Journal of Accounting Research

Vol. 29 No. 1 Spring 1991

Printed in U.S.A.

Earnings as an Explanatory
Variable for Returns
PETER D. EASTON* AND TREVOR S. HARRIS
Introduction
In this paper we investigate whether the level of earnings divided by price at the beginning
of the stock return, period is relevant for evaluating earnings/returns associations. 1 The primary
model motivating this research relies on the idea that book value (owners' equity) and market value
are both "stock" variables indicating the wealth of the firm's equity holders. The related "flow"
variables (after adjusting for dividends) are respectively, earnings divided by price at the beginning
of the retur period {A/P~i) and market returns. It then follows that earnings divided by beginning
of period price should be associated with stock returns.
Although models based on a relation between market value and book value are used
occasionally in the accounting research literature (see, for example, Landsman [1986], Harris and
Ohlson [19871, and Bart

* Macquarie University and University of Chicago; tColumbia University. The paper is a revised
version of working papers entitled "An Empirical Evaluation of Accounting Income Numbers:
Further Evidence" and "Evidence of Accounting Earnings as an Index of Change in Value." The
authors wouid like to acknowledge comments from workshop participants at the following
universities: Arizona, Auckland, California at Berkeley, California at Los Angeles, Columbia,
CUNY-Baruch College, Harvard, Macquarie, Michigan, New South Wales (AGSM), and
Southern California. Special thanks are due to Vic Bernard, Jim Haggard, Robert Lipe, Jim Ohlson,
Eric Noreen, Stephen Penman, Ram Ramakrishnan. Jake Thomas, and anonymous referees. The
study was partly funded by the Faculty Research Fund, Columbia Business School, Columbia
University and by the Institute of Professional AccountiBg, Graduate School ofBusiness,
University of Chicago.
1
The variable of interest is not the standard earnings-to-price ratio which is based on
contemporaneous, or past, earnings divided by contemporaneous, or past, price (A_i/P_,).

HALAMAN 1
[1989]), another frequently used model expresses price as a multiple of earnings. This latter model
is generally used to motivate empirical studiesof the relation between security returns and change
in earnings or between abnormal returns and unexpected earnings (see, for example Beaver,
Lambert, and Morse [1980] (henceforth BLM) and Collins and Kothari [1989] (henceforth CK)).
However, we show that the assumption that price is a multiple of earnings also implies that the
earnings level variable (A/P-i) is a relevant explanatory variable for returns.
Although all the valuation models discussed in this paper indicate the potential relevance
of the level of current earnings divided by beginningof-period price, they do not exclude the
relevance of change in earnings divided by beginning-of-period price (AA/P_i). For example,
differences between the book value and stock price could be a function of earnings. Thus, while
the primary motivation of the empirica analysis is to evaluate the relevance of the earnings level
variable (A/P-i), the analysisalso considers and tests tbe relevance of the change in earnings
variable (AA/P_i) for explaining stock returns.
The results provide evidence that current earnings divided by beginning- of-period price
(A/P-i) is associated with stock returns. Univariat regressions show that A/P-i and AA/P_i are each
associated with returns. In multiple cross-sectional regressions of annual returns on both the levels
(A/P-i) and the changes (AA/P-i) variables, the coefficient on earnings levels is statistically
significant (at 1% or better) in all years,
while the coefficient on earnings changes is significant (at this level) in less than half the years.
Additional analysis suggests that the relevance of the earnings level variable (A/P-i) for assessing
the association between returns and earnings does not derive merely from a correlation between
the two earnings variables.
The primary empirical analyses focus on raw returns as the dependent variable because it
is the return measure defined in the valuation models which we invoke. However, much of the
empirical literature evaluating the association between earnings and security prices considers the
relation between unexpected (abnormal) returns and unexpected earnings. A measure of
unexpected earnings frequently used in association studies involving annual return windows is
change in earnings, sometimes deflatedby the beginning-of-period price. Given the measurement
erro inherent in any unexpected earnings measure and the relevance of theearnings levels variable
(A/P_i) in the return association tests, it I pertinent to consider whether earnings levels are useful
when considering the unexpected return/unexpected earnings relation. In multiple regressions of
annual cumulative abnormal returns—based on a (monthly)market model—on both A/P_j and
AA/P_,, the earnings levels variable has statistically significant explanatory power over the
earnings changevariable, and vice versa. Given that both earnings variables measure unexpected
earnings with error, we suggest, in the spirit of Brown et al.

HALAMAN 2
[1987], that studies which use the residual from a regression of annual abnormal returns on
unexpected earnings might mitigate the effect of measurement error by including both earnings
level and earnings change variables as measures of unexpected earnings.
The relevance of the earnings levels variable suggests new opportunities in our search for
a better understanding of the associations between accounting earnings and returns. For example.
Lev [1989], who expresses concern about the pervasiveness of low R^ statistics in returns/earning
association studies, cites the focus on earnings levels as a potential direction for improvement.
The models relating earnings variables and security returns are presented in section 2. After
describing the data and sample selection procedure in section 3, empirical analyses of the relation
between the earnings variables and security returns are documented in section 4. Section 4 also
addresses the issue of whether earnings levels and earnings changes capture the same or different
information. The use of earnings divided by beginning-of-period price as an instrument for
unexpected earnings is addressed in section 5. Section 6 contains a summary of theresults and
some conclusions.
2. The Relation Between Earnings and Returns
2.1 RETURNS AND EARNINGS ASSOCIATIONS BASED ON ABOOK VALUE
VALUATION MODEL
The idea that price and book value are both measures of the "stock" value of the
shareholders' equity may be expressed more formally as;
P,, = BVj, + Uj, (1)
where Pjt is the price per share of firm j at time t, BVj, is the book value per share of firm
j at time t, and u,, is the difference between Pjt and BV,,.
The difference between market and book values iuj,) can result from many factors
including the choice of conservative accounting practices and other information incorporated in
price but not yet reflected in accounting values. The relation between the "flow" variables—
accounting earnings and security returns^may be obtained by taking first differences ofthe
variables in equation (1). This yields:
(rumus) + u;,. (2)
But, in general:
(RUMUS)ABVj, = Aj, ~ dj , (3)
where Aj, is accounting earnings per share of firm j over the time period
HALAMAN 3

t ~ I to t, and dj, is dividends paid per share of firm ; over time period t~ ito t .2
Substituting (3) into (2), rearranging, and dividing by Pj^-i yields:
(APj, + dj,}/Pjr^i = Aj,/Pj,-r + u;. (4)
That is, if stock price and book value are related, as we might expect, then earnings divided by
beginning-of-period price should be an appropriate variable for explaining returns.3

2.2 RETURNS AND EARNINGS ASSOCIATIONS BASED ON AN EARNINGS

VALUATION MODEL
Because some of the empirical literature focuses on an earnings-based valuation model, we
consider an alternative model which expresses price as a multiple of earnings. That is;
PJ, = pAj, + Uj, (5)
Ohison [1989a] demonstrates that the Miller and Modigliani [1961] dividend irrelevance
proposition requires that if a dividend is paid on security 7 at time t, then equation (5) must be
written as .4
PJ, + dj, = pAj, + Vj,. (6}
It follows that:'^
(AP,, + dj,)/Pj,-, = p[AAjJPj,^,] + vj,. (7)
That is, there is a linear relation between change in earnings divided by
beginning-of-period price and security returns over that period.6
2
In the empirical analysis all data are adjusted to reflect the implicit assumption that prices,
dividends, and accounting variables are calculated based on the shareholding at a particular point
in time. Further, in principle, dj, reflects net withdrawals by the firm's owners.
3
The factors included in Uj, and uj, are not germane to this paper. The variable u", is relevant
forthe empirical analysis and is considered in section 4.
4
The coefficient p is frequently assumed to be constant across firms and time periods (see, for
example, BLM in an empirical analysis and Ohison [1989a] in a theoretical framework).
5
Changes in earnings have been used in a way similar to equation (7) in BLM which uses equation
(5) to test the following form of the earnings/return relation:
RUMUS…
While CK examine change in earnings via the relation:
RUMUS…
in a reverse regression framework.
6
Implicit in equation (7) is the assumption that a dividend is paid at time t but there is no dividend
paid at time t - 1. If a dividend is paid at t - 1, equation (7) becomes:
PJ.-,] - dj,-JP,,-, + vj,. Ha) RUMUS
HALAMAN 4
Of particular relevance to this study is the fact that dividing equation (6) by beginning-of-
period price yields:
RUMUS (P,, + d,,)/P,,-, = AAiJPn~A + vJ,. (8)
This equation suggests that from an earnings valuation perspective, earnings levels
(divided by beginning-of-period price) will be associated with returns. The return variable (AP,, -
l- dj,)/Pj,-i can be obtained from (8) by subtracting one from each side of the equation and then
expanding the left-hand side.7

2-3 COMBINING BOTH VALUATION PERSPECTIVES

As a practical matter, for most companies the stock price is likely to be a function of both
book value and earnings. For example, Ohlson [1989a] presents a model that suggests that the
variable u^, in equation (1) is partly a function of earnings. By combining a "book value only
model (similar, in principle, to equation (4)) and an "earnings only"model (summarized, in
principle, by equation (7)) he proposes a valuation relation in which price is a weighted function
of book value and earnings.8 In a similar manner, equations (4) and (7) may be combined to give:

(AP,, + dj,)/P,,-, = kp[XAjP,,.,] + a- k)[AjJP,,.,] + w,, (9)

where /? is a factor for weighting the contribution of change in earnings versus earnings
levels in the explanation of stock returns.
In the empirical analyses, we examine the relations between earnings and returns implied
by (i) equations (4) or (8) for earnings levels (ii) equation (7) for earnings changes, and (iii)
equation (9) for both earnings measures together.9

2.4 POTENTIAL CONFOUNDING EFFECTS

Prior empirical research has also examined the relation between earnings/ price ratios and
returns. Basu [1977], for example, finds a positive

For practical pur]joses, both d^,-i/P;,-i and, in particular, the cross-sectional variation in
this variable are sufficiently small so as to have no effect in the empirical analyses which
include an intercept term.
7
Equations (4) and (8) both express returns as a function of earnings levels divided by
beginning-of-period price. Reconciliation of these equations requires:
RUMUS
This is a familiar definition of earnings under certainty with p equal to the reciprocal of the required rate
of return plus one (Ohlson [1989bl).
8
Ohlson's [1989a] model provides a role for earnings and book value in a dynamic uncertainty
environment that relies on the simple "clean-surplus" relation (that is, ABV,, = Aj, - dj,) and the Miller and
Modigliani [1961] propositions. While we provide a more heuristic analysis, it should be noted that relations
(4), (7), and (9) are consistent with the Ohlson model in which earnings and book value are defined as
"primitive" and fundamental economic variables.
9
The variables u",, vj,, and Wj, are important in this paper only as they affect the empirical analyses.
Thus, we leave discussion of these terms to section 4.
HALAMAN 5
association between returns and historical earnings/price ratios. This result potentially affects the
interpretation of the empirical results. Since:
RUMUS A,/P;,-! = ^AjJPj,^, + A,,_i/P,,_, (10)
it is not possible to distinguish between ii) the combined explanatory power (for returns) of change
in earnings divided by beginning-period price and prior-period earnings (i.e., for period t - 2 to ( -
1) divided by the price at the beginning of the return period iAjt-\fPjt-\), and {ii) the explanatory
power of current earnings (i.e., for period t - 1 to £) divided by beginning-of-period price. Inclusion
of any two of the variables in equation (10) as explanatory variables in a regression model
precludes inclusion of the third. Therefore, we consider the explanatory power of each of the three
earnings variables represented in equation (10) and then compare these to the explanatory power
ofthe empirical counterpart of equation (9).
It has also been shown that returns vary with firm size (Banz [1981] and Reinganum
[1981]); size is just one proxy for variables which may explain security returns but are omitted
from equation (9). For example, size could proxy for a variable which causes Uj, (in equation (1))
to differ from zero. Given past empirical accounting research and the question being addressed in
this paper, we choose not to pursue a search for potential additional explanatory variables.

3. Data and Sample Selection

The sample is selected from the period 1969-86 using the criteria:( i) annual earnings per
share and the factor to adjust for stock splits and stock dividends are available on the 1987
Compustat Primary, Secondary, Tertiary and Full Coverage Annual Industrial File; (ii) security
price and the factor to adjust for stock splits and stock dividends are available on the Center for
Security Prices iCRSP) Daily Returns File for the first trading day of the ninth month prior to the
fiscal year-end; and (iii) monthly security return data are available on the CRSP Monthly Returns
File for 69 months prior to and 3 months after the fiscal yearend.
This selection procedure results in a sample of 20,188 firm-year observations. An
additional 192 firm-year observations are deleted because either Ajt/Pjt-], ^jt/Pjt-i, or Ajt-i/Pjt-i is
not between +1.5 and —1.5. 10 Earnings and price variables are adjusted for stock splits and stock
Dividends .11
10
This truncation rule was imposed to ensure that the results were not unduly affected by a few outlying
(unusual) observations. However, truncation did not change the substance of the results.
11
AU analyses are based on a return period extending from 9 months prior to 3 months after the fiscal year-
end, corresponding roughly with the period between earnings announcements. The analyses were repeated
for the subsample of 2,947 firms with no change in fiscal year-end and the date of announcement of fourth-
quarter earnings available on the
HALAMAN 6
4. Empirical Analyses
To better understand the empirical validity of the models described in section 2, and the role of the
current level of earnings, we consider first the correlations between stock returns and each of the
earnings variables. The correlations are described via univariate regressions to facilitate a
comparison with the multivariate regression which empirically estimates the relation expressed in
equation (9). The analyses facilitate consideration of the incremental explanatory power of the
levels and changes variables and the extent to which overall explanatory power is improved by the
incorporation of the levels variable (Lev [1989]).

4.1 UNIVARIATE ANALYSES

We begin with univariate regressions of returns and the earnings levels and changes variables. The
regression models are:
RUMUS+ an[Ajt/Pjt~i] + ^ (11)
and:
RUMUSRJ, =^ 0« + 0n[AAy,/Pj,-,] + 4 (12)
where;
RUMUS R (P +
Although the presence of an intercept is not implied by the theoretical relations that
underpin these regressions (equations (4) and (7)), the omitted variables that may explain security
returns (incorporated in u"t or vjt) may have, on average, a nonzero effect implying nonzero
intercept terms (cttQ and t/ito).
These and all other regression models are estimated for the pooled cross-section and time-
series sample as well as for each year [t) of available data. The results from regressions of the
models in (11) and (12) are reported in table 1. In the regression using the pooled sampie of all
19,996 firm-year observations as well as in the annual cross-sectional regressions, the coefficients
an and .^n are significantly different from zero at the 0.01 level. The R-^ from the pooled regression
based on the levels model in equation (11) is 7.5% compared to the i?^ of 4% from the equivalent
regression for the changes model in equation (12). For the year-by-year regressions, the R'^ from
the levels model is higherthan the fi^ from the changes model in 14 of the 19 years and is at least
twice as high in 7 of these years. While the R'^ from the changes model (12) is higher than the R'^
from the levels model (11) in 5 of the years,

Compustat Quarterly Industrial File. Returns (and abnormal returns) were calculated for the 12
months up to and including the earnings announcement month. Since the results for the analyses of this
subsample are qualitatively similar to those of the larger sample, only the results based on the larger sample
are reported.
HALAMAN 7
TABLE 1
Simple Regressions of Annual Security Returns on Deflated Earnings Leuels and
Earnings Changes
Levels Model:^ Rj, = am + anAjt/Pjt-\ + i]t
Changes Model: flj, = 0«) + 0,,AAj,/-Pj7-i + 4
(t-statistic are provided in parentheses.)
* Significant at 0,01 £ d < 0,05
** Significant at iv ^ 0.01.
1
Description of regression variahles: Rjt, ia the return on a share of firm j over the 12 months
extending from 9 months prior to the fisca] year-end to 3 months after ihe fiscal year-end, Aji is
accounting earnings per share of firm j tor period t, and P,,_, is the price per share of firm j at time
t-1
2
N is the number of observations in ihe regression.
3
This is the mean ol the yearly coefficients, estimated lo test for the effect of cross-sectional
correlations in the error terms.

HALAMAN 8
there are no years in which it is twice as high.12 These results indicate that, as the models
descrihed in section 2 suggest, the current earnings level variable, AjJPjt-i, is correlated with stock
returns. These univariate results suggest also that we can expect both levels and changes variables
to be associated with returns.13
Given the equality expressed in equation (10), we also consider the association between
Ajt-i/Pjt-i and returns by estimating the following regression model:
Rjt - e«) + Bn[A,-i/Pj,^,] + e% (13)
The results from the regressions based on model (13) are reported in table 2. The
coefficients from the pooled regression are statistically significant at the 0.01 level. However, the
R2 is 0.003 as compared to R 2 of 0.075 and 0.040 from the pooled regressions of equations (11)
and (12), respectively. The results from the annual cross-sectional regressions indicate statistically
significant On coefficients (at the 0.01 level) in 7 of the 19 years. In all years the R2 from
regressions of equation (13) are lower than the R 2 from regressions of the levels model (11) by
several multiples. While this is generally also true of comparisons between the R2 from regressions
of the models in equations (13) and (12), in one year (1984) the regression based on Ajt-i/Pjt-i has
an R 2 of 0.059 while the regression based on AAjt/Pjt-iRUMUS has an R2 of 0.036.
As a result of the equality expressed in equatioii (10) it is necessary to interpret the
univariate regressions with caution. But, it is useful to note that there are years (for example, 1973
and 1976) in which the R2 from regressions on Ajt-i/Pjt-i are zero while the Hh from the regression
based on Ajt/Pjt-i are at least 80% higher than the Rh from the equivalent regressions based on
AAjt/Pji-i. Thus, overall, these results suggest that the difference in associations between security
returns and the earnings levels [Ajc/Pjt-x) and earnings changes {AAjt/Pjt-i) variables reflects more
than the earnings/price effect documented by, for example, Basu [1977].
Another reason to interpret the results with caution is the potential bias in the coefficients
due to cross-sectional correlation in the error terms of the regressions. Bernard [1987] suggests
that for regressions based on annual returns, if it is assumed that each annual regression is
independent, then the mean and standard error of the coefficients obtained from the annual
regressions may be used to test whether this mean is statistically different from zero. If it is, then
the bias from any cross-sectional correlation will not be sufficient to negate the statistical

12
There is no statistical reason to use the comparison of R2 being twice as high. We use this simply
to provide a sense of the order of magnitude of the difference. Our focus on R2 stems from the
emphasis on this statistic in recent review papers by Bernard [1989] and Lev [1989] who note that
this statistic has been consistently low in earnings/returns association studies.
13
We also calculated the Spearman correlations between stock returns and each of the earnings
variables (not reported). The results were qualitatively the same as the correlations which can be
imputed from the R2s reported in table 1.

HALAMAN 9
TABLE 2
Regressions of Annual Security Returns and Prior-Period Earnings Divided by
Beginning-of-Period Price
Prior Earnings Model:' Rj, = 0^ + 9,iAj,_i/P;,_i + t%

(t-statistics are provided in parentheses.)

*Significant st 0.02 < a S 0.05.
** Significant at a s 0.01.
1
Description of regression variables: RJt is the return on a share of firm ; over the 12 months
extending from 9 months prior to the fiscal yeai-end to 3 months after the fiscal year-end. Ajt, is
accounting earnings per share of firm j for period t, and Pj,-i is the price per share of firm; at time
t- 1.
2
N is the number of observations in the regression,
3
This is the mean of the yearly coefficients, estimated to test for the effect of cross-sectional
correlations in the error terms.
HALAMAN 10
relevance of the variable. This calculation is reported in the last line of tables 1 and 2. Both
coefficients a^ and i^n are statistically different from zero at the 0.01 level while 6a is statistically
different from zero at the 0.05 level. Thus, the significance of the earnings coefficients is unlikely
to be a result of potential cross-sectional correlations. Although in this paper we are not concerned
with the magnitudes of the coefficients, it is interesting to observe, from the test for the effect of
cross-sectional correlations in the errors, that the coefficient ai, is, on average, not significantly
different from one. This result is consistent with the book value valuation model in equation (4).14

4.2 MULTIVARIATE ANALYSES

The model of returns incorporating both the earnings levels and changes measures, as
summarized by equation (9), is examined empirically via the following cross-sectional regressions:
RUMUS Ru = To. + 7u[4-./-P;'-i] + y2t[AAjJP,t^,] + 4. (14)
In moving to the multivariate regression with both earnings levels and changes as
explanatory variables, we choose to use the current levels variable (v4y,/Pj(_i) because it is the
levels variable which is consistent with the theory. Given the equality expressed in equation (10),
we can obtain the same amount of explanatory power in the multivariate regressions hy including
any two of the three earnings variables. The discussion in section 2.2 and the theoretical model in
Ohlson [19896] justify the inclusion of the two variables we have chosen. On the other hand, we
know of no theoretical model that justifies the inclusion of both. Aji-i/Pjt-i and either Ajt/Pjt-i or
AAjc/Pjt-i. The results based on (14) are reported in table 3.
The regression using the pooled (all years) sample yields an estimated coefficient yu of
0.71 (t-statistic = 28.3). Further, 71, is significant at the 0.05 level or better in all 19 years. The
coefficient 721 is significant in the pooled regression (t-statistic = 7.1) and in 8 of the 19 years
(one of these significant coefficients is negative).^'^ Comparing the R% from the multivariate
regressions and the univariate regressions discussed in the previous subsection (reported in table
1), we naturally obtain a similar picture. In 11 of the years when AAji/Pjt-i is added to the
regression model (11) the change in R^ is insignificant; that is, the addition of
14
Equation (9) suggests the existence of correlated omitted variables in the univariate
repession modets so that we expect these models to be misspecified. However, in the interest of
facilitating interpretation of these univariate regressions, we conducted additional tests of the
properties of the error terms. We could not reject (at the 0.01 level) a null hypothesis that the error
terms were normally distributed in all cases. Also, relevant scatter plots did not reveal any
nonlinearities.
15
All reported results are based on the sample of 19,996 firm-year observations. This sampie
excludes the 192 observations with unusual earnings numbers (see section 3). For the pooled
regression using the sample of 20,188 observations, ya is 0.20 ((-statistic = 16.4) while 72, is 0.04
(f-statistic = 4.3)

HALAMAN 11

TABLE 3
Earnings Levels and Multiple Regressions of Annual Security Returns and
Deflated Changes
Models :^ ft,, = jot + 7i< [-Ajt/Pj,--i] + y2t[^Ajt/Pjt-,] + (%
(t-statistica are provided in parentheses.)
*Significant at 0,01< a < 0.05.
** Significant at a < 0.01.
1
Description of regression variables: R,, is the return on a share of firm ;" over the 12 months
extending from 9 months prior to the fiscal year-end to 3 months after the fiscal year-end, Aj, is
accounting earnings per share of firm j for period t, and P,,-i is the price per share of firm j at
time £ - 1 .
2
N is the number of observations in the regression,
3
This is the mean cf the yearly coefficients, estimated to test for the effect of cross-sectional
correlations in the error terms,

HALAMAN 12

AAyr/Pjt-Irumus .. will yield a ("partial") F-statistic which is not significant at the 0.05 level.16
On the other hand, there is not one year in which the inclusion of Ajt/Pjt-i in the regression model
(12) does not yield a significant (at the 0.05 level) improvement in R^.
 An obvious question which arises is the extent to which the results might he affected by
collinearity among the variables in (14). For each regression we computed the condition indexes
which Belsley, Kuh, and Welsch [1980] (henceforth BKW) advocate as the primary measure for
detecting collinearity. BKW suggest that mild multicollinearity exists if the maximum condition
index is between 5 and 10, and potentially severe multicollinearity exists if the condition index is
over 30 . 17 The highest condition index we obtained was 4, and in most yearly regressions the
maximum condition index was below 2.5.^* Thus, collinearity does not seem to influence our
results,
As an additional specification test we performed several analyses on the residuals from
each multivariate regression. These included checks for normality and consideration of various
scatter plots. A null hypothesis of normality could not be rejected at the 0.01 level in all cases, and
the plots revealed some heteroscedasticity but no other obvious problems. To ensure that the
inferences made are not affected by any inefficiency caused by the heteroscedasticity we calculated
the t-statistics after correcting for the heteroscedasticity in tbe manner described by White [1980].
These f-statistics are not reported as they are qualitatively similar to those reported in table 3, and
it is easier to make comparisons between the univariate and multivariate regressions using the
standard ordinary least squares estimates.
In a manner similar to that described in subsection 4.1, we tested for the effect on inferences
about the coefficients from potential crosssectional correlations in the error terms. The results of
these tests are reported at the bottom of table 3 and indicate that any such crosssectional correlation
does not bias against concluding that each variable's coefficient is statistically significant.
Overall, the evidence suggests that both the current earnings levels variable {Ajt/Pjt-i) and
the earnings changes variable {^jt/Pjt-i) are relevant for explaining returns, and the two variables
are not just substitutes. They are complements in the sense that, for the pooled sample and for
several individual years, significantly more of the cross-sectional variation in returns is explained
by both earnings levels and earnings changes than is explained by either variable considered alone.
16
The R^ reported for the multivariate regressions are adjusted for degrees of freedom. "Partial" F-
statistics may be calculated directly from the t-statistics since the "partial" F-statistic is the square
of the (-statistic on the added variable.
17
Warga [1989) shows that the condition index is a valid diagnostic for financial return data and
that the bounds established by BKW are robust.
18
We also calculated a variance inflation factor (BKW [1980, p. 93]) for each regression. The
critical value for indicating severe collinearity from this statistic is 10. In no case was the factor
above 3 in any of our regressions.

HALAMAN 13
5. Earnings Levels as a Measure of Unexpected Earnings
The preceding analysis considers the association between earnings and returns based on
the valuation models described in section 2. The empirical results reported in section 4 suggest
current earnings as an explanatory variable for returns. Since the focus of much of the literature
on the relation between earnings and returns has been on unexpected earnings (sometimes
measured as AAjt/P,,-i) and unexpected returns, we evaluate whether the current earnings variable,
Ajt/Pjt-u is relevant as an explanatory variable for unexpected returns.
One model of the unexpected earnings/unexpected returns relation is:
Rumus R,> - E[Rjt] = ai + a2i(A,, - Aj,..,)/Pj,^,\ + e,, (15)
where ai and aa are regression coefficients, Rjt is the return on security j for time t, and ejt is the
regression disturbance term.
One interpretation of this model is that Aji-i represents expected earnings {if earnings
follow a random walk) and Ajt - Ajt-i is then scaled by Pjt-i to conform with the left-hand-side
return variable. An alternative interpretation of (15) is that \Ajt/Pjt--i - Ajt-\/Pjt-\\ represents scaled
unexpected earnings with Ajt-i/Pjt-i serving as the measure of expected Ajt/Pjt-i- If, as the evidence
in Beaver and Morse [1978] suggests, earnings/ price ratios are mean-reverting, Ajt^i/Pjt-i may be
a poor measure of expected Aji/Pjt-i. Consider the extreme situation where earnings/ price ratios
revert immediately to a mean and the reversion is driven by the earnings variable. In this
circumstance, a cross-sectional constant, Kt, would be a more precise measure of expected Aj,/Pjt-
i. That is, an alternative to (15) would be: \Rj, - E[Rj,]] = a[ + a!, !A,,/P,,_i - K,] + e/, (16)
where K; is a cross-sectional constant.
In this case, current earnings levels divided by beginning-of-period price will have more
explanatory power for unexpected security returns (equation (16)) than do earnings changes
divided by beginning-of-period price (equation (15)).19 Although this extreme situation may not
be observed as a practical manner, it demonstrates the point that earnings levels divided by
beginning-of-period price may be a useful alternative measure of unexpected earnings.
We do not wish to imply that the relations in equations (15) and (16) are derived from
formal models. Rather they are representations of the presumed association between unexpected
earnings and unexpected returns first hypothesized by Ball and Brown [1968]. Consequently, in
contrast to the previous analysis in which the relevance of the earnings
19
We are grateful to a referee for suggestions that considerably improved the articulation of this argument.
A similar argument is made in Biddle and Seow [1990].

HALAMAN 14
levels variable was based on a valuation model, in the current context, Ajt/Pjt^i is more
appropriately interpreted as an alternative construct for the generic notion of unexpected earnings.
Brown et al. [1987] demonstrate that multiple proxies for unexpected earnings may reduce
the measurement error bias in regression estimates of the coefficients relating unexpected earnings
and unexpected returns. In view ofthe fact that change in earnings has been a dominant measure
of unexpected earnings, we consider both earnings changes (equation (15)) and earnings levels
(equation (16)) as measures of unexpected earnings using the procedure described by Brown et al.
Our measure of unexpected return is the residual from the market model:
Rjt = AV + ^ijRmt + Zj, (17)
where R^^t is the CRSP equally weighted market index for month t and (17) is estimated over the
60 months prior to the month of the accumulation of returns.
Similarly to Brown et al. [1987], we consider the following regressionmodel:
CARj, - *o< + •^itUEy, + ^2tUE2jt + vjt (18)
where CARjt is the cumulative abnormal return (monthly residuals from the monthly
market model (equation (17)) calculated over the 12 months extending from 9 months prior to
through 3 months after the fiscal yearend, UEyi is measure 1 of unexpected earnings = AjtjPjt-y,
and UE^j, is measure 2 of unexpected earnings s Ayl;£/-P/;-i •
These regressions are conducted for the pooled sample and each year t of available data.
Results are reported in table 4. The coefficients (*i,) on the earnings levels variable {AjtfPjt-i) are
significantly different from zero (at the 0.01 level) in 12 ofthe 19 years while the coefficients (*2£)
on the earnings changes variable (AA;(/-P;(-i) are significant in 15 of the 19 years at the same
significance level. In the regression on the pooled sample, "^u has a t-statistic of 14.0 and ^u has a
t-statistic of 23.0. Thus, the level of earnings is associated with raw returns, as anticipated by the
valuation models described in section 2, and with unexpected returns- In the spirit of Brown et al.
[1987], earnings levels might be used to mitigate the effects of error when unexpected earnings
are measured using earnings changes (that is, UEzt)

6. Summary and Conclusions

This study demonstrates an association between the level of current accounting earnings divided
by beginning-of-period price iAjt/Pji^i) and stock returns. These results are consistent with more
detailed theoretical models in Demski and Sappington [1989] and, in particular, in Ohlson

HALAMAN 15
TABLE 4
Multiple Regressions of Market Model Cumulative Abnormal Returns and Deflated
Earnings Levels and Earnings Changes
Model:' CARjt = *« + *u[Ay,/Py,-,] + *a( [AAjJPj^,] + r,j,

(t-statistics are provided in parentheses.)

* Significant at 0.01 < a < 0.05.
** Significant at a sO.Ol.
1
Description of regression variables: CARjt is the cumulative abnormal return on a share of firm j
over the 12 months extending from 9 months prior to the fiscal year-end to 3 months after the fiscal
year-end, A,t is accounting earnings per share of firm j for period t, and P,,-i is the price per share
of firm j at time t — I.
2
N is the number of observations in the regression.
HALAMAN 16
[1989a; 19896], which suggest earnings divided by beginning-of-period price as an explanatory
variable for returns. In multivariate regressions of security returns on both the current earnings
level and the earnings change variables, both coefficients are generally significantly different from
zero. This result suggests that both earnings variables play a role in security valuation. Similar
results are obtained from multiple regressions of abnormal returns on the two earnings variables
included as proxies for unexpected earnings.