Rev Quant Finan Acc (2014) 43:75–96

DOI 10.1007/s11156-013-0365-9

ORIGINAL RESEARCH

The information content of disaggregated accounting

profitability: operating activities versus financing
activities

Steve C. Lim

Published online: 16 March 2013

! Springer Science+Business Media New York 2013

Abstract This paper reports three empirical findings on the differential information
content of the components of accounting profitability. First, the paper finds that the
shareholder profitability driven by operating activities has a stronger association with
annual stock returns than the shareholder profitability driven by financing activities. The
finding provides empirical support for the FASB Financial Statement Presentation project,
and the project suggests disaggregating accounting profitability into operating and
financing activities. Second, the paper finds that the sustainable portion of operating
profitability has a stronger association with annual stock returns than the unsustainable
portion. This finding contributes to the literature by extending the two popular methods of
breaking down operating profitability (DuPont analysis and operating liability leverage)
into sustainable versus unsustainable operating income. Penman (Financial statement
analysis and security valuation. McGraw-Hill, New York, NY, 2010) suggests disaggre-
gating operating income into sustainable versus unsustainable operating income. Finally,
the paper identifies the conditional persistence in Amir et al. (Rev Acc Stud 16:302–327,
2011) as one of the empirical attributes that affects the valuation usefulness of disaggre-
gated accounting profitability. The conditional persistence measures the marginal contri-
bution of disaggregated profitability to the persistence of aggregate profitability. This paper
reports that the disaggregation is more useful in firms with significant differences in the
conditional persistence of disaggregated components than in other firms. Test results are
robust to controls for cross-sectional and time-series dependence in error terms.

Keywords Accounting profitability ! Operating activities ! Financing activities !

Conditional persistence

JEL Classification M41 ! G19

S. C. Lim (&)
Texas Christian University, Fort Worth, TX, USA
e-mail: s.lim@tcu.edu

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76 S. C. Lim

Academic research and financial statement analysis textbooks disaggregate financial

statements into operating activities and financing activities to improve profitability fore-
casts, association with stock prices, and association with stock returns. This paper inves-
tigates two issues related to the information content of disaggregated accounting
profitability in the FASB’s Staff Draft of an Exposure Draft on Financial Statement
Presentation (July, 2010). In the Staff Draft, the FASB proposes requiring firms to dis-
aggregate the statements of comprehensive income and financial position into operating
and financing activities. Implicit in the FASB’s proposal is the assumption that disag-
gregating financial statement items into operating and financing activities is useful in
forecasting future profitability and/or in equity valuation.
The first research question is whether disaggregating profitability into operating and
financing activities has greater information content for equity valuation than aggregated
profitability. Current literature provides mixed evidence on this issue. For example, Esplin
et al. (2010) find little evidence of an incremental benefit to separating profitability into
operating and financing activities for forecasting future profitability. In contrast, Nissim
and Penman (2003) report that the financing effect on future profitability is significantly
less persistent than the operating effect. Results from empirical studies explaining cross-
sectional variation in stock price are also mixed. For example, Callen and Segal (2005) find
that the 1-year-ahead equity price predictions of the Feltham and Ohlson (1995) model are
no more accurate than the aggregate model of Ohlson (1995) and report that they fail to
find evidence of greater information content when profit is disaggregated into operating
and financing activities.1 In contrast, Nissim and Penman (2003) report a higher persistence
of operating profitability using the price-to-book ratio as their dependent variable.
Aboody and Lev (1998) suggest three different procedures for assessing the value
relevance of accounting information: (1) ability to predict future profitability (predictive
analysis), (2) association with stock price levels (valuation analysis), and (3) association
with stock returns (information content analysis). What is missing in the literature is the
information content analysis of operating and financing profitability, and I provide the first
such evidence in this paper.
Test results show that the association between return on operating activities and annual
stock return is stronger than the association between return on financing activities and
annual stock return. This finding helps justify the FASB’s decision in the Staff Draft that
firms classify financial statement items into a business (or operating) section and a
financing section.2 This paper contributes to the literature by extending the value relevance
test of operating activities and financing activities to the information content analysis.

1
The stated motivation for distinguishing between operating and financing activities is that operating
activities create values whereas financing activities are assumed to be zero net present value activities. In
addition, some financial assets and liabilities are reported close to the market value (e.g., SFAS #115) while
operating assets and liabilities are reported on a lower of cost or market rules. When a balance sheet item is
reported at market value, the book value is expected to earn the required rate of return and residual earnings
become zero. Therefore, Feltham and Ohlson (1995) propose an equity valuation model whose value is
driven by future return on net operating assets.
2
The Staff Draft proposes that firms classify assets and liabilities in the statement of financial position into
business and financing sections, and then cohesively maintain those classifications across the statement of
comprehensive income and the statement of cash flows. The Staff Draft further separates the business
section into operating activities and investing activities. This paper calls the business section in the Staff
Draft as operating activities following prior literature. For example, this paper classifies investments in
property, plant, and equipment as operating activities, and investments in other firms’ fixed income secu-
rities as financing activities.

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Operating activities versus financing activities 77

In addition, the paper finds that conditional persistence serves as an empirical attribute
that makes disaggregation more or less useful than the aggregate reporting. Amir et al.
(2011) define unconditional persistence as the autocorrelation coefficient obtained from a
variable’s time-series and conditional persistence as the marginal contribution of a
disaggregated component’s persistence to the persistence of an aggregate profitability.
They motivate their investigation into conditional persistence from empirical findings in
prior studies. For example, Swaminathan and Weintrop (1991), Ertimur et al. (2003),
Ghosh et al. (2005), Jegadeesh and Livnat (2006) report that returns’ association with
earnings is higher than their association with revenues even though revenues have higher
unconditional persistence than earnings.
To test whether conditional persistence serves as an empirical attribute that makes the
disaggregation more useful in the returns association, I apply the differential market
association test to two different groups of firms. The first group consists of firms with
significant differences in conditional persistence between operating profitability and
financing profitability. The second group consists of all other firms with no significant
difference in conditional persistence between operating profitability and financing profit-
ability. Test results suggest that disaggregating accounting profitability is more useful in
the first group than in the second group.
The second research question asks whether disaggregating the operating profitability into
sustainable operating income and unsustainable operating income is useful in equity valua-
tion. Two methods are commonly used to break down operating profitability. The first, the
DuPont analysis, decomposes the operating profitability into two multiplicative components,
operating profit margin and net operating asset turnover ratio.3 The second method breaks
down operating profitability into two additive components based on the operating liability
leverage equation, return on operating assets, and return from operating liability leverage.4
Penman and Zhang (2006) claim that investors care about the sustainable component of
earnings because equity values are based on expected future residual operating income rather
than current earnings. Therefore, I adopt a third approach and decompose the operating
profitability into two additive components and find that annual stock returns are more highly
associated with sustainable operating income than unsustainable operating income. This
finding suggests that the market differentiates the sustainable portion of operating profit-
ability from the unsustainable portion of operating profitability.5 When sample firms are
further classified into two groups based on conditional persistence, test results indicate that
the disaggregation is more useful in the group of firms with significant differences in the
conditional persistence of sustainable operating income and unsustainable operating income
than in the group of firms with no significant difference in the conditional persistence.

3
Using cross-sectional analysis with annual data, Soliman (2008) reports that the change in asset turnover ratio
is more important than the change in operating profit margin in explaining the market reaction to accounting
information. He infers that copying the efficiency of other firms’ business models is harder than competing
away the operating profitability of those firms. In contrast, Amir et al. (2011) report the opposite findings and
claim that their results are intuitive because the operating profit margin has higher conditional persistence than
the asset turnover ratio. They use the firm specific time-series analysis with the quarterly data.
4
Nissim and Penman (2003) derive two leveraging equations that are relevant for analyzing profitability
and valuing firms. Financial leverage arises from financing activities such as raising funds in the capital
market for their business operations. Operating liability leverage arises from operating activities such as
trading with business suppliers, customers, and employees in the product and labor markets.
5
Although there is no consensus on how best to measure sustainable operating income, one common
approach is to start with GAAP-based operating income and then eliminate unsustainable operating income
items. This paper separates sustainable from unsustainable operating income using income statement items
suggested in Penman (2010). See ‘‘Appendix’’ for details.

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78 S. C. Lim

Overall, findings suggest that the capital market is differentiating operating profitability
from financing profitability and sustainable operating income from unsustainable operating
income. Consistent with the intuition in Amir et al. (2011), the paper also finds that the
disaggregated accounting profitability is more useful in equity valuation when there is a
significant difference in conditional persistence among profitability components.
The usefulness of disaggregated information is one of the central issues in accounting
standard setting. Accountants have gained substantial intuition about when disaggregation is
useful through extensive dealings with numerous aggregation/disaggregation issues. These
include reporting components of earnings, assets and liabilities, cash flows, consolidation,
and segment reporting.6 FASB Concepts Statement No. 5, Recognition and Measurement in
Financial Statements of Business Enterprise (1984), reflects this intuition. It states that
‘‘classification in financial statements facilitates analysis by grouping items with essentially
similar characteristics and separating items with essentially different characteristics.’’ As
examples of relevant characteristics, Statement No. 5 cites continuity or recurrence, stability,
risk, and reliability. This study applies such intuition to the information content analysis of
operating and financing profitability and finds evidence consistent with the differential value
relevance of the components of accounting profitability.
The paper proceeds as follows. Section 1 outlines the reformulated financial statements
and presents the five explanatory variables used in the analysis. Section 2 describes the
sample and variable measurement. Section 3 discusses the methodology and test results.
Section 4 concludes.

1 Components of shareholder profitability and operating profitability

The following balance sheet and income statement separate out operating activities and
financing activities:
.
Balance sheet
OA (operating assets) OL (operating liabilities)
FA (financial assets) FO (financial obligations)
CSE (common shareholders equity)
OA ? FA OL ? FO ? CSE
OA ? FA = OL ? FO ? CSE and NOA = NFO ? CSE
Income statement
Operating income after tax (OI)
Net financial expense after tax (NFE)
Comprehensive income (CNI)

6
Among many returns studies on disaggregation, see Lipe (1986), Barth et al. (1990), Ohlson and Penman
(1992), and Ali (1994) for components of earnings, and Ajinkya (1980), Tse (1989), and Bodnar and
Weintrop (1997) for segment reporting. Regarding other effects of disaggregation on the stock market, Amit
and Livnat (1988), Collins and Simonds (1979), and Simonds and Collins (1978) examine market risks,
Swaminathan (1991) examines the variability of stock prices at the time of disclosure, and Greenstein and
Sami (1994) examine bid-ask spreads. Also, see Pacter (1993) for an extensive research report on segment
reporting.

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Operating activities versus financing activities 79

Operating assets (OA) and operating liabilities (OL) are those involved in producing
goods and services for customers. Examples of operating assets are accounts receivable,
inventories, and property, plant, and equipment. Operating liabilities arise from trading
with customers or suppliers in the course of business operations. Examples of operating
liabilities include accounts payable, advances from customers, and projected benefits
obligation for defined benefits pension plans. Net operating asset (NOA) is defined as the
difference between operating assets and operating liabilities.
Financial assets and financial liabilities are those involved with distributing excess
funds from operations to stakeholders and raising funds for operations. Examples of
financial obligations include current maturities of long-term debt, long-term borrowings,
capitalized lease obligations, and preferred stock. Examples of financial assets include cash
and cash equivalents, short-term investments, and long-term investments in fixed income
securities.7 Net financing obligations (NFO) is defined as the difference between financial
obligations (FO) and financing assets (FA).
Textbooks on financial statement analysis often propose an additive decomposition of
return on common equity (ROCE) into return on net operating assets (RNOA) and return on
financial leverage (RFLEV). The return on net operating assets reflects the profitability of
operating activities, whereas the return from financial leverage reflects the profitability of
financing activities. RNOA is net operating profit after tax (NOPAT) divided by net
operating assets (RNOA = NOPAT/NOA). The return from financial leverage is the dif-
ference between ROCE and RNOA.8
For example, Penman (2010) decomposes ROCE into two factors. The financial
leverage equation is ROCE = RNOA ? [FLEV 9 (RNOA - NBR)]. RFLEV, the second
component of ROCE in the expression above, is the product of financial leverage (FLEV)
and the financial leverage spread (Fspread) between RNOA and NBR. If RNOA is greater
than NBR, the financial leverage would work favorably and increase ROCE. Otherwise, it
would work unfavorably and decrease ROCE. This paper uses RNOA and RFLEV as two
explanatory variables for the first research question, which examines whether the market
differentiates the profitability of operating activities from the profitability of financing
activities. Warren Buffet states in the 2008 annual report of Berkshire Hathaway Inc. that
he uses ‘‘businesses earning good returns on equity while employing little or no debt’’
(p. 26) as one of his six acquisition criteria. If Buffet’s strategy is representative of the
market, then the market should assign more weight to profits derived from business
activities than it does to profits derived from financing activities.

7
Theoretically, the operating portion of cash and cash equivalents should be separated from the excess cash
holdings because companies hold cash and cash equivalents not only for financing activities but also for
operating activities. From an implementation perspective, however, identifying the excess cash holdings is
difficult. Therefore, I follow Nissim and Penman (2001) and classify all cash and cash equivalents into
financing assets assuming zero operating cash holdings.
8
RFLEV is computed from either NBR (net borrowing rate) or RNFA (return on net financial assets)
depending upon the size of financial obligations relative to financial assets. If the financial obligations
exceed the financial assets, I use NBR in computing RFLEV, where NBR is defined as net financial expense
after tax divided by net financial obligations (NBR = NFE/NFO). If the financial assets exceed the financial
obligations, I use RNFA in computing RFLEV, where RNFA is defined as net financial income after tax
divided by net financial assets (RNFA = Net Financial Income/NFA).

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80 S. C. Lim

2 Sample and variable measurement

The sample covers all firm-year observations on the annual Xpressfeed COMPUSTAT and
monthly CRSP files from 1963 to 2009 (47 years) that satisfy the following requirements
outlined in Nissim and Penman (2003): (1) the company is listed on the NYSE, AMEX, or
NASDAQ-NMS; (2) the company is not a member of the financial industry (SIC codes
6000–6999); (3) the book value of common equity is at least $10 million; and (4) the
annual averages of the beginning and ending balances of operating assets and net operating
assets are positive. I delete the upper and lower one percent of each cross-sectional
(annual) distribution of regression variables to minimize the impact of outliers.9 These
criteria result in a sample of 62,926 (61,771) firm-year level (change) observations.
The appendix describes how variables are measured and how ratios are computed for
the shareholder profitability and operating profitability analyses. I follow the sample
selection criteria and variables measurement in Nissim and Penman (2003) with the
additional requirement that monthly stock returns data be available from CRSP for the
information content analysis. Stock returns are measured using buy and hold market
adjusted returns (raw return minus the corresponding value-weighted return) over the
12 months (-8, …, ?3) with the event month 0 being the end of the fiscal year. All
income numbers are on an after-tax basis, and I use comprehensive net income to avoid
excluding any value changes from the analysis following Penman (2010).10

3 Methodology and test results

3.1 Descriptive statistics

Table 1 reports the distributions of shareholder profitability, operating profitability, and the
components of each. Table 2 reports the time-series means of the Pearson and Spearman
cross-sectional correlations among the regression variables. In both tables, Panel A pro-
vides statistics for the levels of profitability whereas Panel B presents statistics for the
changes in profitability.
Panel A of Table 1 shows that the market value of equity (i.e., firm size) is highly
skewed with a median of $280 million and a mean of $2,996 million. The medians of
shareholder profitability (11.9 %) and operating profitability (9.8 %) compare closely to
those in Nissim and Penman (2003). The majority of operating profitability is derived from
the sustainable portion as the mean (median) of RSOI is 12.5 % (12.5 %) while the mean
(median) of RUOI is -2.4 % (-3.1 %). The mean (median) annual return is 2.8 %
(-1.4 %). Soliman (2008) reports mean (median) returns of 6.6 % (-0.3 %) for the time
period of 1984–2002. The lower annual return reported in Table 1 is likely due to the
inclusion of data from recent economic recessions.

9
I obtain qualitatively similar results when I replace upper and lower 1 % deletion with upper and lower
1 % winsorization.
10
First, tax on net financial expense is computed as the product of net interest expense (interest expense—
interest income) and the marginal tax rate. Next, I compute the taxes on operating income as the sum of
reported tax expense and the tax on net financial expense. Sustainable operating income after tax is
computed as the difference between sustainable operating income before tax and taxes on operating income.
Unsustainable operating income after tax is the difference between operating income and sustainable
operating income after tax.

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Operating activities versus financing activities 81

Table 1 Descriptive statistics

ROCE RNOA RFLEV RSOI RUOI MVE

Panel A: Components of
shareholder and operating
profitabilities (level variables)
Mean 0.102 0.012 0 0.125 -0.024 2,996
STD 0.162 0.138 0.104 0.144 0.114 13,767
5% -0.148 -0.067 -0.129 -0.058 -0.176 12
10 % -0.039 0 -0.068 0.002 -0.126 20
25 % 0.056 0.058 -0.016 0.071 -0.07 58
50 % 0.119 0.098 0.006 0.125 -0.031 280
75 % 0.173 0.151 0.032 0.184 0.016 1,289
90 % 0.237 0.222 0.063 0.258 0.089 4,937
95 % 0.291 0.284 0.094 0.321 0.158 11,465

DROCE DRNOA DRFLEV DRSOI DRUOI RET

Panel B: Components of
shareholder and operating
profitabilities (change variables)
Mean -0.01 -0.007 -0.003 -0.003 -0.004 0.028
STD 0.174 0.118 0.115 0.095 0.097 0.358
5% -0.24 -0.173 -0.119 -0.127 -0.138 -0.473
10 % -0.144 -0.104 -0.064 -0.078 -0.076 -0.367
25 % -0.051 -0.037 -0.019 -0.029 -0.022 -0.195
50 % -0.002 -0.001 0 0 0 -0.014
75 % 0.032 0.025 0.014 0.024 0.019 0.196
90 % 0.106 0.081 0.05 0.064 0.067 0.462
95 % 0.194 0.143 0.101 0.109 0.118 0.667

Panel A is based on 62,926 non-financial firm-year observations from Xpressfeed annual COMPUSTAT and
monthly CRSP files. Panel B is based on 61,771 firm-year observations. The sample observations are listed
on the NYSE, AMEX, or NASDAQ-NMS and the book value of equity of each firm is at least $10 million.
The sample must have positive annual averages of operating assets and net operating assets. I delete the
upper and lower one percent of annual regression variables to minimize the impact of outliers. For prof-
itability measures, see Appendix for details
In Panel A, ROCE is return on common equity as defined in Eq. (16). RNOA is return on net operating
assets as defined in Eq. (17). RFLEV is the return from financing activities and is defined in Eq. (18). RSOI
is the return from the sustainable portion of operating income as defined in Eq. (19). RUSOI is the return
from the unsustainable portion of operating profitability in Eq. (20). MVE is the market value of equity at
the end of the fiscal year
In Panel B, all variables are the same as Panel A variables except they are now change variables denoted by
D in front of the variable name. RET is the market adjusted 12 months buy and hold stock returns

Table 2 shows that the majority of correlations among components of shareholder

profitability and operating profitability are positive. The correlations are negative for
sustainable operating income and unsustainable operating income as well as for operating
profitability and financing profitability. These negative correlations may be the results of
baking out one component profitability from the aggregate profitability to get the other
component profitability. However, the results indicate a positive correlation between
changes in operating profitability and changes in financing profitability.

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82 S. C. Lim

Table 2 Correlations among components of shareholder and operating profitability

ROCE RNOA RFLEV RSOI RUOI

Panel A: Components of
shareholder and operating
profitabilities (level variables)
ROCE 0.795 0.491 0.512 0.267
RNOA 0.897 -0.115 0.657 0.319
RFLEV 0.471 0.145 -0.1 -0.01
RSOI 0.545 0.588 0.087 -0.491
RUOI 0.217 0.247 0.043 -0.516

DROCE DRNOA DRFLEV DRSOI DRUOI

Panel B: Components of
shareholder and operating
profitabilities (change variables)
DROCE 0.784 0.71 0.433 0.484
DRNOA 0.895 0.132 0.625 0.545
DRFLEV 0.579 0.274 -0.006 0.161
DRSOI 0.483 0.567 0.073 -0.292
DRUOI 0.439 0.444 0.223 -0.305

Pearson (Spearman) correlations are above (below) the main diagonal

Correlations are calculated for each year, 1964–2009, for non-financial NYSE, ASE, NASDAQ-NMS firms
with the common shareholders’ equity at year-end of at least $10 million. The table reports the time-series
means of the 46 annual cross-sectional correlations. The Panel A (B) is based on 62,926 (61,771) firm-year
observations. See notes to Table 1 for explanations of variables

3.2 The associations between profitability and returns

The first research question investigates whether the association between operating profit-
ability and annual stock returns differs from the association between financing profitability
and annual stock returns. To address the first research question, I estimate the following
regression Eq. (1) in two steps. Following Amir et al. (2011), I include unexpected
earnings and unexpected revenue as control variables
Rit ¼ a0 þ a1 ROCEit þ a2 RNOAit þ a3 RFLEV þ a4 UEit þ a5 URit þ eit ; ð1Þ
where UE is the annual change in earnings and UR is the annual change in sales revenue. Both
UE and UR are scaled by the market value of equity at the beginning of the fiscal year.
Specifically, in the first step, I run 46 annual cross-sectional regressions of annual
returns on shareholder profitability, unexpected earnings, and unexpected revenue and
report mean coefficients. These regressions serve as the baseline for the first research
question. In the next step, I run the same regression, replacing the shareholder profitability
with operating profitability and financing profitability. The difference in the mean slope
coefficient on RNOA and RFLEV will indicate whether investors understand the previously
documented differential persistence of the components (Nissim and Penman 2003).
Panel A of Table 3 presents summary statistics from 46 cross-sectional annual regressions
for the years 1964–2009. I drop the first year, 1963 from the analysis due to the need for lagged
variables. The reported statistics are the time series means of cross-sectional regression

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Operating activities versus financing activities 83

coefficients and the proportion of positive coefficients. FM-t is Fama–MacBeth t-statistics

estimated from the time-series of cross-sectional regression coefficients and FM–NW-t is
FM-t adjusted for time-series dependence with the Newey–West procedure.11 Panel A of
Table 3 shows that the annual stock return has a stronger association with operating profit-
ability than with financing profitability, as the coefficient on RNOA (0.509 with FM-t value of
9.41) is significantly larger than the coefficient on RFLEV (0.356 with FM-t value of 6.97). F-
test for the equality of RNOA and RFLEV was 9.57, with a p value of 0.002. The FM–NW-t
suggests the presence of temporal dependence in residuals because it is consistently lower
than the FM-t value. For example, FM-t on RNOA is 9.41 whereas FM_NW-t on RNOA is
7.81.
Gow et al. (2010) show that FM–NW-t fails to correct for the cross-sectional and time-
series dependence in the error terms simultaneously. The authors show that inferences in
common accounting research settings are altered substantially when both forms of
dependence are corrected with two-way cluster-robust standard errors (CL2). Therefore, I
have applied the CL2 in estimations and report the results in Table 3.12 Panel B of Table 3
shows that CL2-t based on two-way cluster-robust standard errors does not affect the
inference made from the FM–NW-t statistic in Panel A of Table 3. Panel B of Table 3
presents the OLS regression coefficients from pooled cross-sectional and time-series
regression on 62,926 firm-year observations during the time period of 1964–2009. HC-t is
heteroscedasticity-consistent t-statistics in White (1980) and CL2-t is t-statistics based on
two-way cluster-robust standard errors in Gow et al. (2010) to correct for both cross-
sectional and time-series dependence in error terms. CL2-t values are consistently smaller
than HC-t values for all regression coefficients. For example, the CL2-t on RNOA is 11.35
whereas HC-t on RNOA is 40.63. Again, the magnitude of CL2-t relative to HC-t suggests
the presence of cross-sectional and time-series dependence in this type of panel data sets.13
Panel C of Table 3 investigates when the disaggregated accounting profitability would
be more useful in equity valuation. The sample size is reduced drastically from 6,082 firms
in Panel A of Table 3 to 1,413 firms in Panel C of Table 3 because I follow Amir et al.
(2011) and estimate the firm/year unconditional persistence using a fixed window size of
the preceding 8 years in a rolling forward manner. In addition, I require each firm to have
at least 8 years’ unconditional persistence data available for estimating the firm level
conditional persistence. The firm level conditional persistence is estimated from regressing
the unconditional persistence of ROCE on the unconditional persistence of RNOA and the
unconditional persistence of RFLEV. I split the sample into two portfolios: Diff and
NoDiff. The Diff portfolio consists of 1,253 firms (88.7 %) whose conditional persistence
of RNOA is statistically different from the conditional persistence of RFLEV at the 5
percent level. The NoDiff portfolio consists of all other 160 firms (11.3 %).
Panel C of Table 3 shows that the difference in regression coefficients on RNOA and
RFLEV is larger in the Diff portfolio firms than in the NoDiff portfolio firms. F-statistics
for testing the equality of two regression coefficients were 26.93 (a p value of less than
11
FM-t is designed to address cross-sectional residual dependence and involves estimating one cross-
!
sectional regression each year. It is computed as b seðbÞ; where b is the time-series mean of regression
coefficients and se(b) is the standard error of the coefficients. FM-NW-t is to correct for serial dependence in
addition to cross-sectional dependence and it is used by Richardson, Sloan, Soliman, and Tuna (2006) and
Bushman and Piotroski (2006).
12
Thompson (2011) and Petersen (2009) provide simple formulas for computing CL2 standard errors.
13
One critical weakness of this paper is that the increase in explanatory power from the disaggregated
earnings is quite limited. For example, Panel A and Panel B of Table 3 show that the increase in disag-
gregated model’s explanatory power is only 2.5 % and 1.87 %, respectively.

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84 S. C. Lim

Table 3 Information content analysis of shareholder profitability (research question #1)

Rit ¼ a0 þ a1 ROCEit þ a2 RNOAit þ a3 RFLEV þ a4 UEit þ a5 URit þ eit
a0 a1 a2 a3 a4 a5 Mean
R2

Panel A: Fama–MacBeth cross-

sectional regression average
Mean -0.034 0.458 0.626 0.058 11.14 %
Prop? 39.1 % 93.4 % 97.8 % 89.1 %
FM-t -2.31 9.44 7.01 6.49
FM–NW-t -1.8 7.49 4.73 4.77
Mean -0.039 0.509 0.356 0.625 0.058 11.42 %
Prop? 39.1 % 95.6 % 91.3 % 97.8 % 89.1 %
FM-t -2.54 9.41 6.97 7.01 6.45
FM–NW-t -1.96 7.81 5.41 4.75 4.8
Panel B: Pooled regression with
two-way cluster-robust standard
errors
Coefficients -0.024 0.491 0.035 -0.001 5.34 %
HC-t -14.33 40.24 2.89 -2.3
CL2-t -1.49 11.31 0.94 -0.94
Coefficients -0.028 0.534 0.409 0.035 -0.001 5.44 %
HC-t -16.08 40.63 23.25 2.85 -2.29
CL2-t -1.65 11.35 8.31 0.94 -0.94
Panel C: Cross-sectional variation
by conditional persistence
Diff subsample (N = 1,253 firms)
Coefficients -0.013 0.26 0.094 0.451 0.059 6.85 %
CL2-t -0.66 4.66 1.39 6.65 5.87
NoDiff subsample (N = 160
firms)
Coefficients -0.019 0.346 0.285 0.296 0.062 6.63 %
CL2-t -0.98 4.41 3.13 2.7 2.66
Panel A of Table 3 summarizes the 46 years’ Fama–MacBeth cross-sectional regressions for the years 1964-
2009. The average number of firms in the cross-sectional regressions is 1,368. Mean coefficients are
estimated from the 46 regression estimates. Prop? is the proportion of positive coefficients. FM-t is Fama–
MacBeth t-statistic and it is defined as the ratio between the mean cross-sectional coefficients and their
standard error estimated from the time series of regression coefficients. FM–NW-t is FM-t adjusted for time-
series dependence with the Newey–West procedure. HC-t is heteroscedasticity-consistent t-statistics and
CL2-t is t-statistics correcting the cross-sectional and time-series dependence in error terms using two-way
cluster-robust standard errors
Rit is the compounded buy-hold market adjusted return (raw returns minus the corresponding value weighted
return), inclusive of dividends and other distributions computed over the 12 months (-8, …, ?3) where the
event month 0 is the fiscal year-end. ROCE is the return on common equity. RNOA is the return on net
operating assets. RFLEV is the return on financial leverage and represents financing profitability. UE is the
unexpected earnings. UR is the unexpected revenue. Both of them are normalized by the market value of
equity at the beginning of the period. See Appendix for details on variables measurement. The Diff (NoDiff)
subsample in Panel C of Table 3 is composed of firms whose RNOA conditional persistence is (not)
significantly different from RFLEV conditional persistence at the 5 % level

123
Operating activities versus financing activities 85

0.01) and 0.42 (a p value of 0.52) for the Diff portfolio and the NoDiff portfolio,
respectively. Therefore, I conclude that the relative conditional persistence of RNOA and
RFLEV is one empirical attribute that affects the valuation usefulness of disaggregated
shareholder profitability or ROCE.
Table 4 reports the effect of ROCE decomposition on market-to-book ratio (MB)
controlling for the effect of macro variables such as economic recession periods and
inflation rates. Table 4 uses the following model:
MBit ¼ b0 þ b1 ROCEit þ b2 RNOAit þ b3 RFLEV þ b4 UEit þ b5 URit þ b6 D recit
þ b7 YTMit þ eit ; ð2Þ

where MB is the ratio between the market value of equity and book value of equity. The
market value of equity is computed as the product of the number of common shares
outstanding (COMPUSTAT data item CSHO) and the closing stock price at the end of the
fiscal year (COMPUSTAT data item PRCC_F). The book value of equity is measured by
COMPUSTAT data item CEQ. D_rec is an indicator variable which equals 1 in the
recession period using the business cycle dates provided by NBER and 0 otherwise. YTM is
the Treasury’s 10-year constant-maturity-yield to maturity. The data source for YTM is the
Federal Reserve Board.
Panel A of Table 4 shows that operating profitability has a stronger association with MB
than financing profitability because the coefficient on RNOA (6.526 with FM–NW-t value
of 5.23) is significantly larger than the coefficient on RFLEV (3.297 with FM–NW-t value
of 3.70). Panel B and Panel C of Table 4 present results consistent with Panel A of Table 4
in terms of the information content of disaggregated accounting profitability. Therefore,
Table 4 supports the notion that disaggregating accounting profitability into operating and
financing activities improves its association with the equity valuation (i.e., valuation
analysis).14

3.3 Sustainable versus unsustainable profitability

The second research question examines whether the return association of the sustainable
(RSOI) and unsustainable (RUOI) components of operating profitability (RNOA) is equal. I
measure sustainable operating income as the difference between sales revenue and the sum
of cost of goods sold, selling, general, and administrative expenses, advertising expense,
and R&D expense. The difference between operating income and the sustainable operating
income is used as the unsustainable operating income. I use the following regression to
investigate the second research question:
Rit ¼ c0 þ c1 RNOAit þ c2 RSOIit þ c3 RUOI þ c4 RFLEV þ c5 UEit þ c6 URit þ git : ð3Þ
I estimate the regression (3) in two steps. In the first step, I use the operating profit-
ability (RNOA), the return from financing activities (RFLEV), and two control variables
(UE and UR) as the explanatory variables. This specification serves as the baseline
regression for the information content of disaggregated operating profitability. In the

14
Inferences were insensitive to replacing MB with price-to-earnings (P/E) ratio for the dependent variable
and D_rec with annual real GDP growth rate from the Bureau of Economic Analysis for the independent
variable. I thank the reviewer for suggesting this model. Cheng and McNarmara (2000) show that the P/E
benchmark valuation method performs better than the MB benchmark valuation method. Du et al. (2011)
use the market return instead of economic variables such as YTM as the proxy for macro variables or
market-wide information.

123
 86
Table 4 Valuation analysis of shareholder profitability (research question #1)
123

MBit ¼ b0 þ b1 ROCEit þ b2 RNOAit þ b3 RFLEV þ b4 UEit þ b5 URit þ b6 D recit þ b7 YTMit þ eit

b0 b1 b2 b3 b4 b5 b6 b7 Mean R2

Panel A: Fama–MacBeth cross-sectional regression average

Mean 1.465 5.663 -2.079 -0.187 -0.147 0.013 19.72 %
Prop? 82.6 % 100.0 % 2.2 % 17.4 % 84.7 % 67.4 %
FM-t 3.72 8.19 -5.71 -5.13 -0.52 0.18
FM–NW-t 3.55 4.61 -3.56 -3.96 -0.44 0.17
Mean 1.298 6.526 3.297 -1.951 -0.185 -0.144 0.036 22.28 %
Prop? 78.3 % 100.0 % 93.5 % 2.2 % 17.4 % 84.8 % 65.2 %
FM-t 3.08 9.35 6.27 -5.92 -5.34 -0.51 0.45
FM–NW-t 3.01 5.23 3.70 -3.70 -4.21 -0.43 0.44
Panel B: pooled regression with two-way cluster-robust standard errors
Coefficients 2.860 2.759 -0.683 0.307 -0.401 -0.158 13.03 %
HC-t 137.32 31.17 -2.37 0.37 -24.40 -69.58
CL2-t 18.05 10.59 -0.86 0.15 -2.05 -7.86
Coefficients 2.829 3.346 1.581 -0.692 0.296 -0.394 -0.162 13.90 %
HC-t 134.11 30.78 9.76 -2.57 0.27 -24.01 -71.11
CL2-t 17.39 9.05 3.86 -0.91 0.10 -2.01 -8.16
Panel C: Cross-sectional variation by conditional persistence
Diff subsample (N = 1,248 firms)
Coefficients 2.697 5.921 1.974 -1.570 -0.258 -0.260 -0.170 24.56 %
CL2-t 23.32 11.13 3.21 -6.00 -4.92 -1.87 -10.81

S. C. Lim
 Operating activities versus financing activities
Table 4 continued

b0 b1 b2 b3 b4 b5 b6 b7 Mean R2

NoDiff subsample (N = 156 firms)

Coefficients 2.744 6.473 2.484 -2.206 -0.301 -0.202 -0.183 25.24 %
CL2-t 15.83 8.24 1.20 -3.52 -3.29 -1.60 -9.50

Panel A of Table 4 summarizes 46 Fama–MacBeth cross-sectional regressions for the years 1964–2009. The average number of firms in the cross-sectional regressions is
1,368. The dependent variable (MB) is the market-to-book ratio at the end of the fiscal year. The market value of equity is computed as the product of the number of common
shares outstanding (COMPUSTAT data item CSHO) and the closing stock price at the end of the fiscal year (COMPUSTAT data item PRCC_F). COMPUSTAT data item
CEQ is used for the book value of equity. Mean coefficients are estimated from the 46 regression estimates. Prop? is the proportion of positive coefficients. FM-t is Fama–
MacBeth t-statistic and it is defined as the ratio between the mean cross-sectional coefficients and their standard error estimated from the time series of regression coefficients.
FM–NW-t is FM-t adjusted for time-series dependence with the Newey–West procedure. HC-t is heteroscedasticity-consistent t-statistics and CL2-t is t-statistics correcting
the cross-sectional and time-series dependence in error terms using two-way cluster-robust standard errors
ROCE is the return on common equity. RNOA is the return on net operating assets. RFLEV is the return on financial leverage and represents financing profitability. UE is the
unexpected earnings. UR is the unexpected revenue. Both of them are normalized by the market value of equity at the beginning of the period. D_rec is an indicator variable
taking 1 in the recession period using the business cycle dates from NBER and 0 otherwise. YTM is the Treasury’s 10-year constant-maturity-yield to maturity. See Appendix
for details on variables measurement. The Diff (NoDiff) subsample in Panel C of Table 4 is composed of firms whose RNOA conditional persistence is (not) significantly
different from RFLEV conditional persistence at the 5 % level
123

87
88 S. C. Lim

second step, I replace operating profitability with its two components. They are the return
from sustainable operating income (RSOI) and the return from unsustainable operating
income (RUOI).
Panel A of Table 5 shows that sustainable operating income has a stronger association
with returns than does the unsustainable operating income because the coefficient on RSOI
(0.547 with FM-t value of 9.89) is significantly larger than the coefficient on RUOI (0.443
with FM-t value of 6.36). F-test for the equality of RSOI and RUOI was 6.00 with a p value
of 0.014. The first 4 lines in Panel A of Table 5 are reproduced from the last 4 lines in
Panel A of Table 3 to serve as the baseline cross-sectional regression.
Panel B of Table 5 shows that CL2 adjustment does not affect the inference made from
test results in Panel A of Table 5 because t-values from the two-way cluster-robust stan-
dard errors are still significant at 11.86 for RNOA and 6.93 for RFLEV. The first 3 lines in
Panel B of Table 5 are reproduced from the last 3 lines in Panel B of Table 3 to serve as
the baseline pooled regression.
I require each sample firm to have 8 years’ prior data to estimate its unconditional
persistence in a forwardly rolling manner in Panel C of Table 5. Likewise, I require each
sample firm to have at least 8 years’ unconditional persistence to estimate its conditional
persistence. Therefore, the sample size in Panel C of Table 5 is reduced from 6,082 firms
to 1,413 firms in Panel A and Panel B of Table 5. The Diff portfolio has 1,149 member
firms (81.32 %) and the NoDiff portfolio has 264 member firms (18.68 %). The difference
of 0.115 (=0.337–0.222) in regression coefficients on RSOI and RUOI for the Diff port-
folio is similar to the difference in the NoDiff portfolio, 0.099 (=0.264–0.165). However,
F-statistics testing the equality of two regression coefficients is much larger in the Diff
portfolio (26.84 with a p value \0.01) than in the NoDiff portfolio (5.23 with a p value of
0.022).
Table 6 reports the effect of disaggregating operating profitability (RNOA) on the
market-to-book (MB) ratio controlling for the effect of macro variables. Table 6 uses the
following regression model:
MBit ¼ d0 þ d1 RNOAit þ d2 RSOIit þ d3 RUOI þ d4 RFLEV þ d5 UEit þ d6 URit
þ d7 D recit þ d8 YTMit þ git : ð4Þ
Table 6 shows that disaggregating the operating profitability into sustainable (RSOI)
and unsustainable (RUOI) operating income doesn’t improve its association with the equity
valuation because none of the three F-statistics was significant for testing the difference
between RSOI and RUOI. Future studies may investigate why the disaggregation of
operating profitability is effective in the information content analysis and not in the equity
valuation analysis.
When I repeat all regressions in Tables 3 and 5 and replace the level components of
profitability with the change components of profitability, I see no changes in the inference
for the differential information contents of profitability components. Test results are not
tabulated. For example, the sample size of 1,413 firms in Panel C of Table 5 with level
variables is reduced to 1,377 firms with change variables. The difference of 0.553
(=0.739–0.186) in regression coefficients on RSOI and RUOI for the Diff portfolio is
similar to the difference in the NoDiff portfolio, 0.585 (=0.758–0.173). However, F-sta-
tistic is much larger in the Diff portfolio (235.38 with a p value \0.01) than in the NoDiff
portfolio (74.23 with a p value of \0.01).
Table 7 presents four selected financial characteristics of firms belonging to the Diff
subsample versus the NoDiff subsample. Subsamples in Panel A (B) of Table 7 are based

123
Operating activities versus financing activities 89

Table 5 Information content analysis of operating profitability (research question #2)

Rit ¼ b0 þ b1 RNOAit þ b2 RSOIit þ b3 RUOI þ b4 RFLEV þ b5 UEit þ b6 URit þ git
c0 c1 c2 c3 c4 c5 c6 Mean
R2

Panel A: Fama–MacBeth
cross-sectional regression
average
Mean -0.039 0.509 0.356 0.625 0.058 11.42 %
Prop? 39.1 % 95.6 % 91.3 % 97.8 % 89.1 %
FM-t -2.54 9.41 6.97 7.01 6.45
FM–NW-t -1.96 7.81 5.41 4.75 4.8
Mean -0.044 0.547 0.443 0.351 0.631 0.06 % 11.93 %
Prop? 32.6 % 95.6 % 86.9 % 89.1 % 97.8 % 86.9 %
FM-t -2.91 9.89 6.36 6.67 7.09 6.62
FM–NW-t -2.25 8.02 5.93 5.24 4.81 4.91
Panel B: Pooled regression
with two-way cluster-
robust standard errors
Coefficients -0.028 0.534 0.409 0.035 -0.001 5.44 %
HC-t -16.08 40.63 23.25 2.85 -2.29
CL2-t -1.65 11.35 8.31 0.94 -0.94
Coefficients -0.035 0.572 0.446 0.423 0.036 -0.001 5.57 %
HC-t -17.92 40.68 27.17 23.7 2.8 -2.31
CL2-t -2.18 11.86 6.93 8.27 0.94 -0.95
Panel C: Cross-sectional
variation by conditional
persistence
Diff subsample (N = 1,149 firms)
Coefficients -0.023 0.337 0.222 0.147 0.412 0.056 6.43 %
CL2-t -1.34 5.71 3.18 2.35 6.51 4.79
NoDiff subsample (N = 264 firms)
Coefficients -0.015 0.264 0.165 0.027 0.541 0.073 9.18 %
CL2-t -0.76 3.93 2.37 0.23 5.95 5.71

Mean coefficients in Panel A of Table 5 are estimated from the 46 years’ Fama–MacBeth cross-sectional
regression estimates. Prop? is the proportion of positive coefficients. FM-t is Fama–MacBeth t-statistic and it is
defined as the ratio between the mean cross-sectional coefficients and their standard error estimated from the time
series of regression coefficients. FM–NW-t is FM-t adjusted for time-series dependence with the Newey–West
procedure. Panel B of Table 5 summarizes pooled cross-sectional and time-series OLS regressions for the years
1964–2009 based on 62,926 firm-year observations. HC-t is White (1980) heteroscedasticity consistent t-statistics
and CL2-t is t-statistics based on two-way cluster-robust standard errors in Gow et al. (2010). The Diff (NoDiff)
subsample in Panel C of Table 5 is composed of firms whose RNOA conditional persistence is (not) significantly
different from RFLEV conditional persistence at the 5 % level
Rit is the compounded buy-hold market adjusted return (raw returns minus the corresponding value weighted
return), inclusive of dividends and other distributions computed over the 12 months (-8, …, ?3) relative to the
fiscal year-end. RFLEV is the return on financial leverage and represents financing profitability. UE is the unex-
pected earnings. UE is the unexpected revenue. Both of them are normalized by the market value of equity at the
beginning of the period. RSOI is the return from the sustainable portion of operating income. RUOI is the return
from the unsustainable portion of operating income. See Appendix for details on variables measurement

123
 90
Table 6 Valuation analysis of operating profitability (research question #2)
123

MBit ¼ d0 þ d1 RNOAit þ d2 RSOIit þ d3 RUOI þ d4 RFLEV þ d5 UEit þ d6 URit þ d7 D recit þ d8 YTMit þgit
d0 d1 d2 d3 d4 d5 d6 d7 d8 Mean R2

Panel A: Fama–MacBeth cross-sectional regression average

Mean 1.298 6.526 3.297 -1.952 -0.185 -0.014 0.036 22.28 %
Prop? 78.3 % 100.0 % 93.5 % 2.2 % 17.4 % 84.8 % 65.2 %
FM-t 3.08 9.35 6.26 -5.91 -5.35 -0.51 0.45
FM–NW-t 3.01 5.23 3.70 -3.70 -4.21 -0.43 0.44
Mean 1.335 6.527 6.843 3.307 -2.018 -0.178 -0.014 0.032 22.51 %
Prop? 80.4 % 100.0 % 100.0 % 93.5 % 4.3 % 19.5 % 84.8 % 65.2 %
FM-t 3.18 9.50 8.56 6.21 -5.73 -5.21 -0.48 0.39
FM–NW-t 3.15 5.32 4.83 3.66 -3.56 -4.16 -0.40 0.4
Panel B: Pooled regression
with two-way cluster-robust standard errors
Coefficients 2.829 3.347 1.582 -0.069 0.206 -0.394 -0.162 13.90 %
HC-t 114.68 30.78 9.76 -2.57 0.27 -24.01 -71.11
CL2-t 17.39 9.06 3.86 -0.91 0.10 -2.01 -8.16
Coefficients 2.814 3.395 3.231 1.600 -0.068 0.141 -0.394 -0.161 13.91 %
HC-t 114.68 28.33 27.55 9.96 -2.55 0.18 -24.04 -68.39
CL2-t 16.23 8.56 8.75 3.99 -0.91 0.07 -2.02 -7.99
Panel C: Cross-sectional
variation by conditional persistence
Diff subsample (N = 1,128 firms)
Coefficients 2.604 6.388 5.678 2.260 -1.628 -0.262 -0.259 -0.167 25.16 %
CL2-t 21.18 13.52 9.13 3.29 -5.53 -5.03 -2.01 -10.79
NoDiff subsample (N = 276 firms)

S. C. Lim
Coefficients 2.844 5.534 5.918 1.348 -1.559 -0.317 -0.241 -0.117 23.61 %
 Operating activities versus financing activities
Table 6 continued

d0 d1 d2 d3 d4 d5 d6 d7 d8 Mean R2

CL2-t 14.91 6.26 4.92 1.28 -4.21 -4.21 -1.46 -8.18

The dependent variable (MB) is the market-to-book ratio at the end of the fiscal year. The market value of equity is computed as the product of the number of common shares
outstanding (COMPUSTAT data item CSHO) and the closing stock price at the end of the fiscal year (COMPUSTAT data item PRCC_F). COMPUSTAT data item CEQ is
used for the book value of equity. Mean coefficients in Panel A of Table 6 are estimated from the 46 years’ Fama–MacBeth cross-sectional regression estimates. Prop? is the
proportion of positive coefficients. FM-t is Fama–MacBeth t-statistic and it is defined as the ratio between the mean cross-sectional coefficients and their standard error
estimated from the time series of regression coefficients. FM–NW-t is FM-t adjusted for time-series dependence with the Newey–West procedure. Panel B of Table 6
summarizes pooled cross-sectional and time-series OLS regressions for the years (1964–2009) based on 62,546 firm-year observations. HC-t is White (1980) heterosced-
asticity consistent t-statistics and CL2-t is t-statistics based on two-way cluster-robust standard errors in Gow et al. (2010). The Diff (NoDiff) subsample in Panel C of Table 6
is composed of firms whose RNOA conditional persistence is (not) significantly different from RFLEV conditional persistence at the 5 % level
RNOA is the return on net operating assets. RFLEV is the return on financial leverage and represents financing profitability. UE is the unexpected earnings. UE is the
unexpected revenue. Both of them are normalized by the market value of equity at the beginning of the period. RSOI is the return from the sustainable portion of operating
income. RUOI is the return from the unsustainable portion of operating income. D_rec is an indicator variable taking 1 in the recession period using the business cycle dates
from NBER and 0 otherwise. YTM is the Treasury’s 10-year constant-maturity-yield to maturity. See Appendix for details
123

91
92 S. C. Lim

on the conditional persistence of the components of shareholder (operating) profitability.

Panel A of Table 7 shows that the Diff subsample is composed of small size firms, low
growth firms, firms with low financial leverage, and firms reporting more frequent losses.
Panel B of Table 7 shows that there are no differences between the two subsamples other
than firm size. The Diff subsample in Panel A of Table 7 has no industry clustering.
However, the NoDiff subsample in Panel A of Table 7 has about 25 % of sample repre-
sented by 4 four-digit SIC codes. They are 4911 (electric services), 4922 (natural gas
transmission), 4924 (natural gas distribution), and 4931 (electric and other services
combined). The Diff subsample in Panel B of Table 7 is overrepresented (about 8 %) by 3
four-digit SIC codes, 2834 (pharmaceutical preparations), 4924, and 4931. The NoDiff
subsample in Panel B of Table 7 is overrepresented (about 11 %) by 3 four-digit SIC
codes, 4911, 4924, and 4931.

Table 7 Financial characteristics of subsamples from conditional persistence

Diff subsample NoDiff subsample

Panel A: Grouping based on operating and financing profitability

Market value of equity 4,677.80 6,860.10
t value = -6.19
Maket-to-book 2.033 2.171
t value = -2.84
Long-term debt to equity 0.668 0.821
t value = -3.81
Loss frequency 0.107 0.083
t value = 4.01
Panel B: Grouping based on sustainable and unsustainable
operating income
Market value of equity 4,693.20 5,997.60
t value = -4.46
Maket-to-book 2.044 2.069
t value = -0.62
Long-term debt to equity 0.688 0.679
t value = 0.23
Loss frequency 0.103 0.108
t value = -0.94

Conditional persistence represents the marginal contribution of disaggregated component’s persistence to

the persistence of earnings. Table 7 has four selected financial characteristics for two subsamples based on
the relative conditional persistence. The Diff (NoDiff) subsample is composed of firms whose conditional
persistence of one component of disaggregated earnings is (not) significantly different from the conditional
persistence of the other component of disaggregated earnings at the 5 % level. The number of firms
belonging to the Diff and NoDiff subsamples in Panel A (B) are 1,253 and 160 (1,149 and 264), respec-
tively. Market value of equity is computed as the product of the fiscal year-end stock price and number of
shares outstanding. Mark-to-Book ratio is computed dividing the market value of equity by the book value
of common shareholders’ equity. Long-term debt to equity is long-term debt divided by the common
shareholders’ equity. Loss frequency is the frequency of reporting losses by sample firms

123
Operating activities versus financing activities 93

4 Summary and conclusion

This paper contributes to the literature by documenting three new findings. First, profit-
ability driven by operating activities is more strongly associated with returns than profit-
ability driven by financing activities. This finding extends the predictive analysis and
valuation analysis of Nissim and Penman (2003) into an information content analysis using
the annual stock returns as the dependent variable. The finding may serve as empirical
support for the FASB’s Financial Statement Presentation Project. The study’s second
finding is that the market assigns more weight to the sustainable portion of operating
profitability than it does to the unsustainable portion. Finally, the study finds that the
conditional persistence in Amir et al. (2011) is an empirical attribute that affects the
valuation usefulness of disaggregated accounting profitability.

Acknowledgments I would like to thank Sudipta Basu, Rick Cazier, In-Mu Haw, SueJin Im, Susan
McMahon, Mary Stanford, Bob Vigeland, and Han Yi for helpful comments and suggestions.

Appendix

This appendix describes how variables are measured and ratios are computed for the
shareholder profitability analysis. It is adapted from Appendix B in Nissim and Penman
(2003) replacing their FTP annual COMPUSTAT data item numbers with Xpressfeed
annual COMPUSTAT mnemonics in the parentheses. The last section of this appendix
includes a description of how unconditional and conditional persistence are calculated.
Financial assets are the sum of cash and cash equivalents (CHE), investment and advances-
others (IVAO), and short-term investments (IVST).
Financial assets ¼ CHE þ IVAO þ IVST ð5Þ
Operating assets are the difference between total assets (AT) and financing assets.
Operating assets ¼ AT & Financial assets ð6Þ
Financial obligations or financial liabilities are the sum of debt in current liabilities (DLC),
long-term debt (DLTT), preferred stocks after taking out the preferred treasury stocks
(PSTK - TSTKP), and preferred dividend in arrears (DVPA). Minority interest (MIB) is
treated as an obligation because the analysis is performed from the perspective of common
shareholders.
Financial obligations ¼ DLC þ DLTT þ PSTK & TSKTP þ DVPA þ MIB ð7Þ
Net financial obligation is the difference between financing obligations and financing
assets.
Net financial obligation ¼ Financial obligation & Financial assets ð8Þ
Common shareholders’ equity is computed as the sum of common equity (CEQ) and
preferred treasury stocks (TSTKP) minus preferred dividends in arrears (DVPA).

Common shareholder0 s equity ¼ CEQ þ TSTKP & DVPA ð9Þ

Net operating assets are computed as the sum of net financial obligation and common
shareholders’ equity.

123
94 S. C. Lim

Net operating assets ¼ Operating assets & Operating liabilities ¼ NFO þ CSE ð10Þ
Net financial expense is measured as after-tax interest expense (XINT) plus preferred
dividends (DVP) minus after-tax interest income (IDIT) plus minority interest in income
(MII) minus the changes in marketable securities adjustment (MSA).

Net financial expense ¼ XINT ð1 & sÞ þ DVP & IDIT ð1 & sÞ þ MII & DMSA;
ð11Þ
where s is tax rate

Comprehensive net income is net income (NI) minus preferred dividends (DVP) plus the
changes in marketable securities adjustment (MSA) plus the change in cumulative trans-
lation adjustment (CTA) following Nissim and Penman (2003). Test results are insensitive
to the inclusion of other differences between comprehensive income and net income into
Eq. (12) below. Those variables are derivative gains and losses (CIDERGL), minimum
pension adjustments (CIPEN), and other adjustments (CIOTHER).
Comprehensive net income ¼ NI & DVP þ DMSA þ DCTA ð12Þ
Operating income is computed as the sum of net financial expense and comprehensive net
income.
Operating income ¼ Net financial expense þ Comprehensive net income ð13Þ
Top statutory federal tax rate plus 2 % average state tax rate is used for the marginal tax
rate. The top federal statutory corporate tax rate was 52 % in 1963, 50 % in 1964, 48 %
in 1965–1967, 52.8 % in 1968–1969, 49.2 % in 1970, 48 % in 1971–1978, 46 % in
1979-1986, 40 % in 1987, 34 % in 1988–1992 and 35 % in 1993–2010, respectively. The
sustainable portion of operating income is measured as the difference between sales rev-
enue (SALE), the sum of cost of goods sold (COGS), selling, general, and administrative
expense (XSGA), advertising expense (XAD), and research and development expense
(XRD).
Sustainable operating income ¼ SALE & COGS & XSGA & XAD & XRD ð14Þ
Unsustainable operating income ¼ Operating income & Sustainable operating income
ð15Þ
CNI
ROCE ¼ ð16Þ
CSE
OI
RNOA ¼ ð17Þ
NOA
RFLEV ¼ ROCE & RNOA ð18Þ
Sustainable operating income
RSOI ¼ ð19Þ
NOA
Unsustainable operating income
RUOI ¼ ð20Þ
NOA
The conditional persistence of disaggregated components is estimated in two steps fol-
lowing Amir et al. (2011). In the first step, I estimate the firm/year unconditional persis-
tence using a fixed window size of the preceding 8 years in a rolling forward manner. In the
second step, the firm level conditional persistence is estimated from the slope coefficient in

123
Operating activities versus financing activities 95

regressing the unconditional persistence of aggregate profitability on the unconditional

profitability of disaggregated components’ profitability. I require each firm to have at least
8 years’ unconditional persistence data available in the second step.

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