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Journal
of Accounting
and Economics
11 (1989) 143-181.
North-Holland
S.P. KOTHARI
University of Rochester, Rochester, NY 1462 7, USA
Received
November
1989
1. Introduction
Considerable
research has focused on the relation between security returns
and unexpected
earnings
to assess the information
content of the latter.
Typically, inferences regarding the information
content of earnings are based
on the significance of the slope coefficient (b) and explanatory
power (R*) of
the following linear model estimated cross-sectionally
and/or
over time:
CAR,, = a + bUXi, + ejt,
where CAR if is some measure of risk-adjusted
over period I, UX;, is a measure of unexpected
01654101/89/$3.5001989,
B.V. (North-Holland)
144
and ei, is a random disturbance term assumed to be distributed N(0, u,). The
slope coefficient, b, is called the earnings response coefficient (ERC).l
Generally, the returns/earnings
relation is investigated using either an
events study or an association study method. The event studies infer
whether the earnings announcement, per se, causes investors to revise their cash
flow expectations as revealed by security price changes measured over a short
time period (typically, 2-3 days) around the earnings announcement. Examples include Foster (1977), Hagerman, Zmijewski, and Shah (1984), and
Wilson (1986, 1987). In essence, the focus is on whether earnings announcements convey information about future cash flows.
In an association study, returns over relatively long periods (fiscal quarters
or years) are regressed on unexpected earnings or other performance measures
such as cash flows [Raybum (1986)] or replacement cost earnings [Beaver,
Griffin, and Landsman (1982)] estimated over a forecast horizon that corresponds roughly with the fiscal period of interest. Association studies recognize
that market agents learn about earnings and valuation-relevant events from
many nonaccounting information sources throughout the period. Thus, these
studies investigate whether accounting earnings measurements are consistent
with the underlying events and information set reflected in stock prices.
Typically, causality is not inferred. Rather, the focus is on whether the
earnings determination process captures in a meaningful and timely fashion the
valuation relevant events.
Regardless of the perspective used, the bulk of the extant empirical literature assumes the returns/earnings relation is homogeneous across firms. The
slope b in eq. (1) is treated as a cross-sectional and temporal constant. Recent
studies relax this assumption to improve eq. (1)s specification and explanatory
power [see, e.g., Beaver, Lambert, and Morse (1980) Ohlson (1983), Miller and
Rock (1985) Kormendi and Lipe (1987), and Easton and Zmijewski (1989)].
By combining alternative valuation models with different earnings process
assumptions these studies provide important insights into factors that explain
variation in ERCs.
This study provides further insights into factors contributing to differential
ERCs in an annual association study context. In contrast to the previous work,
we examine temporal as well as cross-sectional determinants of ERCs. The
temporal variation in ERCs is hypothesized to be negatively related to the
risk-free interest rate. We expect cross-sectional variation in ERCs to be
positively related to earnings persistence and negatively related to firms
systematic risk. In addition, we hypothesize that ERCs are positively related to
growth opportunities that are not likely to be fully captured by persistence
In using the term response we do not imply causality. The term is used in a generic sense to
measure the degree of comovement
between security returns and shocks to an earnings series
without necessarily
implying that the latter cause the former. The distinction
is made clearer
below.
145
estimated using time series models. Our empirical results are consistent with
all these predictions.
We also demonstrate empirically that the earnings/returns
relation varies
with firm size, where size is a proxy for information environment differences.*
Differences in information environment affect the extent to which price
changes anticipate earnings changes [Collins, Kothari, and Rayburn (1987)
and Freeman (1987)]. Once differences in the information environment are
controlled by varying the return holding period, there is little difference in the
extent to which price changes covary with earnings changes across firm size.
This explains the differential magnitude of ERCs as a function of firm size
documented in Burgstahler (1981), Freeman (1987), and Collins et al. (1987).
Our analysis also suggests that association studies that use a holding period
corresponding to a firms fiscal period (or between earnings announcement
dates) understate the earnings/returns association. Holding periods that begin
at an earlier point in time and span a longer time horizon enhance the
earnings/returns
association relative to the conventional twelve-month holding periods, particularly for larger firms.
In section 2 we identify the determinants of ERCs using a simple dividend
capitalization model where accounting earnings are assumed to be related to
future dividends. In section 3 we discuss how noise in accounting earnings
measurement and variation in the information environment affect the estimation of ERCs. We also propose ways to deal with these problems empirically.
Section 4 identifies the sample used in our empirical analysis. Section 5
demonstrates differences in the strength of earnings/returns relation for large
versus small firms as one varies the return holding period. Section 6 is broken
into two parts: first, variation in the earnings/returns relation over time and
its association with long-term risk-free interest rates are documented; second,
cross-sectional variation in the earnings/returns relation and its association
with risk, earnings persistence and/or growth are documented. Section 7
summarizes our findings and discusses some of the implications of our results
for past and future research.
2. Equity valuation and determinants of earnings response coefficients
This section outlines
discounted present value
relation between current
current periods earnings
Information
environment
is defined broadly to include all sources of information
relevant to
assessing
firm value. It includes government
reports on macroeconomic
conditions,
industry
reports and trade association
publications,
firm-specific news in the financial press and reports
issued by analysts
and brokerage
houses in addition
to accounting
reports, and vertical and
intra-industry
information
transfers via sales and industry reports.
146
P,,= ft E,(%+k)
k=l
as
Tfil
{l/i1 + E(fL+,)l>~
where
E,( Di,+k) = expectation
at time t of dividends to be received at the end of
period t + k, and
E( R i1+7) = expected rate of return on the security from the end of t + T - 1
to the end of t + 7.
In writing eq. (2), the future expected rates of returns are assumed known and
the only uncertainty
about future prices is due to reassessments
through time
of expected
future dividends.
These assumptions,
together with the other
assumptions
underlying
the Sharpe-Lintner
Capital Asset Pricing Model
(CAPM), are sufficient for the multiperiod
CAPM to hold [Fama (1977)].
To derive the ERC, we assume accounting
earnings are related to future
dividends
and, hence, unexpected
earnings cause investors
to revise their
expectations
of future dividends
leading to security price changes. Future
expected dividends are assumed to be related to current earnings according to
E,(&+k)
= hir+kXr,
A,r+k 0,
k=1,2
,...,
oo,
(3)
The unexpected
eq. (4) as
R;z-
return
Et-i(R,,)
or
uR,,=
associated
= [P;,-
with unexpected
E,-i(Pi,)
earnings
is derived
141
using
E~-~(D,,)I/PL~-~
+ Di,-
(5)
f~
{L[1
+E(&+,)I
>1U&/ft-~>
[ it+k
x*, + Z
k=l
7=1
2.2. Determinants
(6)
Using the CAPM eq. (6) and further assuming that pi, is either constant
through time or highly positively autocorrelated
through time, we conclude
that the ERC is a decreasing
function
of a securitys systematic
risk. In
valuation
terms, the higher the systematic risk the smaller the present value of
a given increase in expected future dividends caused by unexpected earnings.
The ERC is affected positively by the hit+k s which relate current earnings
to future dividends.
If the earnings time series has a high persistence
(i.e.,
current periods earnings shocks tend to persist in the future and affect future
earnings expectations),
then dividend expectations will be revised more than if
earnings shocks have low persistence. Thus, the higher the earnings persistence
the higher the hrr+k~.
The effect of persistence on ERC can be shown more formally in the context
of a specific earnings process. Earnings persistence is typically measured by
estimating
an ARIMA time series earnings process [e.g., Kormendi and Lipe
(1987)]. If earnings follow an IMA(l, 1) process, earnings expectations
for all
future periods will be revised by (1 - fl)a,, where a, = X, - E,_,( X,) and 0 is
the moving average process parameter.
Thus, revisions in earnings expectations are an increasing
function of (1 - e), the persistence
of an IMA(l, 1)
process. Because dividends are assumed a positive fraction of earnings, greater
persistence
will lead to larger revisions in dividend expectations
and the ERC
will be larger. Implications
of persistence under alternative
earnings process
148
Table 1
Persistence
Earnings
process
ARIMA(O.l,
[random
AE,(X,+,)
1
0)
or
=+ku,
ARIMA
earnings
processes
walk]
ARIMA(O,O,
1)
-@.a,
k=l
k>l
1-O
r a,
L-1
(19W1
ARIMA(O.1,
[Beaver,
1)
(1-B)u,
forall
Lambert,
and
Zmijewski
(1989)]
(1+ r)/r
ARIMA(2,l.O)
[ Kormendi
and
4, = (1 + +,)a,
k= 1
1 - &/(l
+ r) -$5/Q
+ r>*
-1
a,
I
Lipe (1987)]
ts earnings, Earnings
follow an ARIMA
time series
prYess.
Following Kormendi and Lipe (1987) and Flavin (1981), the present value of the revisions in
earnings expectations
caused by (I, over an infinite horizon for an ARIMA( p, d, q) process is a
function of the AR( c$) and MA( 8) paramenters
as follows:
earnings
response
coefficient
assumptions
used in previous studies are presented
in table 1. Assuming
constant
discount rates and an isomorphic relation between future earnings
expectations
and future dividend expectations,
one plus the right column in
table 1 presents the theoretical
ERC for each of the alternative
earnings
processes. The theoretical ERC is the price change induced by a one-dollar
shock to current earnings and is equal to one plus the present value of the
revisions in expected future earnings caused by this shock. Therefore, the ERC
149
150
parameter ARIMA estimates derived from lengthy time series represent some
sort of a weighted average of changing
growth opportunities
over time.
Because we expect the persistence estimates from time series models to be
deficient in accurately reflecting current growth opportunities,
we include a
proxy for the latter as an additional determinant
of ERCs.
In addition
to the three cross-sectional
determinants
of the ERC, we
hypothesize
interest rates as a temporal determinant
of the ERC. To derive a
temporal relation between interest rates and the ERC, we assume that the
expected
rates of returns in the future periods vary over time. That is,
E(Rit+7) can vary over t. We further assume that the current risk-free interest
rate is highly positively autocorrelated
with the future risk-free interest rates.
Because the risk-free interest rates are a component of E(R,,+,), the higher the
current risk-free interest rate the higher the expected rate of return on the
security in the future periods. Therefore,
we predict a negative relation
between interest rates and the ERC through time.3
In hypothesizing
the negative temporal association
between interest rates
and the ERC, we deviate from the assumption underlying the discounted cash
flow model and the multiperiod CAPM that all the future E( R,,,,)
are known
at time t and, thus, cannot vary with t. However, relaxing this assumption
generates an interesting
empirical prediction
and is consistent with the evidence that both nominal and real interest rates change through time [see, e.g.,
Ibbotson and Sinquefield (1985)]. If the ERC is derived using continuous
time
valuation
models like Merton (1973) or by allowing uncertainty
in future
commodity
prices and the future investment
opportunity
sets [Long (1974)],
the effect of interest rate variation through time on the ERC will enter into the
model more directly. These extensions are beyond the scope of this paper, but
are fruitful avenues for future research.
To summarize,
we identify four factors contributing
to cross-sectional
and
temporal differences in the ERC. The ERC is positively related to earnings
persistence and economic growth opportunities.
The ERC is negatively related
to the securities future expected discount rates. The discount rate is made up
of (i) the risk-free interest rate, R,, and the market risk premium, and (ii) the
firms CAPM beta risk. Because R, and the market risk premium are the same
for all firms, they obviously are not a source of cross-sectional
variation in
ERCs. The ERCs are negatively related to the interest rate levels through time
and the CAPM beta risk in the cross-section.
3We use a partial equilibrium analysis to examine the interest rate effect on the ERG. Interest
rate changes affect, among other things, the saving/investment
decisions of individuals
and
corporations
which, in turn, affect the firms future cash flows. Incorporating
these effects on cash
flows and their present values to derive a relation between interest rates and the ERCs requires a
complete equilibrium
analysis that is beyond the scope of this paper. We essentially ignore the
saving/investment
and associated cash flow implications
of interest rate changes in making our
predictions.
Vuriation
151
unexpected returns
as follows:
cov(W,Jx,,) =f(
c+>
P ersistence,
(->
(+I
risk, growth,
cross-&tional
variation
earnings
c-1
interest
rates ).
temporal
variation
Empirically,
at least two other factors affect the estimated COV(UR,~,UX,~)
and, hence, the estimated ERC: (a) noise in reported accounting
earnings as
an indicator
of future expected dividends
and (b) the firms information
environment.
The above two factors lead to error in measuring UX,,. Empirical proxies for
UX,, contain
error because: (i) Accounting
earnings measure firms future
dividend paying ability with error. The market uses other variables in addition
to accounting
earnings in forecasting future expected dividends and in this
sense unexpected
accounting
earnings is a noisy predictor
of revisions in
future expected dividends. (ii) The markets earnings expectation
at a given
152
point in time differs from a simple time series earnings expectation proxy. The
presence of competing (and more timely) sources of information in addition to
reported earnings renders the time series earnings expectation a noisy measure
of UXi, [see, e.g., Collins et al. (1987) and Freeman (1987)].
Measurement error in a UXi, proxy attenuates the ERC and makes it
difficult to detect the influences of the ERCs determinants. The bias in an
estimated ERC can be substantial. Indeed, evidence in Beaver et al. (1980)
suggests that ERCs estimated at the individual security level using a time
series earnings expectation proxy for UX,, understate the true or theoretical
ERCs by as much as 70-80%, on average.
If we could obtain a better measure of the markets earnings expectation at
time r - 1, the measurement error problem in a proxy for UXi, would be
reduced. However, empirically this is difficult. While analysts forecasts are
better than time series proxies [Brown et al. (1987a, b)], they are not available
in a machine-readable form over the time period examined in this study and
they are generally available only for the larger, more widely held firms. An
alternative approach to reduce the measurement error problem is to set t - 1
(i.e., the beginning of the holding period) at a point such that the time series
proxy (in our case, a random walk specification) approximates the markets
earnings expectation. We adopt the latter approach by varying the return
window.
Varying the return window ensures that a particular UX,, proxy matches up
closely with the true (but unobservable) market earnings expectation and
provides a specification check on previous work relating earnings changes to
security returns. This allows us to u e the same earnings expectation model
across all firms (which is typically done in empirical work) and find the point
in calendar time when that particular proxy best approximates the markets
earnings expectation for a particular firm. This ensures that the estimated
response coefficient fully captures the markets valuation of unexpected earnings. Varying the return window also allows us to assess how this affects the
earnings/returns
association as measured by adjusted R* across firm size.4
In addition to error in UX,, proxy, cross-sectional differences in the information environment contribute to nonrandom variation in the earnings/
returns relation. If firm size is a proxy for information environment differences, then different size firms will exhibit different ERCs on measuring UXjrs
over a fixed holding period for all firms [see, e.g., Collins et al. (1987)]. In this
sense returns measured over fixed holding periods contain error. Holding the
earnings expectation model and the return cumulation period constant across
all firms can result in a spurious association between firm size and ERCs in an
41f returns are the dependent variable and we vary the length of the holding period from one
model to another, then the adjusted Rs are no longer comparable
since the total sum of squares
will differ from one model to another.
153
annual association study. This spurious correlation occurs because of differences in the lead-lag structure in the earnings/returns relation caused by the
information environment differences for large versus small firms. Moreover, if
the lead-lag relation between returns and earnings changes is ignored and
time series proxies for UX,, are used, then association studies will severely
understate ERCs.
154
based largely on the evidence in Beaver, Lambert, and Ryan (1987). In section
2 we posited that the ERC is related to four factors: earnings persistence (+),
growth (+), risk (-),
and interest rates (-).
In reverse regressions,
these
functional
relations are inverted. That means the RRC increases in risk and
interest rates and decreases in earnings persistence and growth. These predictions are expected to hold when earnings changes are scaled by price which is
the scaling variable according to the analysis in section 2 and in Christie
(1987). However, if earnings changes are scaled by previous years earnings as
in Beaver et al. (1980) and many other earnings association studies, then RRC
is likely to exhibit lesser association with the four determinants
for reasons
discussed in section 3.3.3.
The inverse of the estimated RRC is the upper bound for ERC. Therefore,
attempts to infer the earnings process or to place other economic interpretations on the inverse of the estimated RRC must be approached with caution.
Accordingly,
we interpret the RRCs conservatively
and use significance tests
only to judge whether its determinants
have the predicted signs.
3.3. I. Empirical measures of returns
The analysis in section 2 suggests that the appropriate
R,, - E,_,( Ri,). We use R,, (return inclusive of dividends)
first approximation
for three reasons:
return metric is
throughout
as a
(1) E,_ t( R,,) is an ex ante measure of expected return, but ex ante measures
of riskless rates and risk premia are not readily available. Most studies use
an ex post measure of E,_ i( R,,) conditional
on the realized market return
for period t which introduces error into the return metric.
(2) Relative to the temporal and cross-sectional
variability in R,,, the variability in E,_,( Rjt) is small. Hence, the use of R,, - E,_i( Rjt) essentially
amounts to using Ri,.
(3) Beaver et al. (1980) and Beaver, Lambert, and Ryan (1987) report that the
earnings/returns
relation is essentially
the same whether one uses R,,
inclusive or exclusive of dividends or market model prediction errors.
3.3.2. Proxy for unexpected earnings
While
measure
price or
reasons
155
(2) Unexpected
change
is used as proxy
of UX in the
156
(2)
nominal returns and earnings changes, ERCs are likely to vary over time
even when scaling by X,_ i.
While price is expressed as a multiple of expected or current earnings, the
prices/earnings relation is unlikely to be deterministic. A more realistic
prices/earnings relation would be
157
periods. The CRSP monthly returns tape contains only NYSE-listed firms. We
use monthly return data to estimate systematic risk because beta estimates
using daily returns data are biased and inconsistent [Scholes and Williams
(1977)]. The subset of NYSE firms for which monthly return data are available
on the CRSP tapes for eight consecutive years ending in year t + 1 is included
in the final sample. Monthly returns for the five years up to the end of year
t - 2 are used in estimating the firms systematic risk (market model betas)
and returns over varying lengths of time for the next three years (i.e., years
t - 1 to t + 1) are used in the regression analysis. These criteria yield a sample
of 9776 firm-year observations. The number of observations in each year
varies from 519 in 1968 to 730 in 1978.
4.2. Descriptive statistics
Descriptive statistics for the sample are presented in table 2. Since the
sample selection criteria result in only firms with NYSE listing, the sample
firms are above average in their equity market values relative to all publicly
traded stocks. The mean firm size is $860.4 million. However, a large standard
deviation ($2644.2 million) of the sample distribution of market values and the
minimum and maximum market values of equity of the sample firms suggest
there is considerable variation in firm size within our sample. This is important
because one of our objectives is to assess whether ERCs are a function of firm
size and to demonstrate that this variation is sensitive to the definition of the
return holding period.
Each securitys systematic risk is estimated by regressing monthly returns
over sixty months on the CRSP equally weighted market return index. The
sample mean beta is 0.92 which suggests that the sample is slightly less risky
than the average security listed on the NYSE. This is expected because the
sample selection criteria are biased towards including larger NYSE firms and
previous evidence suggests that firm size and beta are inversely related [see, for
example, Banz (1981)].
Summary statistics for the percentage change in earnings variable (%AX,)
are based on 9045 firm-year observations because we exclude observations
with a negative denominator or observations with I%AX,l > 2008. The
reduction in sample size is due largely to firms reporting losses (negative
denominator) and thus represents an asymmetric loss in the sample. This is a
problem that is common to all the research studies using the %AX, variable.
On average, firms in our sample report an annual increase of 7.85% in their
earnings over the years 1978 to 1982. The second earnings variable, change in
earnings deflated by price (A Xt/P1_r), is free from the negative denominator
The
decision
to exclude observations
with
consistent with previous research in this area.
seem arbitrary,
but
it is
158
Table 2
Summary
statistics
Variable
Market
value of
equityb
Risk
(beta)
Percentage
change in
earnings
Change in
earnings
scaled by
price
for market
N
9776
Mean
860.4
Median
Standard
deviation
245.3
2644.1
9776
0.92
0.87
0.40
9045
7.85%
8.63%
43.22%
9718
0.82%
0.77%
10.94%
in earnings:
Minimum
Sample
of 9776
Maximum
1.86
47,888
- 0.37d
3.01
- 200.0%
198.0%
- 97.85%
99.76%
Initially
any firm listed on the Compustat
Industrial
Annual or the Compustat
Annual
Research tape with a December 31 fiscal year-end and a minimum of three years of earnings data
during 1968-82 is included in the sample. From this sample, the subset for which monthly return
data are available
for eight consecutive
years ending in 1969-83 is included in the sample
analyzed in this study.
bMarket value of equity is defined as the beginning of the year share price times the number of
shares outstanding;
in millions of dollars.
Market
model beta estimated by regressing monthly returns over five years on the NYSE
equally weighted index.
dMarket model betas of three securities are negative.
Percentage
change in earnings, WAX,, is change in earnings per share from year t - 1 to r
divided by the earnings per share for year t - 1, all adjusted for stock splits and dividends. A total
of 731 observations
with negative denominators
or \%A X,1 z 200% are excluded.
Change in earnings scaled by price, A X,/P,_ Lr is change in earnings per share from year t - 1
to t divided by share price at the beginning
of year t. A total of 58 observations
with
IAX,/P,_,l>
100% are excluded.
problem. Therefore,
it has a larger sample of 9718 firm-year
observations.
Observations
with (AX,/P,_,I > 100% are excluded which causes a small
reduction
in sample size from 9776 to 9718 observations.
The sample mean
and standard
deviation
for the distribution
of AX/P,_,
are 0.816% and
10.94%.
5. Firm size, information environment, and holding period returns
As noted earlier, a contemporaneous
regression of annual returns on earnings changes understates
the ERC and the degree of understatement
varies
Once again, the decision to exclude observations with /A X,/P,_ ,( > 100% is arbitrary, but, as
can be seen from table 2, these observations
are more than nine standard deviations away from
the mean. Inclusion of these observations
in the sample would likely have an undue influence on
the estimated regression coefficients.
159
with firm size. If firm size is correlated with risk, growth, and persistence
(which seems likely), then failing to control for differences in the lead-lag
structure
of returns and earnings will confound
tests for differences in the
earnings/returns
relation due to the factors identified earlier.
To demonstrate
the relation between firm size and the lead-lag
structure,
we regress earnings changes (scaled by Pt_lor X,_,) on security returns from
the contemporaneous
and lagged fiscal year according to the following model:
where, consistent with previous research, R;,is measured from April of year t
to March of year t + 1 and R itI is measured in an analogous fashion.
Results in the first two rows of table 3, using all stocks in the sample, reveal
that coefficients on both current and lagged years returns are of comparable
portion of the events
magnitude
and highly significant. l2 Thus a nontrivial
contributing
to accounting earnings changks in the current period are captured
in security returns from an earlier period.
To ascertain whether the degree to which lagged returns explain earnings
changes varies with firm size, we partition our sample into three equal-sized
groups by ranking firms each year according to the beginning
of year equity
market vales. Results of estimating eq. (8) for the small, medium, and large
firm groups are reported in the lower portion of table 3. Lagged years returns
possess significant
explanatory
power for all three size groups. However, the
magnitude
and significance of f1 in relation to f2 suggest that R,+,is more
important
in explaining earnings changes for large versus small firms, which is
consistent
with Collins et al. (1987) and Freemen (1987).
While the above analysis suggests that the earnings/returns
association
is
enhanced by including returns from an earlier time frame, the results do not
identify exactly how far back one should go. This is difficult to specify a priori
and will vary as a function of the timing of valuation
relevant economic
events, the nature of a firms information
environment,
and how quickly
economic events are captured in the accounting
earnings numbers. Basically,
then, it becomes an empirical issue.
To shed some light on this issue, we regress earnings changes on returns
where the return measurement
is started at varying points in time and
extended
over varying time frames. We always use buy-and-hold
returns.
Specifically, we vary the start of the return cumulation
process from January
of fiscal year t - 1 to June of fiscal year t and allow the length of the holding
However,
even after
160
Pooled
Dependent
variable
I
Firm sizeb
NC
( t-s&)d
on contemporaneous
,.
and lagged
,.
(r-skgd
( t-s:2at)d
Adj. R2
AT/p,-,
All
9718
0.001
(3.04)
0.038
(10.56)
0.058
(16.82)
3.56%
%AX,
All
9045
0.034
(7.18)
0.256
(16.78)
0.310
(21.47)
6.90
AX/p,-,
Small
3215
0.005
(1.87)
0.031
(3.86)
0.083
(10.79)
3.68
AX/p,-,
Medium
3251
- 0.002
(- 1.09)
0.045
(9.43)
0.043
(9.34)
4.61
AX/p,-,
Large
3252
0.000
(0.33)
0.044
(11.69)
0.033
(9.31)
5.72
%AX,
Small
2725
0.032
(2.92)
0.213
(6.90)
0.384
(12.93)
6.76
%AX,
Medium
3126
0.024
(3.14)
0.255
(10.54)
0.293
(12.70)
7.28
%AX,
Large
3194
0.045
(7.37)
0.311
(13.94)
0.231
(10.99)
7.97
161
14Conclusions
based on adjusted Rs are not affected by our choice of reverse regression. This
follows because in case of simple regression adjusted R* is unchanged when the independent
and
dependent
variables
are interchanged
[see Maddala (1977, pp. 77-79)]. Our discussion
of the
sensitivity
of the degree of association
to length and cumulation
period of returns ignores
magnitudes
of slope coefficients from all the regressions. The magnitude of the slope coefficient is
maximized
when adjusted R* is maximized since R* is an increasing function of the estimated
slope when it is positive.
To improve the visual clarity of the graphs, figs. 1 and 2 do not plot adjusted
Rs when
returns are measured over 17 and 18 months. The results for A X,/P,_ I are virtually identical to
those reported here.
D. W. Cohs
- Ott, t
Jan,
1
at-
I
12
1
6
1
Beginning
holding
t -
-J
I
16
--__
period
12
15
13
-El-
16
14
Fig. 1. Large-firm
changes in period
Dee, t
163
Jan. t+l
Jan, I - Dee,
t -
c------Beginning
I-
13
14
_ month
Fig. 2. Small-firm
changes in period
t --__
12
Mar. I+1
16
12
1
+I-
holding
period
15
il-
16
164
length) that begin at an earlier point in time for large firms compared to small
firms.16
To summarize, a conventional 1Zmonth return period understates the
earnings/returns
association, particularly for larger firms. The association is
maximized when returns are measured over 15 months starting from August of
year t - 1 for large and medium firms and November of year t - 1 for small
firms. All further analysis is performed using returns measured over the
15-month intervals appropriate for each size grouping. In the remainder of
the analysis the AX,/P,_, variable is defined as AX, scaled by price at the
beginning of the appropriate 15-month return interval for each firm. This
ensures that the scale variable is consistent with the model in section 2.
6. Determinants
but similar
results
as reported
here.
Even if we were to identify the term structure of interest rates, it is not obvious how to use
that information
in relating the response coefficient to interest rates. It seems that some kind of a
weighted average interest rate is called for where the weights are proportional
to the expected
levels of interest rates and inversely proportional
to their timing. We do not know the extent of
improvement
in the relation between interest rates and RRCs that would result from such an
exercise and leave it for future research.
165
Government
bond yields
annual
earnings
changes
and
on
change
Return
periodd
Product moment
(p-value)
Rank order
(p-value)
A x,/P,-,
January-December
0.68
(0.005)
0.84
(0.001)
s&Ax,
January-December
0.50
(0.060)
0.55
(0.035)
AX/P,-,
15 months
0.73
(0.002)
0.85
(0.001)
%AX,
15 months
0.55
(0.034)
0.50
(0.056)
Long-term
Government
bond yields used as proxies for risk-free interest rates are taken from
Ibbotson and Sinquefield (1985).
bAnnual return response coefficients (n,s) are estimated from the following annual reverse
regressions:
%A X,, or A X,,/P,,_ 1= %, + yl, R,, + E,,. The sample selection criteria employed to
obtain data for these regressions are given in footnote a to table 2.
A X,/P,_ 1 is change in EPS from year t - 1 to t divided by share price at the beginning of the
relevant return period (i.e., 12- or 15-month period). A total of 58 observations
with /A X,/P,_ 1I>
100% are excluded.
%AX, is change in EPS from year t - 1 to t divided by the EPS for year f - 1. A total of 731
observations
with negative denominators
or IBA X,1 > 200% are excluded.
Return period refers to the independent
variable in the annual regressions.
R,, is raw return on
security i over the relevant return period.
dReturn period January-December
is 12 months starting from January of fiscal year t for each
security. The 15-month return period starts in November of fiscal year t - 1 for the small firms
and starts in August of fiscal year t - 1 for the medium and large firms,
All correlations
are based on 15 annual observations
for the period 1968 to 1982.
166
rates and RRCs. The p-values are small despite only 15 annual observations
(1968-82)
used to estimate correlations.
Correlations
using response coefficients based on 1Zmonth returns are comparable to those based on 15-month
returns.
As expected, the correlations
when %AX, is the dependent
variable in the
earnings/returns
relation are smaller compared
to those using A X,/P,_,.
Using 15-month returns and SAX,, product moment (rank order) correlation
between the response coefficient and interest rates is 0.55 (0.50) which has a
p-value of 0.034 (0.056). These results are consistent with interest rate fluctuations having less influence on response coefficients estimated with the previous
years earnings as the scale factor on AX,. However, the correlations
are still
consistently
positive and statistically significant. Thus, the sensitivity to interest rates is reduced but not eliminated by using earnings as the scale factor. A
likely reason for the association is that the response coefficient for year t also
reflects the effect of any interest rate change during the year on the returns on
all securities.
6.2. Risk and growth expectations as determinants of the return
response coeficient
This section analyzes the factors explaining cross-sectional
differences in the
earnings/returns
relation. First, we test the effects of risk and growth (and/or
persistence)
using the entire sample of firms identified earlier. To estimate
firm-specific persistence using time series analysis requires a lengthy earnings
history. Since this requirement
reduces our sample by about one-half, we
report the effects of persistence
on the earnings/returns
relation
in the
following
section using only the subsample
that meets the necessary data
requirements.
We use common stock betas estimated from monthly returns as a proxy for
the riskiness of earnings. The market value to book value of equity relative to
the median market value to book value ratio of all the sample firms in each
year is used as a proxy for the firms economic growth opportunities.
The
difference between the market value and book value of equity when measured
relative to the market average roughly represents
the value of investment
opportunities
facing the firm [Smith and Watts (1986)]. The market to book
value ratio depends upon the extent to which the firms return on its existing
assets and expected future investments
exceeds its required rate of return on
equity. Since future earnings are affected by the growth opportunities,
the
higher the market to book value of equity ratio, the higher the expected
earnings growth. We use the market to book value of equity ratio as of the
beginning
of each year t as a proxy for expected growth. This proxy for
growth, however, is also likely to be affected by earnings persistence. That is,
high market to book value of equity ratio is likely to be associated with high
167
persistence
as well. Therefore, on the basis of our regression results we cannot
conclude unambiguously
that ERC is affected by growth. Rather, a relation
between market to book ratio of equity and ERC will suggest that growth
and/or
persistence affect ERC.
To assess the effect of risk and growth on the RRC, the following model is
estimated in year t from 1968 to 1982:
A X,,/P,,-
(9)
where
= return measured over the appropriate
U-month
period for the small,
medium, and large firms,
MB,, = market to book value of equity ratio, calculated at the beginning
of
year t,19
84, = market model systematic risk.20
R,,
168
Table 5
Effect of risk and growth expectations on the response coefficient from an earnings/price
Annual regression analysis from 1968-82.a
AX,,/P,,-,
or %A&, =
YO, +
x,R,,
Expected
dependent
Independent
variable
AX/p,-,
YW+%
sign when
variable is
BAX,
Intercept
* 4,
n,B,,
* R,,
relation:
E,,
%AE,
0.023
(0.62)
Return
(R,,)
Growth
(MB,, * R,,)
-0.021**
( - 4.31)
-0.57**
( - 4.69)
Risk
(R,, * R,,)
0.028*
(2.67)
- 0.067
(- 1.70)
0.080**
(4.92)
0.661**
(11.09)
time series sampling distribution of the regression coefficients, they are free
from the cross-sectional dependence problem described in Bernard (1987).
Results using the A X,/P,_,
variable are uniformly consistent with our
hypotheses. The ur coefficient on return is positive and significant. v2 on the
growth/return
interaction is equal to -0.021 and reliably negative as predicted. Similarly, the response coefficient increases in risk as seen from the
coefficient estimate of 0.028 which is significant at 1% level. The evidence
suggests risk and growth (and/or persistence) significantly impact the RRC
when earnings change is scaled by price.
The coefficient estimates on the return and growth variables from the
regression using %AX, as the dependent variable have the same sign as when
AX, is scaled by P,_l. The coefficient for which a prediction can be made, j$
is positive and highly significant. The coefficient on the growth/return interaction (j$) too is significant and negative. Thus, when X,_, is the scale variable,
the RRC is significantly influenced by growth (and/or persistence). The
risk/return interaction (7s) is not significantly different from zero. This result
169
170
Effect
of risk, growth
earnings/returns
expectations,
and interest rates on the response coefficient
relation: Pooled regression analysis using data from 1968-82.*
AX,,/p,,~,or%AX,,=y,+u,,D,,+
an
+Y~~D~~+Y~MB,,*R,,+Y~P,,*R,~+Y~~*R,~+~~
Expected
dependent
Independent
from
sign when
variable is
Estimated
coetlicient
Dependent
( r-statistic)b
variable
%AX,
variable
- 0.059**
(- 15.58)
Intercept
-0.272**
(- 16.62)
D6X
0.054**
(9.50)
0.273**
(11.30)
D69
0.062**
(11.03)
0.276**
(11.52)
D 70
0.060**
(10.82)
0.250**
(10.49)
0.062**
(11.27)
0.280**
(11.77)
D 72
0.076**
(14.00)
0.451**
(19.43)
D 73
0.083**
(15.28)
0.504**
(21.90)
D 74
0.090**
(16.31)
0.467*
(19.88)
0.030**
(5.75)
0.180**
(7.97)
D 76
0.066**
(12.61)
0.331**
(14.86)
D 77
0.067**
(12.89)
0.356**
(16.11)
D 7R
0.080**
(15.40)
0.413**
(18.54)
D 79
0.069**
(13.26)
0.338**
(15.38)
0.027**
(5.10)
0.119**
(5.39)
0.050**
(9.56)
0.230**
(10.35)
- 0.042**
(-4.75)
D71
45
D 80
43,
- 0.024**
(- 11.70)
(P,, * K,,)
0.018**
(3.36)
Interest
(I, * R,,)
0.012**
(15.36)
0.062**
(17.78)
Adjusted
R*
12.73%
9718
17.98%
9045
Growth
(MB,,
Risk
* R,,)
PO.013
( - 0.53)
171
Table 6 (continued)
Sample selection criteria are given in footnote a to table 2.
A X,/P,_,
is change in EPS from year t - 1 to f divided by share price at the beginning of the
15-month return period. A total of 58 observations
with /A X,/P,_ II > 100% are excluded.
%A X, is change in EPS from year t - 1 to t divided by the EPS for year I - 1. A total of 731
observations
with negative denominators
or ISA X,1 > 200% are excluded.
R,, is raw return on security i over the relevant return window.
R,, is measured
over a
15.month
period beginning in November of year r - 1 for the small firms and over a 15-month
period beginning in August of year [ - 1 for the medium and large firms.
MB,, is the market to book value of equity ratio calculated at the beginning of each year 1.
/I$, is the market model systematic risk estimate obtained by regressing 60 monthly returns
ending in year t - 2 on the CRSP equally weighted return index.
I, is the long-term Government
bond yield in year t.
DhX through
dummies which are set = 1 for observations
from
D,, are annual intercept
respective years 68 through 81 and area set = 0 otherwise.
hSignificance at a = 5% is indicated by one asterisk (*) and at a = 1% by two asterisks (**). One
tailed r-tests are performed when sign of the coefficient is predicted. Otherwise two-tailed t-tests
are performed.
To summarize,
variation in the earnings/returns
relation is explained by
differences in risk, growth (and/or persistence), and interest rate factors when
earnings changes are scaled by Pt_l. The relation between earnings changes
and returns appears to be less sensitive to risk differences when the scale factor
is last years earnings.
Analysis
in section 5 revealed that differences in the earnings/returns
relation are related to firm size which is hypothesized
to reflect differences in
information
environment.
We show below that for both definitions
of the
earnings change variable firm size is nor incrementally
useful in explaining
variation in the RRC once we adjust the holding period return to account for
differences in the information
environment
and growth and risk factors are
included in the model.
In table 7 we report results of estimating the following model in each year t
from 1968 to 1982:
AX,,/f,-1 or %A-%,
= ~0 + YS,, + ~ztMB,t * R,, + Y3rPir
* R,,
+ y,,Size,, * R,, + qf,
where Size;, = 1 for the medium and large firms and 0 for the small firms
where firms are reclassified every year. all other variables are as defined earlier.
For both specifications
of the earnings change variable, v4 is not significantly
different from zero. The size coefficient is - 0.008 (t-statistic = - 0.78) when
P1_ 1 is the scale variable and it is 0.022 (t-statistic = 0.44) when X,_, is the
deflator. Once again, when AX, is scaled by Pt_l all of the other coefficients
172
Table 1
Effect of risk, growth expectations,
returns relation:
from an earnings/
AX,,/P,,~,~~%AX,,=~O,+Y,,R,,+~~,MB,,*R,,+Y,,B,,*R,,+~,,S~~~,,*R,,+F,,
Expected
dependent
Independent
variable
sign when
variable is
%AX,
AX/p,-,
Intercept
Estimated
coefficient
Dependent
A X,/P,-
- 0.001
( - 0.17)
Return
(R,,)
0.089*
(4.69)
Growth
(MB,, * R,,)
- 0.021**
(-4.59)
Risk
(I$, * R,,)
0.025*
(2.26)
Size
(Size,, * R,,)
- 0.008
( - 0.78)
(r-statistic)
variable
%AX,
0.023
(0.64)
0.651**
(10.98)
~ 0.060* *
(- 5.10)
- 0.059
(-1.54)
0.022
(0.44)
a relation
persistence
between persistence
and ERC, the error in
and the error in the proxy for unexpected
173
earnings variable (VX) pose a nontrivial problem. The problem arises because
the error in estimating earnings persistence using an ARIMA model at the
individual firm level can be large. Moreover, this error is likely to be related to
the error in the proxy for UX. If ERC is estimated using eq. (1) it varies
inversely with the measurement error in the lJXi, proxy and a spurious
correlation between estimated persistence and estimated ERC could result
simply because estimation errors in the two variables are correlated.
We analyze the relation between persistence and response coefficients differently from previous research and in a way that reduces the correlated
measurement error problem noted above. We first estimate IMA(l, 1) persistence factors of those firms with a complete earnings history on the Compustat
tape. This data restriction cuts our original sample approximately in half. We
then test the interaction of the estimated persistence variable with returns
(8, * R,,) along with other interaction terms in the cross-sectional regression
equation described earlier in eq. (10) and table 6.23 Since we estimate RRCs
rather than ERCs, the coefficient on persistence is predicted to be negative.
Moreover, the dependent variable is the scaled annual earnings change rather
than the ERCs. Since the dependent variable in our analysis is not conditional
on the individually estimated IMA(1,l) models, potential spurious correlation
because of measurement error is reduced.
The limitation of estimating persistence using reported earnings, as noted
earlier, is that the estimate is confounded by earnings growth. Thus, the
persistence estimates also reflect economic growth and this adversely affects
our ability to separately document the growth and persistence effects.24 Because both persistence and growth proxies are included in the regressions,
coefficients on each reflect each variables incremental effect on the RRC. If
both proxies are measuring the same underlying construct, then incremental
association of each variable with the RRC implies that neither proxy fully
captures the underlying construct. Unfortunately, this cannot be verified
empirically.
The results of adding the earnings persistence variable to the model for the
reduced subsample of firms are reported in table 8. When the dependent
variable is A X,/P,_ 1 the coefficient on persistence is significantly negative as
predicted (-0.051 with a t-statistic of -4.91). For this specification, all the
other factors that are hypothesized to affect the earnings/returns relation (i.e.,
growth, risk, and interest rates) have the predicted sign and are statistically
23Because estimated
@s could be positive or negative, we use (1 - 0) instead of -0 as the
multiplier in the persistence/return
interaction variable. This ensures that the multiplier is always
positive and the higher the (1 - 0) value the higher the persistence. (1 - 0) is the persistence factor
for an IMA(1, 1) process as seen, for example, in Beaver et al. (1980) or table 1.
24Altematively,
as we have noted earlier, the results in the earlier tables could be reflecting
effect of persistence
and growth on the RRC rather than the effect of growth alone.
the
Table 8
Effect
of risk. growth,
earnings/returns
A X,,/P,,
persistence,
and interest rates on the response coefficient
relation: Pooled regression analysis using data from 1968-82.a
an
Independent
from
variable
AT/p,-,
sign when
variable is
%AX,
Estimated
coefficient
Dependent
AT/p,-,
(t-statistic)
variable
%AX,
- 0.065**
(- 13.17)
- 0.327**
(- 15.86)
D68
0.062**
(8.98)
0.333**
(11.73)
D69
0.074**
(10.71)
0.372**
(13.17)
D 70
0.064**
(9.26)
0.286**
(10.09)
0.059**
(8.56)
0.263*
(9.17)
Intercept
D71
D 72
0.077:
(11.21)
0.491**
(17.21)
D,,
0.093**
(13.49)
0.579**
(20.43)
D 74
0.116**
(16.28)
0.630**
(21.48)
D75
0.012
(1.75)
0.132**
(4.70)
D 76
0.073**
(10.67)
0.371**
(13.06)
D 77
0.072**
(10.58)
0.396*
(14.05)
D 7*
0.086**
(12.51)
0.459**
(16.23)
D 79
0.079**
(11.61)
0.441**
(15.64)
D80
0.030**
(4.34)
0.153**
(5.49)
0.062**
(9.10)
0.333**
(11.86)
- 0.024**
(-8.23)
- 0.066**
(- 5.46)
0.049**
(5.85)
0.17u**
(4.85)
DUl
Growth
(MB,, * R,,)
Risk
(P,, * R,,)
Interest
(I, * R,,)
0.01s**
(12.95)
0.059**
(10.19)
Persistence
(0, * R,,)
- 0.051**
( - 4.91)
0.062
(1.36)
19.43%
4841
27.33%
4587
Adjusted
N
R2
175
Table 8 (continued)
Initially
any firm listed on the Compustat
Industrial
Annual or the Compustat
Annual
Research tape with a December 31 fiscal year-end and complete earnings data during 1968-82 is
included in the sample. From this sample, the subset for which monthly return data are available
for eight consecutive
years ending in 196943
is included in the sample analyzed in this study.
A X,/P,_ 1 is change in EPS from year t - 1 to t divided by share price at the beginning of the
15-month return period. A total of 58 observations
with Id X,/P,_, 1z 100% are excluded.
%A X, is change in EPS from year r - 1 to t divided by the EPS for year t - 1. A total of 731
observations
with negative denominators
or l%AX,1 > 200% are excluded.
R,, is raw return on security i over the relevant return window.
R,, is measured
over a
15-month period beginning in November of year I - 1 for the small firms and over a 15-month
period beginning in August of year t - 1 for the medium and large firms.
MB,, is the market to book value of equity ratio calculated at the beginning of each year t.
/I,, is the market model systematic risk estimate obtained by regressing 60 monthly returns
ending in year t - 2 on the CRSP equally weighted return index.
I, is the long-term Government
bond yield in year r.
Dbx through
dummies which are set = 1 for observations
from
OR1 are annual intercept
respective years 68 through 81 and are set = 0 otherwise.
8, is the persistence coefficient measured as (1 - 0) from an IMA(l.l)
process.
Significance
at a = 5% is indicated by one asterisk (*) and at a = 1% by two asterisks (**).
One-tailed
r-tests are performed
when sign of the coefficient is predicted.
Otherwise two-tailed
r-tests are performed.
significant.
When the dependent
variable is %AX, the coefficient on persistence has a positive sign, but is statistically
insignificant.
Again, this can be
explained, in part, by the scaling factor, X,-r, which itself is a function of the
same parameters
that determine
the persistence
measures. Finally, the explanatory
power of the model applied to the reduced sample is considerably
higher than for the full sample with an adjusted R2 of 19.43%, when AX,/P,_,
is the dependent
variable and 27.33% for %AX,. The corresponding
adjusted
R2s for the full sample from table 6 are 12.73% and 17.98%.
The significance levels of the various estimated coefficients reported in table
8 could be overstated because the OLS standard errors ignore cross-correlation
among data. We, therefore, estimate a model similar to eq. (9) in each year
from
1968 to 1982. The only difference
is that we now include
a
persistence/return
interaction
variable as well. These results are reported in
table 9. Statistical inferences are drawn from the sample mean and standard
error of the coefficient estimates from the 15 yearly cross-sectional
regressions.
Results using the A X,/P,_ 1 variable are uniformly consistent with the hypothesized relation between the RRC and risk, growth, and/or persistence factors.
The coefficient
on the persistence
variable is -0.069
(t-statistic = -2.95)
which is negative at a 5% significance
level. When %AX, is the dependent
variable, the coefficients on risk and persistence are not reliably different from
zero, but the coefficient on growth is negatively related to the RRC at 5%
significance
level. Overall, the results indicate
that risk, growth, and/or
persistence
are significant determinants
of the RRCs when earnings changes
176
Table 9
Effect
of
an
Independent
from
variable
* x,/P, -
sign when
variable is
%AX,
Intercept
Estimated
coefficient
Dependent
(~tatistic)~
variable
*X,/p,-,
%AX,
- 0.003
(-0.36)
0.23
(0.47)
0.153**
(4.55)
- 0.017**
(-4.14)
- 0.053*
(-2.31)
(P,, * R,,)
0.051*
(2.01)
0.081
(0.84)
(6, * R,,)
-0.069**
- 0.039
(-0.38)
_____
Return
(R,,)
Growth
(/JB,, * R,,)
Risk
Persistence
( - 2.95)
0.695**
(4.08)
are scaled by price. However, these factors have less influence on RRCs when
earnings changes are scaled by last years earnings.
Table 10 summarizes how the explanatory power of the earnings/returns
relation is enhanced by varying the return interval and by incorporating terms
that capture the effects of risk, growth, and/or persistence and interest rates
on the RRC. The first two columns report adjusted R*s from models estimated with the full sample, while the last two columns present similar results
for the subsample with complete data throughout our sample period. Comparing the first two rows of table 10 we see that the explanatory power of a model
where earnings changes are regressed on returns more than doubles when we
111
Row
R2 from earnings
A x,/P,-,
regression
using
Full sample
Dependent
returns
variable
%Ax,
Dependent
AX/L,
variable
%AX,
(1)
12-month April to
March returns
2.47%
4.01%
2.11%
(2)
15-month
6.32
9.87
8.37
13.04
(3a)
8.14
10.09
11.29
13.22
(3b)
11.63
13.71
(4a)
15-month
annual
proxies
growth,
interest
17.98
19.05
27.31
(4b)
19.43
27.33
retumsd
returns with
dummies and
for risk,
and
rates
12.73
2.96%
Sample selection criteria for the full sample are given in footnote a to table 2 and for the
sa?ple consisting of firms with complete data for 15 years are given in footnote a to table 8.
When full sample is used, there is no proxy for persistence
included as an independent
variable.
Table values are adjusted Rs from regressing either A X,/P,_ 1 or % X, on the set of variables
indicated in the left-hand column,
dThe 15-month returns that are associated with the earnings change in period I are measured
from August,_ 1 to November,
for large and medium firms and November,_,
to February,+ 1 for
small firms.
use a 15month
return holding period beginning
in August of t - 1 for
large/medium
size firms and November of r - 1 for small firms. Adding terms
that proxy for varying levels of risk, growth and/or
persistence, and interest
rates (row 3 versus row 2) increases the explanatory
power by an additional
10-30S%. Finally, adding annual dummies to capture the year-to-year
differences in average earnings changes contributes
an additional
50-708
to the
adjusted R2 of the pooled model (row 4 versus row 3).
178
Comparing
the first and last row of table 10 shows the dramatic improvement achieved by varying the return interval and allowing nonconstant
intercept and slope terms in the earnings/returns
relation. For the full sample the
adjusted R2 increases by 415% when the dependent variable is A X,/P,_, and
by 348% when the dependent variable is %AX,. The comparable improvements
for the reduced sample of firms with complete earnings data throughout the 15
years of our study were 821% and 823%. Despite these dramatic improvements
in overall explanatory
power it is obvious that a substantial
amount
of
variation
(roughly, 70-80s)
in accounting
earnings changes is unrelated
to
security returns. This suggests there is ample room for further refinement in
the earnings/returns
relation and/or that accounting earnings contain a large
noise component
that is irrelevant to valuing the firm.
7. Summary
and implications
This paper extends the empirical literature on the differences in the relation
between earnings and security returns. Using a simple discounted
dividends
valuation
model we hypothesize that the earnings response coefficient varies
negatively
with the risk-free interest rate and systematic risk; and it varies
positively with growth prospects and earnings persistence. This analysis predicts cross-sectional
and temporal variation in the amount of price change
associated with earnings changes.
Our empirical analyses suggest methodological
refinements that have implications
for past and future association
study research. We examine
the
implications
of differences in the information
environment
which are characteristic of the security market. Specifically, we show that conventional
association study methods that measure returns over the fiscal 1Zmonth
period, or
the degree of association
befrom April, to March,_ r, seriously understate
tween price changes and earnings changes in an annual association
study
context. The price/earnings
association improves dramatically
on starting the
measurement
period earlier than the contemporaneous
fiscal period. Varying
the return measurement
period for different size firms controls for the information environment
differences among the large and small firms and also
explains
the previous finding that the degree of price change to earnings
change varies with firm size.
Empirical evidence is consistent with the predictions that the ERC increases
in growth and/or
persistence and decreases in interest rates and risk. Because
the proxies used for growth and persistence could potentially
reflect the effect
of both variables, we cannot conclude unambiguously
that growth and persistence affect ERC individually.
To reduce the errors-in-variables
problem, we
use reverse regression to document
the effect of differences in persistence
and/or
growth, risk, and interest rates on the response coefficient.
179
180
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