations between security price and present value
(see table 1), implying that accounting earnings and security price are
comparable predictors of the future stream of dividends.

A more precise comparison of accounting earnings and security price
as predictors of future dividends may be made using the results from
regression (9). The coefficient C2t is significantly different from zero
irrespective of the discount rate used in calculating P)t. Apparently,

security price provides statistically significant incremental predictive
power with respect to future dividend realizations. However, the increase
in explanatory power (measured in terms of the magnitude of the R2

statistics) is small (3-5%).
The coefficient c1t is significantly different from zero when Pjt is
calculated using a high discount rate, but c1t is not significantly different
from zero when P}t is calculated using a low discount rate. The significant
incremental explanatory power of accounting earnings is somewhat surprising. The fact that this significance declines as the discount rate
decreases suggests that accounting earnings provide significant incre21 A significant c1t coefficient suggests error in measurement of Pjt and warrants further
investigation of the method of estimation of this variable.
22 The similarity of the results across samples is not surprising in view of the fact that
the observations are by no means independent. In a sense there is only one observation
and the results may not be generalizable beyond the 1962-80 observation period. Since the
time series of Pjt, Ejt, and Pj*t is nonstationary, it is possible that the relationship between
these variables might have been different had the cross-section been based on a different
slice across history. On the other hand, the similarity of the results is a sign that the
multicollinearity of Ejt and Pjt does not seriously affect the validity of conclusions drawn
from these results.

TABLE 2
Relation Between Accounting Earnings, Security Prices, and the Present Value of the Next
19 Years of Dividend Realizations
Regression (8) Regression (9)
Discount Rate pi*,= bot + b1tEjt + ejt Pjt = Cot + c1tEjt + C2tP t + Pit
bDt bt RR2 Cot Cit C2t R2
(tbo) (tblt) (t.Ot) (t."t) (t-12d
rijT- 1.73 13.22 0.53 8.23 4.69 0.35 0.56

(K = 1.6) (0.51) (12.75)** (2.76)** (2.78)** (6.17)**
r2j1 -0.69 16.12 0.55 7.49 5.47 0.44 0.59

(K = 1.4) (0.16) (11.45)** (2.15)* (2.76)** (6.45)**
r3j, -3.80 19.63 0.56 6.48 6.25 0.55 0.60

(K = 1.2) (-0.69) (10.37)** (1.55) (2.65)** (6.45)**
r4jT -7.83 23.84 0.57 5.08 7.04 0.69 0.61

(K = 1) (-1.01) (9.46)** (0.99) (2.49)** (6.77)**
r5jT -13.04 28.87 0.57 3.13 7.83 0.87 0.62

(K = 0.8) (-1.47) (8.71)** (0.50) (2.30)* (6.85)**
r61T -19.67 34.80 0.58 0.49 8.56 1.08 0.63
(K = 0.6) (-1.69) (8.09)** (0.06) (2.08)* (6.88)**
r7jT -27.97 41.73 0.58 -2.98 9.20 1.34 0.63

(K = 0.4) (-1.90) (7.57)** (-0.31) (1.86) (6.88)**
r81T = rfT -50.16 58.70 0.59 -12.76 10.03 2.01 0.64

(K= 0) (-2.19)* (6.76)** (-0.90) (1.41) (6.81)**
Security price and accounting earnings data for 1962 and future dividend realizations over the period
1962 through 1980 discounted to a present value according to the risk-adjusted dividend capitalization
formula.
** Significant at the 0.01 level.
mental explanatory power (over security price) with respect to dividend
realizations in the near future. If this is the case, then the apparently
significant incremental explanatory power may simply be an artifact
resulting from the use of a discount rate in the calculation of Pj*t that is
too high. A possible explanation for the high cross-sectional correlation
between accounting earnings and dividend realizations in the near future

is that both accounting earnings and dividend realizations tend to lag in
their adjustment for changes in the economic well-being of the firm.
These lags arise because (i) accounting earnings are based only on
historical data, and (ii) firms are reluctant to change the level of dividend
payments in the short run.
Empirical support for the above explanation of the significance of the
cit coefficient is obtained by replacing Pj*t in regressions (7), (8), and (9)
with the annual dividend realization in each year of available data (that
is, 1962 through 1980). These regressions may be written as follows:
dj= a67 + a1IPjt + EJ' (7')
djT = bl, + b117Ejt + ej! (8')

and:
dj= c0T + C7TEjt + CTPft + yjT (9')

68 PETER D. EASTON
5.0 -
IN
4.6 - --accounting earnings
42 -
6 3.8 -
FIG. 1.-Significance of th assciaton btwee (1)security price

co3.4 co - ~ \
2.6-
2.2
1962 1965 1968 1971 1974 1977 1980
Year of Dividend Realization (r)
FIG. 1.-Significance of the association between (1) security price and future annual
dividend realizations and (2) accounting earnings and future annual dividend realizations.
Based on regressions (7') and (8'):
djT = a', + a'Pjt + ET (7')
dj, = bo1 + b TEjt + ej!. (8')
Graphs show t-statistics for tests of:
Ho: a, = 0, and
Ho: b, = 0.
where dj, is the dividend realization of firm j in year T. These regressions

are repeated for each T, T = t, . . . , T where T in this case is in units of
years. Security price and accounting earnings for fiscal year 1962 are
examined as predictors of annual dividend realizations over the next 19
years.23
Figure 1 graphs the t-statistics for tests of the null hypothesis; a', = 0
and b1' = 0 for estimation intervals 1 to 18 years (that is, predictions for
23 The analyses were repeated using security prices and accounting earnings for each of
the years 1963 to 1979 as predictors of dividend realizations over the remaining years of
available data (that is, 17 years of dividend realizations were predicted using 1963 accounting earnings, etc.). The analyses were also repeated for a cross-section and time series of
all of these data. The results are qualitatively equivalent to those based on the 1962
accounting earnings and security price data reported here. These regressions were also
conducted for portfolios made up of pairs of securities weighted such that the portfolio beta
is one. The coefficient relating price to future annual dividends is a function of both risk
and dividend policy. Aggregation into the portfolios had the aim of, at least, reducing the
error associated with cross-sectional variation in the coefficient. The results were qualitatively equivalent to those reported here.

1 .0
0.8 CM
0 0.6 - Incremental explanation

0.2 Explanation provided by
_o0
Inre
etal
explanation
0.
1962
1965
1968
1971
1974
1977
1980
Year of Dividend Realization (b)

*incremental explanation stgnificant at the 0.05 level
incremental explanation significant at the 0.10 level
FIG. 2.-Decomposition of the coefficient of determination of (R2) from multiple regressions of future annual dividend realizations on accounting earnings and security price.
Regressions
dT= COT + clTEjt + C2~j + yLj' (9') RT2

djT =box blT jt +ejtT(8't) R12
dT= aO + aflTPjt + ef, (7') 2

Decomposition of RT2 (the "total" explanation of cross-sectional variation in d1)):
-incremental explanation provided by accounting earnings alone
RT 2 R2 =RE2
-incremental explanation provided security price alone
RT2 _ f12 = RP2

-explanation provided by both accounting earnings and security price
HT -2 _ RP.
each of years 1963 to 1980). The correlation between security price and
annual dividends and between accounting earnings and annual dividends
is significant (as indicated by the t-statistic) even for annual dividend

realizations 18 years into the future. The statistical significance of the
incremental explanation of the cross-sectional variation in future annual

dividend realizations provided by either price or accounting earnings is
shown in figure 2. The double asterisks indicate that the coefficients C1'T
and c2T are significantly different from zero (that is, statistically significant incremental explanatory power in accounting earnings and security
price, respectively). Figure 2 also shows the decomposition of R2 from
70 PETER D. EASTON
the multiple regression of annual dividends on both accounting earnings

and security price.24
Accounting earnings provide significant incremental explanation (over
price) of the cross-sectional variation in dividend realizations for seven
years into the future. Security price provides significant incremental

information in later years. These results support the suggestion that the
apparently significant clT coefficient in regression (9) may simply be an

artifact of the discount rate used in the calculation of Pj). Also note from
figure 2 that in all of the 18 years, the incremental explanation of the
cross-sectional variation in annual dividend realizations provided by

either accounting earnings or security price is small relative to the
variation explained by both security price and accounting earnings,

suggesting that accounting earnings provide a good summary of all future
dividend realizations.
In summary, the results reported in this section indicate that there is
a strong information link between accounting earnings and the future
stream of dividends, but there is statistically significant information in
security price that is not summarized in accounting earnings.
5. Comparison of Accounting Earnings and Current

Dividends as Information Variables
Since the primary focus of this paper is on the information link between
accounting earnings and the present value of future dividends, and since
an explanation for the existence of this link is that accounting earnings
are a readily available summary information number, it is pertinent to
ask whether the nonaccounting (but certainly as readily available) infor-
mation number, current dividends, is also such a summary datum. The

important question is whether the information in accounting earnings is
subsumed by information implicit in current dividends.
Over the past decade a number of authors (including Pettit [1972;
1976], Watts [1973; 1976], Laub [1972; 1976], Aharony and Swary [1980],
and Kwan [1981]) have tested the information content of dividends
hypothesis. In each case these authors have investigated the incremental
information contained in dividend announcements while attempting to
control for information already released in the announcement of earnings
per share. The conclusions of Pettit, Laub, Aharony and Swary, and
Kwan differ from those of Watts. Pettit concludes that "substantial
24 This decomposition is described by Theil [1971]. If the coefficient of determination
from the multiple regression (9') is denoted RT2 and the adjusted coefficients from simple
regressions (8') (independent variable earnings) and (7') (independent variable price) are,
respectively, denoted R12 and R22, then RT2 _ R12 = RP2 represents the incremental
explanation of the cross-sectional variation in annual dividends provided by security price,
while RT2 _ R22 = RE2 represents the incremental explanation provided by accounting
earnings. The remaining component of RT2 (i.e., RT2 _ RE2 _ RP2) represents the information
common to both earnings and price.
information was conveyed by the announcement of an unexpected change

in dividends, while earnings announcements when controlled for dividend
changes had virtually no effect." Watts concludes that, once the earnings
effect is controlled for, the information content of the change in dividend

payment is "trivial." The principal reasons for the differences in conclu-
sions are, first, each study requires an expectations model-these differ

across studies-and, second, separation of the information conveyed by
dividends and by earnings is difficult-errors lead to differences across

studies. The aim of this section is to seek empirical evidence of a
framework underlying the contemporaneous association among current
dividends, accounting earnings, and security prices. This contemporaneous association is used as an indication of information content by each
of the authors cited above.25
In this section, the basis for comparison of the information content of
accounting earnings and current dividends is the extent to which they

summarize available information about the future cash receipts from
equity investment.26 Tests of the information link between current dividends and future cash receipts are based on the following regression:
t= aot + aitDjt + Zjt (10)

where Dit is the dividend per share paid on security I in year t, aot and
alt are regression coefficients, and zjt is the regression disturbance term.
Comparison of the t-statistic on the alt coefficient with the t-statistic on
the bit coefficient from regression (8) (see table 2) provides an indication
of the relative strength of the information links between accounting
earnings and future cash receipts and current dividends and future cash
receipts. A more precise comparison is based on the regression:
Pj*t = /ot + /1tEjt + /2tDj t + Yjt (11)

where the incremental explanatory power in earnings and in current
dividends is assessed via tests of significance of the coefficients 0i1, and

02t respectively.
If firms follow a policy of dividend stabilization (observed by Lintner
[1956] and Fama and Babiak [1968]), current dividends will be good
predictors of dividend realizations in the short-run future. Since higher
discount rates put a greater weight on dividend realizations in the near

future and a lower weight on the cash receipt at the end of the holding
period, discount rates that are too high will tend to bias the results
25 The information link between accounting earnings, current dividends, and future
benefits is also examined in these papers. These studies examine the hypothesis that
dividends convey information about next periods' accounting earnings. The obvious advantage of using next periods' accounting earnings as a measure of future benefits is that it
avoids problems associated with measurement of P5t. However, the issue of whether
accounting earnings are a good summary of expected future benefits is not addressed.
26 Staubus [1965] examined the information content of accounting data from this point
of view.
72 PETER D. EASTON
toward the conclusion that current dividends are a good information

variable with respect to the future benefits from equity investment. To
examine this contention, regressions (10) and (11) are repeated with
present value replaced by the annual dividend realization in each year of
available data. That is:
= a I + a4,Djt + Zj! (10')
and:
O',= / + O',Ejt + t32TDjt + y)/S (11')
where dj, is the dividend realization in future period i-. The reported
results are for the 18 regressions in which t = 1962 and X- 1963, ...
1980.
The t-statistics for the at t coefficient are plotted in figure 3. Dividends

in the current period are significantly correlated with dividend realizations for each of the 18 years into the future (tat = 4.54 for X- = 1980).
The decomposition of the R2 statistic from regression (11') is plotted
in figure 4. (The decomposition is analogous to the decomposition of the
R2 statistic for regression (9') plotted in figure 2.) Current (1962)
dividends provide significant incremental explanation of cross-sectional
variation in future dividend realizations for each of the next 18 years
(1963 through 1980). Current dividends obviously dominate 1962 ac-
30.0 -
26.0
22.0 -
CO 18.0 .f
.
CO 14.0
10.0
6.02.0
1962 1965 1968 1971 1974 1977 1980
Year of Dividend Realization (T)

FIG. 3.-Significance of the association between current annual dividend realizations
and future annual dividend realizations. Based on regression (10'):
dj7 = a', + ca',Djt + Zj7. (10')

Graphs show t-statistics for test of:
Ho: a, = 0.

10.
Incremental explanation
provided by
current dividends
0.8
cc
? ~. . . . . . . N~.. . . . . / provided by
o 0.6
Incromental explanation
0 : . . . . :.: .:.:::.:.:.:.:.: :.::::..::. .:.: accounting earnings
m Eoplanation provided by
0 2- W c urrent d ividend s
0.0 0 IJI/
1962 1965 1968 1971 1974 1977 1980
Year of Dividend Realization (r)

"incremental explanation significant at the 0.05 level
,incremental explanation significant at the 0.10 level
FIG. 4.-Decomposition of the coefficients of determination (R2) from multiple regressions of future annual dividend realizations on current annual dividend realizations and
security prices.
Regressions
__
dj, = Fo' + f1hEjt + f23Djt + yZi. (11') RT2

dj7-
a',
',Djt
Zin
(10
')R-22
di,=a',+aaDPt+zej (81') R2
Decomposition of RT2 (the "total" explanation of cross-sectional variation in dj,):
-incremental explanation provided by current dividends alone
RT2 R2 = RD2
-incremental explanation provided accounting earnings alone
RT 2 R 2 RE2
-explanation provided by both accounting earnings and security price
RT 2 _RD2 RE2.
counting earnings as predictors of the next four years of dividend realizations, but accounting earnings provide significant incremental explanatory power for dividend realizations over the years 1967 through 1980.
The results from regressions (10) and (11) are summarized in table 3.
As expected from the analyses of regressions (10') and (11'), these
results are sensitive to the choice of the discount rate in the present
value calculation. Despite the high correlation between current dividends
and dividend realizations for a considerable length of time into the future,
the correlation between current dividends and Pt (see table 3) is low-
74 PETER D. EASTON
TABLE 3
Relation Between Accounting Earnings, Current Dividends, and the Present Value of the
Next 19 Years of Dividend Realizations
Regression (10) Regression (11)
Discount Rate Pi*t = aot + atDjt + zjt Pi*, = Sot + #ItEit + f2tDit + Yjt
aot
ait
R2
/3ot
#it
02t
(toot) (t.1t) (tfot) (tfl t) (tflt)
r1j, 1.09 26.00 0.20 4.75 13.99 -3.75 0.53

(K = 1.6) (0.07) (2.22)* (0.98) (12.42)** (-1.03)
raj, -0.11 0.69 0.19 4.46 17.44 -6.39 0.56

(K = 1.4) (-0.01) (2.10)* (0.77) (12.14)** (-1.44)
r3j, -1.51 36.19 0.19 4.18 21.67 -9.88 0.57

(K = 1.2) (-0.07) (1.99)* (0.60) (11.80)** (-1.82)
r4j, -3.24 42.62 0.18 3.79 26.82 -14.40 0.58

(K = 1) (-0.12) (1.88) (0.45) (11.47)** (-2.18)*
r5tj, -5.43 50.08 0.17 3.23 33.04 -20.16 0.59

(K = 0.8) (-0.16) (1.79) (0.31) (11.14)** (-2.51)**
r6j, -8.19 58.65 0.16 2.42 40.47 -27.39 0.60

(K = 0.6) (-0.19) (1.70) (0.19) (10.84)** (-2.83)**
raj, -11.60 68.39 0.15 1.31 49.25 -36.29 0.60

(K = 0.4) (-0.22) (1.63) (0.09) (10.55)** (-3.12)**
r81j = rf7 -20.60 91.36 0.14 -1.98 71.07 -59.72 0.62

(K= 0) (-0.27) (1.50) (-0.09) (10.02)** (-3.66)**
Current dividends and accounting earnings data for 1962 and future dividend realizations over the
period 1962 through 1980 discounted to a present value according to the risk-adjusted dividend
capitalization formula.
**Significant at the 0.01 level.
particularly in comparison with the correlation between current earnings
and PR (see table 2). The t-statistics on the coefficient alt are positive
and they increase as the discount rate increases. This result may be
explained by the observation (in figure 3) that the correlation between
current dividends and future dividend realizations declines as the time
interval between current dividends and the future dividend realization
increases.
The results from regression (11) indicate that accounting earnings
provide significant incremental explanatory power (of the cross-sectional variation in PRt) over current dividends. It is interesting to note
that current dividends provide significant incremental explanation of the
cross-sectional variation in P}t when the estimate P}t is calculated using

lower discount rates. This result is somewhat surprising in view of the
results in figures 3 and 4 which suggest that a higher discount rate would
favor dividends as a candidate information variable. Note, however, that
for all discount rates used in the calculations of P)t, the coefficient /2t is
negative. That is, conditional on the level of accounting earnings, the
higher the current dividends, the lower the present value of the future
dividends. This result is a reflection of the trade-off between dividends
and retained earnings (implicitly the trade-off between dividends and
capital gains).27 The negative 02t coefficient lends support to the claim
that accounting earnings are a good information number in the following
sense. If all other information is ignored, higher current dividends imply
higher future dividends (a,, is positive), but for a given level of accounting
earnings, higher current dividends imply lower future dividends (12t is
negative).28 These results are consistent with the notion that accounting
earnings reflect the dividend-paying ability of the firm and that these
earnings may be either paid in the current period or reinvested.29
In summary, the results in this section support the contention that
accounting earnings are a good summary information number. The
information summarized in accounting earnings is by no means subsumed
by the information in current dividends. In fact, information in accounting earnings is apparently useful in interpreting the information in
current dividends.
6. Summary and Conclusions

Information content studies have generally been based on the contemporaneous association between "surprise" in the announcement of finan-
cial statement data (principally accounting earnings and current dividends) and abnormal security returns. This paper examines empirically
the proposition that the contemporaneous association reflects the information link between financial statement data and future benefits (meas-
ured as future dividends realizations) and the valuation link between

future benefits and security prices.
The theoretical link between security prices and future dividends is
the risk-adjusted dividend capitalization formula. Empirical tests of this

link are confounded by the difficulty in estimating the expected dividends
and the expected rate of return which is used to aggregate the stream of
27 The following regression recognizes the fact that earnings are either retained and
reinvested or paid out as dividends:
i*t = 'Ifo + 'It(Ejt - Djt) + T2tDit + (jt- (hla)

Comparing the coefficients from regression (11a) to those from regression (11), it can be
shown that:
Tut = lit, Var(TIt) = Var(flt) and T2t = (Olt + #2t)From the results in table 3 it can be seen that TI2t > 0 for every method of calculating P]*t.
Thus the negative /2t coefficient is due to the inclusion of dividends in the earnings variable.
28 The negative sign is also obtained when Pj*t in regression (9) is replaced by Pjt. For
this regression using 1962 data, the coefficient /2t is significant at the 10% level. Although
the purpose of this section is to examine the information link, the fact that similar results
are obtained when the contemporaneous association is examined is reassuring inasmuch as
those results nullify the argument that the results based on Pj*t may simply be an artifact
of the method of calculating Pj*t.
29 The negative sign of the f2t coefficient is not robust across time periods or across
subsamples in any one time period.
76 PETER D. EASTON
dividends to a present value. Nevertheless, the evidence suggests that

price is the present value of the future stream of dividends. The other
fundamental link is the information link between accounting earnings
and future dividends. Evidence of this link is provided by a highly

significant correlation between accounting earnings and present value.
Security price, however, provides significant incremental explanation
(over accounting earnings) of the cross-sectional variation in present
value. Apparently, there is information about future dividend realizations
that is not captured by accounting earnings.
In summary, the empirical results in this paper show that accounting
earnings are a good predictor of the future stream of cash receipts from
an equity investment and that there is a strong correlation between
security price and the present value of future cash receipts. Considered
together, these results provide empirical evidence of the framework that

explains the contemporaneous association between accounting earnings
and security price.
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Accounting Research Center, Booth School of Business, University of Chicago

Wiley, Accounting Research Center, Booth School of Business, University of Chicago

Journal of Accounting Research

Accounting Earnings and Security

Valuation: Empirical Evidence of

relation between accounting data and contemporaneous security prices.

information link, between accounting data and the future stream of

generally regarded as being tautologically equal to the present value of

expected future benefits of share ownership. The contemporaneous as-

sociation between accounting earnings and security price is therefore a

Copyright (?, Institute of Professional Accounting 1986

ACCOUNTING EARNINGS AND SECURITY VALUATION 55

content of accounting data have relied on market-based measures of

expected future benefits justifies the use of market-based measures of

accounting earnings and security prices require some consideration of

the expected future benefits themselves. In this paper, ex post dividend

provide information;2 and (ii) the risk-adjusted dividend capitalization

dividend capitalization formula. This formula expresses the value of a

adjusted dividend capitalization formula) on security price. The results

56 ACCOUNTING EARNINGS AND SECURITY VALUATION: 1985

compare information content. The analyses are based on cross-sectional

The association between accounting earnings and present value has

strong statistical significance, indicating that accounting earnings are a

cross-sectional variation in present value in addition to that provided by

accounting earnings and the present value of expected future dividends.

on dividends is positive. In other words, if all other information is ignored,

dividends. Thus, the information in accounting earnings appears to be

ACCOUNTING EARNINGS AND SECURITY VALUATION 57

2. Data and Sample Selection

Standard and Poor's Compustat Annual Industrial File. Security prices

3. The Descriptive Validity of the Dividend Capitalization

neously seek evidence of security market rationality and of the descriptive

validity of the risk-adjusted dividend capitalization formula.

Pj*t= E E[djs I Zt]/ f (1 + E[rjT I ZJ)

+ E[d1TI Zt]/ 11 (1 + E[rjT I Zt])

expected liquidating dividend E[d]T I Zt] is represented by the security

8 A shortcoming in the estimation of the expected return on the security is reliance on

ACCOUNTING EARNINGS AND SECURITY VALUATION 59

the time of the announcement of accounting earnings. Estimates of beta

research on estimating the expected return on the market. Merton [1980]

observes that estimating expected return on the market by taking the

estimate of the return on the market (and implicitly the sensitivity to

estimation procedure using estimates of Pj*t based on eight different

0.4, and 0) of the historical average market premium.

The estimate of Pj*) may be written as follows:

Pi~t = E disl H ( 1 + j )+ Pi TI 1 ( 1 + Aj (3)

Pj}t is the ex post rational price of the security at time t. A number of

ality/efficiency based on estimates of Pj*t for portfolios of common stocks.

Pit = E [Pjnt I zt] (4)

Var(Pj*t) > Var(Pjt). (6)

In each of these papers, the empirical evidence reveals that security

prices violate the variance inequality specified in equation (6), leading to

In this paper, market rationality, as defined by equations (4) and (5),

Pt= aot + a1tpjt + 'it (7)

estimator is calculated according to the method described by White

of observations. Also, all regressions are conducted in "levels" form (for

estimation of P>. The effect of error in measurement of Pitt will be less

Var(3) = (X'X/n)_ E [eZ2(xixi)]/n(X'X/n)-1.

ACCOUNTING EARNINGS AND SECURITY VALUATION 61

in the cross-sectional levels regression than in a change formulation. If

other errors-particularly errors in estimation of dividend realizations

dividends in the near future may be associated with an underestimate of

formulation that is based on changes in Pj*t will tend to emphasize errors

(K = 1.4) (5.07) (24.02)