15.Kothari-Information in Prices About Future Earnings - Implications For Earnings Response Coefficie PDF

Journal of Accounting and Economics 15 (1992) 143-171.
North-Holland
Information in prices about future earnings
Implications for earnings response coefficients*
S.P. Kothari
Unioersily qf Rochester. Rochester. NY 14627, USA
Richard G. Sloan
Uniuersily of Pennsylvania. Philadelphia. PA 19104-6365, USA
Received April 1990, final version received February 1992
Stock return over a period reflects the market’s revision in expectation of future earnings. Account-
ing earnings over the same period, however, have limited ability to reflect such revised expectations.
Therefore, returns anticipate earnings changes and the earnings response coefficient from a regres-
sion of returns on contemporaneous earnings changes is biased toward zero. We reduce this bias by
including leading-period returns in pricexarnings regressions. The resulting estimated earnings
response coefficient magnitudes suggest that the capital market, on average, views earnings changes
to be largely permanent. This is consistent with the random walk time series property of annual
earnings.
1. Introduction
Recently the relation between time series properties of earnings and earnings
response coefficients [formally defined below in eq. (l)] has been a topic of
considerable interest among accounting researchers [see, e.g., Kormendi and
Lipe (1987), Collins and Kothari (1989), Easton and Zmijewski (1989)J Since
*We acknowledge Celal Aksu, Andrew Alford, Vie Bernard, Fischer Black, Carol Frost, Dan
Givoly, Paul Healy, Pat Hughes, Bob Lipe, Tom Lys, Jim Manegold, Krish Palepu, K. Ramesh,
Doug Skinner, Charlie Wasley, Ross Watts, Peter Wilson, Jerry Zimmerman, Mark Zmijewski,
workshop participants at the University of Arizona, Harvard University, Northwestern University,
Ohio State University, University of Southern California, Temple University, Washington Univer-
sity at St. Louis, and especially an anonymous referee and Ray Ball (the editor) for many useful
comments. S.P. Kothari acknowledges financial support from the Bradley Policy Research Center at
the Simon School and the John M. Olin Foundation.
0165-4101/92/$05.00 0 1992-Elsevier Science Publishers B.V. All rights reserved

144 S.P. Kothari and R.G. Sloan, Iqformation in prices about -future earnings
time series properties of annual earnings suggest that firms’ earnings changes are
largely permanent, the earnings response coefficient is predicted to be about
(1 + l/ri), where ri is the expected rate of return on firm i’s equity [Kormendi
and Lipe (1987) and Collins and Kothari (1989)l.l Earnings response coeffi-
cients reported in the literature, however, are considerably smaller than implied
by the time series properties of earnings. For example, Penman’s (1990, table 2)
estimate using annual returns/earnings data is 0.894, whereas Kormendi and
Lipe (1987, table 1) report a median coefficient of 2.5. Ali and Zarowin (1992),
who control for the effect of serial correlation in earnings, report a median
earnings response coefficient of 1.59. Use of analysts’ earnings forecasts as better
proxies for the market’s expectation also yields coefficients of similar mag-
nitudes [see, for example, Easton and Zmijewski (1989a,b) and Brown, Griffin,
Hagerman, and Zmijewski (1987) who use Value Line’s quarterly earnings
forecasts].
In this paper we resolve the apparent inconsistency between the time series
behavior of annual earnings and the market’s valuation of earnings changes, as
reflected in an earnings response coefficient estimate, by using the information in
stock prices about future earnings. By exploiting the earnings forecasts em-
bedded in security prices, we obtain coefficients that are comparable to those
implied by the time series properties of earnings.
One source of stock prices’ predictive ability with respect to future earnings
changes is that the information set reflected in the market’s expectations, and
thus in prices, is richer than that in the past time series of earnings. Price change
over a period reflects revision in the market’s expectation of future earnings as
well as realized earnings over the period. In comparison, accounting earnings
over a period primarily summarize: (i) the effect of sales transactions during
a fiscal period that have generated cash or almost certainly will generate cash
(e.g., cash sales and net change in receivables), (ii) the effect of past periods’
activities (e.g., via depreciation expense and cost of goods sold), and (iii) cash
outlays for investments generating uncertain future benefits (e.g., research and
development and advertising expenses). Compared to stock prices, earnings thus
have a limited ability to contemporaneously reflect the market’s revised expec-
tations of future cash flows. Such limited ability is attributable to the conserva-
tism, objectivity, verifiability, and other conventions that underlie Generally
Accepted Accounting Principles (GAAP). For example, earnings for a period are
unlikely to reflect the expected net cash flow from a new growth opportunity
facing the firm. Since, on average, the market’s expectations eventually get
reflected in earnings, price changes anticipate earnings changes, or prices lead
‘Annual earnings changes exhibit a small degree of negative serial correlation [see, for example,
Ball and Watts (1972, tables 3.4). Brooks and Buckmaster (I 980), and Ali and Zarowin (1992)]. For
a typical firm, we therefore expect its earnings response coefficient to be somewhat smaller than
(1 + l/r,).
S.P. Kothari and R.G. Sloan, Information in prices about firure earnings 145
earnings2 This phenomenon has long been recognized in the literature. For
evidence in the accounting literature, see Ball and Brown (1968), Beaver, Lam-
bert, and Morst (1980) Brown, Foster, and Noreen (1985), Collins, Kothari, and
Rayburn (1987), Freeman (1987) and Collins and Kothari (1989).
The effect of prices leading earnings on an earnings response coefficient, can
be seen from the following commonly estimated regression:
Rit = YOi + yli UEi* + &it 9 (1)

where Ri, is return in excess of its expected return for firm i measured over fiscal
quarter or year t, UEi, is reported earnings minus a proxy for the market’s
expectation of earnings at the beginning of period r, scaled by price at the
beginning of period t, yoi is the intercept, yri is firm i’s earnings response
coefficient, and Eiris a disturbance term. Consider estimating eq. (1) using annual
returns and a time series expectation of annual earnings to obtain UEi,. The
limitation of a time series expectation is that the market’s expectation is based
on a richer information set. Therefore, UEi, will be measured with error and the
coefficient on UE, will be biased towards zero. This is suggested by numerous
researchers. For example, Watts and Zimmerman (1986, p. 55), in their dis-
cussion of the Beaver, Clarke, and Wright (1979) study, reason that earnings
response coefficient estimates could be biased toward zero because ‘stock price
adjustment to some factors reflected in annual earnings may have occurred in
previous years’.
To reduce the bias that arises because information in prices about future
earnings is ignored, we include return over a leading period in Ri, .3 The average
earnings response coefficient increases from 3.1 when annual, contemporaneous
priceearnings regressions are estimated, to 6.0 when returns from the three
previous years are also included in Ri,. Compared to the previous research,
which documents that return over one leading year is related to the annual
earnings change [see, e.g., Beaver et al. (1980), Brown et al. (1985) and Collins
and Kothari (1989)], we provide reliable evidence that returns measured over
three leading years contain information about an annual earnings change. The
increase in the average earnings response coefficient suggests leading-period
‘We hasten to add that by ‘prices lead earnings’ we do not imply there is any ‘error’ in historical
cost accounting earnings. While managers have incentives to ‘manipulate’ accruals [e.g., Healy
(1985)], it is neither necessary nor do we rely on such ‘manipulations’ or ‘error’ to argue that returns
anticipate earnings changes. Moreover, since accrual ‘manipulations’ do not have a first-order stock
price effect, returns are unlikely to be useful in forecasting future earnings changes stemming from
accrual ‘manipulations’. The latter are probably helpful in forecasting future earnings changes on the
basis of past earnings changes.
‘Collins and Kothari (1989) also include leading-period returns in estimating price-arnings
regressions. They measure return over a 15-month window that begins five (two) months earlier than
the fiscal period t for the large (small) firms. We include up to three leading years’ returns to more
fully exploit the information in prices with respect to future earnings.
146 S.P. Kothari and R.G. Sloan, Information in prices about future earnings
returns are as important as contemporaneous returns in terms of their sensitivity

to annual earnings changes. Perhaps more importantly, the inference is that the
capital market views earnings changes to be largely permanent, which is consist-
ent with the annual earnings’ time series properties.
We also report earnings response coefficients estimated using both returns
and earnings measured over relatively long windows of up to four years [see also
Easton, Harris, and Ohlson (1992) who focus on the explanatory power of
price-earnings regressions]. While a longer window is expected to be more
effective than a shorter one in reducing the bias stemming from earnings
anticipation, a longer window is, a priori, unlikely to be as effective as including
leading-period returns. Longer priceearnings measurement windows cannot
fully incorporate earnings anticipation impounded in returns. Instead, longer
windows reduce the proportion of the earnings change that has already been
anticipated. This is supported by our results. Longer windows for both returns
and earnings yield less biased earnings response coefficient estimates, but not to
the same extent as when leading period returns are included.
Our empirical analysis using longer measurement windows for returns and
earnings differs from Easton, Harris, and Ohlson (1992) in one important
respect. We estimate time series, compared to their cross-sectional regressions;
we focus on earnings response coefficient magnitudes whereas they evaluate the
degree of price-earnings association. The degree of price-earnings association
attributable to risk differences (and therefore expected return differences) in
a cross-section is an increasing function of the return-earnings measurement
interval. This clouds researchers’ ability to unambiguously attribute any in-
crease in the explanatory power of cross-sectional regressions to variation in
unexpected earnings across firms. This issue is discussed more fully in sec-
tion 4.2.
Section 2 provides the rationale for a relation between leading-period returns
and earnings response coefficients. Data, sample selection, and descriptive
statistics are provided in the third section. Section 4 presents empirical results.
The earnings response coefficients’ sensitivity to leading-period returns and to
measurement intervals is documented in sections 4.1 and 4.2. Diagnostic tests’
results are discussed in section 4.3. A summary and implications for other
research are provided in section 5.
2. Implication of accounting principles for earnings response coefficients
In an efficient market, price changes reflect the revision in the market’s

expectation of future cash flows, whereas accounting earnings have only a
limited ability in this respect. As a result, the market’s expectation reflects
a richer information set than a time series expectation. The primary reason for
this is that conservatism, objectivity, verifiability, and other conventions that
S.P. Kothari and R.G. Sloan, Information in prices about future earnings 147
underlie GAAP limit accounting earnings’ ability to contemporaneously reflect

the market’s revision in expectation of future net cash flows.
We illustrate this by considering the timing of the impact of several economic
events on stock prices and current and expected future cash flows and earnings.
Events such as long-term sales contracts (e.g., aircraft sales, shipbuilding) affect
the market’s expectation of future earnings and cash flows, and stock prices
reflect these revised beliefs at the time the economic events become known.
Neither earnings nor cash fows for the period, however, fully reflect their
expected future cash flow implications. Around the time of new investments,
stock prices reflect their net present values [e.g., McConnell and Muscarella
(1985) and Chan, Martin, and Kensinger (1990)]. Earnings for the period in
which capital investments are made are reduced by the depreciation charge, and
cash inflows from the new investment are captured in future earnings only when
revenues are generated. Thus, returns are expected to lead earnings changes.
That is, price changes are expected to have some predictive power with respect
to future earnings changes. This, however, does not imply that price changes
represent a perfect forecast of future earnings changes.
Research and development investments are expensed in the period in which
they are incurred, whereas the expected cash inflows from these investments are
reflected only as and when they materialize in the future. Because prices reflect
the present value of the expected net effect of the expenditures around the time of
these investments [see Chan, Martin, and Kensinger (1990)], prices will lead
earnings. Other examples of investments that are expensed in the period in
which they are incurred include advertising, marketing, repair and maintenance,
restructuring costs [e.g., Brickley and VanDrunen (1990)], and plant closing
costs [Blackwell, Marr, and Spivey (1990)]. Finally, growth opportunities (i.e.,
opportunities to make positive net present value investments) facing a firm are
reflected in stock prices, but are not generally reflected in earnings until they
begin to generate revenues [e.g., Brealey and Myers (1988) and Ross, Wester-
field, and Jaffe (1990)].4 Thus, in the presence of growth opportunities, returns
tend to anticipate future earnings changes.
One implication of prices leading earnings is that the market’s expectation of
earnings differs from a time series expectation. Since annual earnings are
reasonably described as a random walk, information in the past earnings is not
useful in predicting successive earnings changes. As of the beginning of a year,
however, the market has typically anticipated some of the current period’s
earnings change. Therefore, in estimating the price-earnings relation either
a timely and accurate proxy for the market’s earnings expectation should be
used, or information in leading-period returns should be exploited. In this study
4The generally observed large price run-up in a target firm’s stock can also be viewed as a growth
opportunity in that the bidder firm is expected to utilize the target firm’s assets more efficiently and
generate greater amounts of cash flows, that will be reflected in future earnings.
1.A.E B
148 S.P. Kothari and R.G. Sloan, Information in prices about fulure earnings
t-3 t-2 t-1 t
P
t-2
P
I-3
Fig. 1. Earnings and returns measurement intervals in lead-lag price+arnings regressions. Two-
year buy-and-hold returns, inclusive of dividends, regressed on annual earnings deflated by price at
the beginning of the return measurement interval. Return measurement interval consists of the
contemporaneous and one leading year. Return observations are overlapping.
we include leading-period returns. We estimate the price-earnings relation using

earnings measured over a given interval (e.g., one year), but with a return
measurement interval that includes a leading time period (see fig. 1). We employ
the earnings level, rather than change, deflated by price as the explanatory
variable in the pricexarnings regression, which is motivated by the random
walk time series property of annual earnings [see Biddle and Seow (1990) and
Ohlson (1991)], and the evidence in Easton and Harris (1991):
Pit/Pit-r = l’i0 + 7il xillpitp* + &it3
where Xi, is accounting earnings over the period t, Pit/Pit_, is one plus the
buy-and-hold return, inclusive of dividends, over the period from the end of
t - r to the end of t, and r > 1 so that leading-period returns are included in

Pit/Pit_,. Thus, when r = 3, we regress overlapping three-year returns on the
third year’s annual earnings scaled by price at the beginning of the return
holding period. As T increases, it is more probable that the information reflected
in Xi, will be incorporated in the return over the period t - t to t. Consequently,
yil is expected to approach its predicted value of (1 + l/‘ri). Note that the
multi-year return over the period t - r to t reflects more information than that
reflected in the one year’s earnings, Xi,. Since this ‘extra’ (uncorrelated) informa-
tion resides in the dependent variable, it does not bias the estimated slope
coefficient, although the R’s will be less than one.’
It is important to determine whether the inclusion of leading-period returns
spuriously increases the estimated earnings response coefficient. In an appendix
we show that, ifprices do not lead earnings and the dividend payout is zero, then
the inclusion of leading-period returns to estimate the earnings response coeffic-
ient has no effect on the coefficient. Thus, the inclusion of leading-period returns
is not helpful unless returns anticipate future earnings changes.
The appendix also examines the effect of a positive dividend payout policy.
The estimated coefficient is biased upwards by the order of the firm’s dividend
yield, which is small compared to (1 + l/ri). This bias arises because of an
asymmetric effect of dividends on the dependent and independent variables.
Specifically, earnings in the Xir/Pir_r variable reflect earnings on the firm’s
initial equity investment and on the increase in investment over time through
earnings retention. Thus, Xi, does not reflect earnings on past dividend pay-
ments. The return variable, Pi, /Pi, _ T, on the other hand, assumes dividends are
reinvested. The result, as shown in the appendix, is that earnings response
coefficient estimates are upwardly biased. Intuitively, the earnings yield is
systematically biased downwards relative to the return-inclusive-of-dividend
variable, which causes the bias. The bias increases in dividend yield and thus
with the length of leading period. We report earnings response coefficients
adjusted for this bias. The adjustment entails dividing the estimated earnings
response coefficients by (1 + dividend yield)‘-‘, where we use the realized
dividend yield of 3.9% per year on the CRSP equal-weighted portfolio from
1926-88 and T - 1 is the number of leading years included in the analysis. Since
the bias is small relative to the magnitude of the predicted and estimated
coefficient, we believe our adjustment is sufficient.
‘We also considered a reverse regression of annual earnings on annual returns, in the spirit of
Beaver, Lambert, and Ryan (1987) to estimate earnings response coefficients. Since prices lead
earnings, the return variable contains information about the current year’s earnings (the dependent
variable in a reverse regression) as well as the future years’ earnings. The presence of the latter type of
information in the return variable means it measures the variable of interest (i.e., the component of
return that is attributable to the current period’s earnings information) with error. The estimated
slope is therefore expected to be biased, much the same way as in the direct regression. See Lipe
(1990, p. 64) and Beaver et al. (1987, pp. 150-151).
3. Data, sample selection, and descriptive statistics
3.1. Data
We use data from the Compustat Quarterly, Annual Industrial, and Annual
Res earth tapes, and the Center for Research in Security Prices (CRSP) monthly
tape. We use earnings data for 1979-88 from the quarterly tape for earnings
measurement intervals shorter than one year and data for 1950-88 from the
annual tapes when the earnings measurement interval is one year or longer.
We use monthly returns to calculate buy-and-hold returns including dividends
over holding periods ranging from one quarter to four years. Returns are meas-
ured over intervals that end in the earnings fiscal quarter- or year-end. The effect
of including earnings-announcement and post-earnings-announcement-period re-
turns on earnings response coefficients is discussed in sections 4.2 and 4.3.
3.2. Sample selection and descriptive statistics
We include all firms that have at least five consecutive earnings and return
observations available for the measurement interval of interest. We apply this
critierion separately for each measurement interval. Thus, if the measurement
inverval is one quarter, then earnings and return data for at least five consecu-
tive quarters must be available. This enables us to estimate a time series
regression separately for each firm.
Table 1 reports descriptive statistics for the earnings yield (X,_,,,/P,_,) and
price relative (P,/P,_,) variables. P,/P,_, is one plus the buy-and-hold return,
inclusive of dividends, over the period t - z to t. The descriptive statistics are
reported for measurement intervals, T, ranging from one to four years. For each
measurement interval, the average earnings yield and price relative are cal-
culated for each firm. Using these firm level data, sample mean, standard
deviation, median, minimum, and maximum values are obtained. For T = 1
year, the average earnings yield for a sample of 2,721 firms is 6.1% and the
median is 9.1%. The mean and median earnings yields for the four-year-interval
sample of 2,319 firms are 13.2% and 12.7%. The mean as well as median
earnings yields reported in table 1 increase monotonically with 7. One reason is
that the earnings per share is deflated by P,_, which, on average, declines in 5.
A second reason is that there is a survivorship bias that results in higher
earnings yield samples as the measurement interval is increased. A survivorship
bias also reduces the sample size from 2,721 for 5 = one year to 2,319 for
T = four years.
Descriptive statistics for P,/P,_, for the various measurement interval sam-
ples are reported in the bottom panel of table 1. The last row reports annualized
mean values. The annualized mean price relatives measured over all intervals
are almost identical. They range from 1.168 to 1.170. This means the average
Table 1
Descriptive statistics for earnings yield (X~_~,JP~_,) and price relative (Pr/Pr_,) variables measured
over intervals ranging from one to four years and data from 1950-88. Sample sizes are from 2,319 to
2,721 firms, l'b
Measurement interval
1 year 2 years 3 years 4 years
Earnings yield
Mean 0.061 0.091 0.112 0.132
Std. deviation 0.156 0.121 0.131 0.143
Median 0.091 0.104 0.116 0.127
Minimum - 2.874 - 2.072 - 2.534 - 2.020
Maximum 0.639 0.856 1.045 1.400
N 2,721 2,588 2,471 2,319
Price relatives
Mean 1.168 1.371 1.598 1.864
Std. deviation 0.139 0.310 0.543 0.788
Median 1.165 1.345 1.532 1.734
Minimum 0.527 0.288 0.102 0.221
Maximum 2.521 3.803 7.492 9.867
Annualized mean c 1.168 1.170 1.169 1.168
aSample selection: Any firm that had earnings data on the Compustat Annual Industrial or the
Compustat Annual Research tape and return data on the Center for Research in Security Prices
monthly tape for five consecutive measurement interval periods during 1950-88 is included. Data for
the longer than one-year measurement intervals contain overlapping periods because the measure-
ment window is moved forward only one year at a time.
~Earnings yield X , _ t , r / P , _ ~ primary annual earnings per share before extraordinary items and
=
discontinued operations for year t, divided by the price at the beginning of the return measurement
interval. All earnings per share numbers and prices are adjusted for stock splits and stock dividends.
Price relative Pf/Pr • = one plus the buy-and-hold return, inclusive of dividends, over the years
t-Ttot.
cAnnualized price relative is calculated as the geometric mean annual price relative for the
particular measurement interval.
a n n u a l r e t u r n o n t h e s a m p l e f i r m s is 1 6 . 8 % t o 1 7 . 0 % . T h e s a m p l e f i r m s ' r e t u r n s
t h u s d o n o t r e v e a l a n y o b v i o u s s u r v i v o r s h i p b i a s p r o b l e m as a f u n c t i o n o f t h e
return measurement interval. The mean and median raw price relatives nat-
urally increase with the measurement interval. The mean price relative increases
f r o m 1.168 f o r t h e o n e - y e a r - i n t e r v a l s a m p l e t o 1.864 for t h e f o u r - y e a r - i n t e r v a l
sample.
4. Regression results
4.1. Leading-period returns' effect on earnings response coefficient estimates

T o e x a m i n e t h e effect o f l e a d i n g - p e r i o d r e t u r n s o n t h e e a r n i n g s r e s p o n s e
c o e f f i c i e n t e s t i m a t e s , we e s t i m a t e t h e m o d e l i n eq. (2) f o r t h e s a m p l e firms. W e
152 s.P. Kothari and R.G. Sloan, Information in prices about future earnings
f o c u s o n t h e effect o f u p t o t h r e e l e a d i n g y e a r s ' r e t u r n s (i.e., r < 4) f o r t w o

reasons. First, with hindsight, there were only slight increases in the earnings
response coefficients from adding more than three leading years' return. We
discuss the results of adding up to nine leading years' return in the 'diagnostic
t e s t s ' s e c t i o n o f t h e p a p e r , t o e n a b l e t h e r e a d e r t o j u d g e t h e efficacy o f a d d i n g
m o r e t h a n t h r e e l e a d i n g y e a r s ' r e t u r n . S e c o n d , as n o t e d e a r l i e r , i n c l u s i o n o f
l e a d i n g - p e r i o d r e t u r n s i n d u c e s a s m a l l u p w a r d b i a s in t h e e s t i m a t e d coefficients.
Table 2
Selected fractiles from the distribution of estimated parameters of firm-specific regressions of price
relatives on earnings deflated by price. Earnings measurement interval is one year and price relatives
are for the contemporaneous one year and for periods that also include leading years. Annual
earnings data from 1950-88. Sample sizes from 2,319 to 2,721 firms?
Pit/Pit-r = ?io~ + 7iltXu/Pit-t + Eit b'c
r=l r=2 r=3 r=4
Panel A: Intercept estimates

Minimum - 1.31 - 2.72 -- 6.59 - 3.53
10th percentile 0.61 0.33 0.31 0.27
Median 0.96 0.85 0.89 0.97
90th percentile 1.18 1.30 1.46 1.67
Maximum 3.27 6.08 4.63 4.27
Mean 0.92 0.83 0.89 0.97
Std. error 0.0057 0.0089 0.0111 0.0136
N 2,721 2,588 2,471 2,319
Panel B: Coefficient on earnings

Minimum - 21.01 - 28.85 - 20.09 - 25.47
10th percentile 0.06 0.50 0.58 0.60
Median 1.89 3.94 4.30 4.42
90th percentile 5.78 9.57 10.12 11.19
Maximum 60.60 104.41 93.52 94.52
Mean 2.56 4.69 5.08 5.45
Std. error 0.0701 0.0966 0.1016 0.1198
aSampte selection: Any firm that has earnings data on the Compustat Annual Industrial or
Research tape for five consecutive years during 1950-88 and return data for the earnings measure-
ment years and the three leading years is included. The return observations contain overlapping
periods when one or more years of leading-period returns are included.
bEarnings yield Xt/Pt-~ = primary annual earnings per share before extraordinary items and
discontinued operations for year t, divided by the price at the beginning of the return measurement
Price relative Pt/Pt-r one plus the buy-and-hold return, inclusive of dividends, over the years
=
t-~tot.
CThe model is estimated by modeling the residuals from the ordinary least squares regressions as
a first-order autoregressive process and then ordinary least squares parameters are reestimated
using transformed variables. The estimated slope coefficients are deflated by (1.039)'- 1 to control for
bias stemming from using dividend-reinvested returns.
S.P. Korhari and R.G. Sloan, Information in prices about future earnings 153
While we provide an approximate correction for this bias, we also avoid adding
unnecessary leading-period returns.
When we include leading-period returns (i.e., r > l), we obtain overlapping
return observations, as shown in fig. 1, and the regression errors become serially
correlated (we discuss below an adjustment for serial correlation in errors).
Under these conditions, ordinary least squares estimators are unbiased, but less
efficient than generalized least squares estimates that take account of the
autocorrelation [Maddala (1977, p. 281)]. We therefore transform the price-
earnings variables by modelling residuals from the ordinary least squares
regressions as a first-order, autoregressive process and then reestimate the
priceearnings regression using the transformed variables. This two-step, full
transform procedure is similar to the Cochrane and Orcutt (1949) procedure.
We also estimate ordinary least squares regressions and regressions using
nonoverlapping return data. The former are discussed in the ‘diagnostic tests’
section and the latter are discussed later in this section.
We report regression results in table 2, comparing the average estimated
coefficient with its predicted value. By focusing on the average coefficient, we
draw inferences about the price-earnings relation of the average security in our
sample. The average coefficient is predicted to be (1 + l/r), where I is the average
security’s expected rate of return on equity.6 We use the average realized annual
return of 17.15% on the CRSP equal-weighted portfolio from 192688 as
a proxy for the expected rate of return. We consider this to be a reasonable
proxy for expected return on the sample firms because the average return on the
sample firms, as reported in table 1, is close to the CRSP equal-weighted return
over 192688 and the market model average beta for the sample using the CRSP
equal-weighted portfolio is 1.Ol. For r = 17.15%, the average earnings response
coefficient is predicted to be 6.83.’
As our hypothesis predicts, the average earnings response coefficient increases
as returns from leading years are included. The average earnings response
coefficient from the annual contemporaneous regressions for 2,721 sample firms
is 2.56. The median earnings response coefficient is 1.89, indicating that the
‘Since (I/N)x(l/r,) 2 l/r, where N is the number of securities, ri is the expected return on security
i, and r is the average expected return for the securities, (1 + l/r) underestimates the predicted
average coefficient. However, since expected return on equities is almost invariably greater than
8&10%, and for reasonable values of cross-sectional variance of the expected returns on equities, the
bias in using (1 + I/r) as the predicted coefficient can be shown to be relatively small. Throughout in
this paper we compare the estimated average earnings response coefficient against (1 + l/r).
7An alternative to using the CRSP realized rate of return as a proxy for r would be to use a proxy
for the expected real rate of return on common stocks. If inflation is assumed to have no real effect
on valuation, then the latter proxy would be consistent with the valuation model underlying the
price-earnings relation. We, however, do not adjust the average realized rate of return on the CRSP
equal-weighted portfolio for the average inflation rate of 3.2% over 192687 [Ibbotson and
Sinquefield (1989)] because it is not obvious how inflation affects the price-arnings multiple. If we
use a proxy for the expected real rate of return, then the predicted value of the earnings response
coefficient is 8.17.
154 S.P. Kothari and R.G. Sloan, It$wnation in prices ahour future earnings
distribution is skewed to the right. More than 90% of the coefficient estimates
are positive. As one, two, and three leading years’ returns are added to the
contemporaneous annual returns, the average earnings response coefficient
increases to 4.69, 5.08, and 5.45 (a 113% increase). Taken together, leading-
period returns are at least as important as contemporaneous returns in terms of
their sensitivity with annual earnings. The median earnings response coefficients
always are lower than the sample means, but they too increase substantially with
the inclusion of leading-period returns. For example, when three leading years’
return is included, the median earnings response coefficient is 4.42.
We next compare the estimated coefficients with their predicted values. The
sample mean’s standard error is affected by (i) cross-correlation among the
coefficient estimates, (ii) variation in the ‘true’ coefficient magnitudes across
firms, and (iii) cross-sectional variation in the degree to which stock prices lead
earnings. Since the price-earnings regressions’ errors are expected to be posit-
ively cross-correlated, the estimated standard errors will likely understate the
‘true’ standard error.8 Cross-sectional variation in the firms’ earnings response
coefficients due to variation in their expected returns will also affect the estim-
ated standard errors. Since we do not model individual firm’s earnings response
coefficients, this will tend to overstate standard errors. However, as seen from
the 10th and 90th percentiles of their distribution in table 2, many firms’
earnings response coefficient estimates appear to substantially deviate from their
predicted values. We, therefore believe sampling variation in the coefficient
estimates dominates the estimated standard errors. Cross-sectional variation in
the degree to which prices lead earnings will also magnify the estimated stan-
dard errors, particularly when return over a short leading period is included. As
T is increased, virtually all the effect of earnings anticipation is incorporated in
the price-earnings relation. Therefore, for t = 4, we expect cross-sectional
variation in the degree to which prices lead earnings will have relatively little
effect on the standard error.
The estimated average coefficient is closer, both in absolute terms and
statistically, to the predicted value of 6.83 as the leading-period return is
incorporated in the analysis. For all leading periods from one to three years,
however, the estimated earnings response coefficient is at least two standard
errors smaller than the predicted value of 6.83. For example, when three
leading-year returns are included, the earnings response coefficient estimate is
5.45, with a standard error of 0.1198. The null hypothesis that the estimated
average coefficient is equal to its predicted value of 6.83 is rejected at a p-value
less than 0.01.
“We report below results of regressions that include the market return as an additional indepen-
dent variable which controls the positive cross-sectional correlation among residuals. As a result, the
estimated standard error of the cross-sectional average earnings response coefficient will be less
biased.
S.P. Kothari and R.G. Sloan, 155
We conjecture earnings response estimates are than

their counterparts for least two First, the an-
nouncement is not in calculating For the in table
we end return measurement with the fiscal year-ends. we
reestimate regressions using measured over ending
three after the year-end, the response coefficients
mates are higher than reported in 2. The earnings
response is 3.09 no leading-period is included it is
when leading over three is included. once the
month announcement return is the average response
coefficient closer to, still reliably than, its value. Second,
research by and Watts Brooks and (1977), Ah
Zarowin (1992), others, suggests annual earnings a small
of negative correlation, which earnings response
cients, on are predicted be somewhat than (1 l/~).~
Overall, results in section are with the that price
lead earnings and on leading-period returns,
earnings response estimates are closer to predicted
values.
Earnings response sensitivity to price-earnings

measurement
This section results of earnings response using
a contemporaneous window both returns earnings. The
tion is assess the of longer windows in
bias in response coefficient The fraction information in
that is by the period’s return expected to
with the measurement window. bias in estimated earnings
coefficients will decline with measurement window
earnings and However, unless window length the life
a firm, earnings anticipation persist. Consequently, measure-
ment for both and returns unlikely to as effective
including leading-period
This analysis longer contemporaneous measurement
window similar to of Easton al. (1992) also study
earnings and The focus their analysis, is on R’s of
price-earnings regressions. estimate time regressions
‘Kormendi Lipe (1991) that collectively higher-order negative correlations

imply response coefficients’ value is 30% less that based the
random time series of annual [also see and Zarowin and
Ramesh Since these are derived a sample 118 firms over a
period, it not obvious they are appropriate benchmark our context.
156 S.P. Kothari and R.G. Sloan. Information in prices about future earnings
and draw inferences from the average earnings response coefficient estimates for
the following reason.
Expected-return variation through time for individual stocks is small com-
pared to the expected-return variation across stocks, particularly when
measurement intervals are long.” The effect of expected-return variation
through time is that the estimated earnings response coefficient, on average, is
approximately equal to (1 + l/ravg), where ravg is the average expected return
over the sample period. The reason for focussing on earnings response coeffic-
ients is that price-earnings regressions’ explanatory power is affected by the
expected-return variation and the problem is acute in a cross-sectional analysis.
The proportion of cross-sectional variation in returns (the dependent variable in
price-earnings regressions) attributable to risk differences is an increasing func-
tion of the measurement interval. Because the independent variable, X, _ ~,f/P, _~,
in price-earnings regressions is a risk proxy [e.g., Ball (1978)], the cross-
sectional association between returns and the X,_,.,/P,_, variable is due to both
unexpected earnings and risk differences. Variation due to unexpected earnings
yield, on average, will tend to be a smaller fraction of the cross-sectional
variation in X,-,.,/P, _rwhen earnings are aggregated, i.e., as the measurement
interval is increased. Variation due to expected earnings yield, on the other
hand, will constitute an increasing fraction of the cross-sectional variation in
X, r,, /Pr _r.Therefore the cross-sectional price-earnings association will also be
due increasingly to cross-sectional differences in expected earnings yields. As
noted above, variation in expected return (and therefore expected earnings yield)
does not bias earnings response coefficient estimates.
We estimate the following time series model for each firm i:
PirlPit-r = YiOr + ;(ilrXir~r.tlPit-r + &ir, (3)
where r = one, two, or three quarters or one, two, three, or four years and
Xir_r,, = firm i’s earnings from t - T to t. When 5 = two quarters, earnings for
two quarters are summed, and when 5 = two years, annual earnings for two
years are summed.
In estimating (3), data availability requirements are more restrictive than
using only annual earnings. As a result, sample sizes decline substantially with
longer price-earnings measurement windows. To the extent expected rates of
return differ across the samples, the estimated earnings response coefficients are
not strictly comparable. Because the smaller samples at the longer measurement
intervals are likely to consist of larger-sized firms with relatively low expected
rates of return, ceteris parihus, their earnings response coefficients are expected
‘?3nce expected returns are positively autocorrelated and mean reverting [e.g., Fama and French
(1988) and Poterba and Summers (1988)], there is relatively less variation in expected returns
through time over longer measurement intervals.
Table 3
relatives on contemporaneous earnings deflated by price. Earnings measurement interval ranging
from one quarter to four years. One-, two-, and three-quarter priceearnings data are from 1979-88
and annual and longer-interval data are from 1950-88. Sample sizes are from 1,002 to 2,721 firms.”
PeIP,,+, = ‘ii07 + BiI~Xit-LIIPil-i + sitb.C
Earnings measurement interval
1 qtr 2 qtrs 3 qtrs 1 year 2 years 3 years 4 years

Minimum _ 0.21 - 1.35 - 0.81 - 1.31 - 3.79 - 2.70 - 2.92
10th percentile 0.82 0.67 0.55 0.6 1 0.32 0.14 0.03
Median 1.01 0.99 0.99 0.96 0.86 0.84 0.75
90th percentile 1.07 1.14 1.21 1.18 1.34 1.47 1.42
Maximum 1.60 1.44 2.02 3.27 5.17 3.56 3.16
Mean 0.97 0.94 0.93 0.92 0.84 0.82 0.74

Std. error 0.0032 0.0055 0.0076 0.0057 0.0102 0.0150 0.0203
N 1,948 1,660 1,536 2.721 2,045 1,535 1.002
Panel B: Annualized slope coejicient estimatesd
Minimum - 7.11 - 11.29 ~ 7.41 - 21.01 - 19.59 - 33.58 - 10.80

10th percentile 0.60 0.27 - 0.06 0.06 - 0.36 - 0.95 - 1.06
Median 1.03 1.39 1.80 1.89 3.53 3.96 4.15
90th percentile 3.17 5.29 7.43 5.78 9.31 11.52 11.79
Maximum 35.27 68.08 128.88 60.60 57.03 62.37 58.95
Mean 1.58 2.28 2.97 2.56 4.23 4.90 4.91

Std. error 0.0450 0.0879 0.1302 0.0701 0.1102 0.1702 0.2161
“For the one-, two-, and three-quarter interval price-earnings data, any firm that had earnings
data on the Compustat quarterly tape and return data on the Center for Research in Security Prices
monthly tape for five nonoverlapping measurement intervals during 1979-88 is included. For the
annual and longer measurement intervals, the Compustat Annual Industrial and the Compustat
Annual Research tapes are used from 1950-88.
bX.,,_,,,/Pi,_, = primary earnings per share before extraordinary items and discontinued opera-
tions, summed over the relevant measurement interval r and then divided by the price at the
beginning of the earnings measurement interval. Price relative P,/Pt_, = one plus the buy-and-hold
return, inclusive of dividends, over the interval t - Tto t. All earnings and price data are adjusted for
stock splits, stock dividends, and dividend payments,
‘The model is estimated by modeling the residuals from the ordinary least squares regressions as
a first-order autoregressive process, and then ordinary least squares parameters are reestimated
using transformed variables.
“Annualized slope coefficient = [1 + r(y^,, - l)], where )l,r is the estimated coefficient from the
regressions. The annualized slope coefficients are deflated by 1.039 to control for bias stemming from
using dividend-reinvested returns.
158 S.P. Kothari and R.G. Sloun, I~formaiion in prices about future earnings
to be larger. Any increase in earnings response coefficient estimates with the

measurement interval is thus due to a better control for earnings anticipation as
well as changing sample composition.
Table 3 reports the results of estimating (3) using price-earnings data meas-
ured over intervals ranging from one quarter to four years. We report an-
nualized values of the earnings response coefficients. Assuming $rr is an estimate
of (1 + l/rr), where rr is the expected rate of return over a period of length
T (expressed as a fraction or multiple of one year), then [l + s(i,, - l)] is the
annualized coefficient estimate.
The average annualized fir using quarterly price-earnings data is 1.58, which
is small compared to the predicted earnings response coefficient of 6.83. When
the measurement interval is two quarters, the earnings response coefficient is
2.28, which is an improvement over the estimate using quarterly data. The
average coefficient increases to 2.56 at a one-year window and 4.91 when the
measurement window is four years.’ ’ The medians for the corresponding
measurement intervals are 1.89 and 4.15. Thus, the earnings response coeffi-
cients exhibit a substantial increase as a function of the measurement interval.
The average coefficients at all measurement intervals are, however, reliably
smaller than the predicted value of 6.83.
The results in table 3 are consistent with a reduced bias in earnings response
coefficient estimates as one increases the earnings and return measurement
interval. The results also suggest that a longer price-earnings window is not as
effective as including the leading-period return because longer price-earnings
mesurement windows do not fully incorporate earnings anticipation. This is
seen from a comparison of the earnings response coefficients reported in table
3 with those in table 2. Specifically, the average earnings response coefficient
estimates reported in table 2 are uniformly greater than those in table 3.
In summary, the results in this section suggest that increasing the price-
earnings measurement window helps reduce bias in earnings response coefficient
estimates, but is not as effective as including leading-period returns.
4.3. Diagnostic tests
4.3.1. Results using returns exclusive of dividends

The tests in this section assess whether the increase in the earnings response
coefficient estimates as leading-period returns are included is spurious. As seen
from the appendix, the earnings response coefficient is biased upwards by
“Somewhat surprisingly. the average coefficient for the three-quarter measurement interval is
2.97 which is greater than that for the annual measurement interval. This is due to a different sample
and time period for the quarterly earnings data compared to the annual and longer-interval earnings
data. The median earnings response coefficients, however, increase monotonically with the measure-
ment interval.
a factor of (1 + dividend yield)‘- ’ and the bias arises because of the asymmetric
effect of dividend payments on returns versus earnings. This bias should be
reduced if returns exclusive of dividends are used. We therefore repeat the entire
analysis using price relatives exclusive of dividends. If all firms’ dividend payouts
are lOO%, then it is easy to show that using returns excluding dividends leads to
an earnings response coefficient of l/r [see e.g., Beaver, Lambert, and Morse
(1980)-J. For a less than 100% divided payout, they predicted earnings response
coefficient is (1 - dividend payout + l/r). The estimated average coefficient
using returns excIuding dividends for none to three leading years are 2.41,4.35,
4.57, and 4.74. These magnitudes are uniformly smaller than those reported
above for the corresponding return measurement intervals in table 2, which
range from 2.56 to 5.45. As expected, the estimates using returns exclusive of
dividends are not smaller by one than those using with-dividends returns
because firms’ dividend payouts are less than 100%. The pattern of the earnings
response coefficient estimates as a function of leading-period returns, however, is
similar to that noted earlier.
We also estimate regressions by including up to nine leading years’ returns. As
more than three leading years’ returns are included in the analysis, the average
coefficient estimated using returns exclusive of dividends shows little systematic
increase. It changes from 4.74 when three leading years’ returns are included to
4.70 when six leading years’ returns are included to 4.64 when nine leading years’
returns are included. The corresponding medians are 3.75, 3.78, and 3.64. The
average and median coefficients are thus largely insensitive to including addi-
tional leading-period returns.
When more than three leading years’ returns inclusive of dividends are added,
the coefficient increases from 5.45 to 6.13 to 6.83 as three, six, and nine leading
years’ returns are included. This means the coefficient, on average, increases by
3.8% per year beyond three leading years. While it is not obvious whether this
small increase is a spurious one (because the sample size declines with additional
leading-period returns), it is too small to explain the increase in the average
coefficient from 2.56 when no leading-period return is included to 5.45 when
three leading years’ returns are included.12
We also assess whether the increase in the average coefficient is due to the
changing sample composition as leading period returns are included in the
analysis. We estimate earnings response coefficients for the subsample for which
price-earnings data are available over all the return mesurement intervals. We
obtain a sample of 1,669 firms. As none to three leading years’ returns are
included, the average coefficients for this sample are 2.52, 4.60, 4.88, and 5.07.
These coefficient values are very similar to those reported in table 2 where the
‘*A portion of the increase in the earnings response coefficient estimates could arise if the same
dividend yield is greater than the dividend yield for the CRSP equal-weighted portfolio that we use
in our adjustment.
sample composition changes with the return measurement interval. Therefore,

differences in the sample composition do not explain the increase in the average
earnings response coefficient.
4.3.2. Pooled time-series and cross-sectional regression results
We discuss results of pooled time-series and cross-sectional regressions with

none to three leading-years’ returns included to provide a comparison with
previous research [e.g., Collins and Kothari (1989)-j and give an indication of the
robustness of our findings against alternative specifications. The pooled regres-
sions constrain the earnings response coefficient to be a cross-sectional constant.
One obtains an unbiased, but statistically less precise estimate of the cross-
sectional mean earnings response coefficient. In estimating the pooled regres-
sions, we exclude 2% extreme observations because of their excessive influence
on the estimated regression.’ 3
When overlapping returns data are used, the earnings response coefficient
increases from 1.25 (standard error = 0.018) for the contemporaneous regres-
sion to 4.89 (standard error = 0.041) when returns over three leading years (i.e.,
T = 4) are included. The corresponding numbers using strictly nonoverlapping
data are 1.25 (standard error = 0.018) and 6.25 (standard error = 0.15). The
difference in the estimated coefficients obtained using overlapping and nonover-
lapping return data likely is due to a systematic difference in the two samples.
A sample selection bias is introduced because, when nonoverlapping data are
used and T = 4, only firms with a minimum of twenty years of continuous data
are included. These firms are relatively large market value firms. Previous
research suggests that expected returns and firm size are negatively correlated
[e.g., Banz (1981) Foster, Olsen, and Shevlin (1984) and Handa, Kothari, and
Wasley (1989)]. We therefore expect the larger, surviving firms’ average earn-
ings response coefficient to be larger. If the 11.8% realized return on the
CRSP value-weighted index from 1926688 was used as a proxy for r for this
sample, then the predicted earnings response coefficient for this sample would
be 9.48.
Overall, the pooled regressions yield coefficient estimates similar to the
cross-sectional average coefficient from the firm-specific time-series regressions.
The basic conclusion from both the analyses is that earnings response coefficient
estimates substantially increase with the inclusion of leading-period returns and
converge toward their predicted values.
“Since we report fractiles of the distribution of firm-specific coefficients, we do not exclude

extreme observations in the analysis discussed earlier.
S.P. Kothari and R.G. Sloan, frzformafion in prices aboul future earnings 161
4.3.3. Results of including the market return in price-earnings regressions
We next report the results of estimating a model similar to (2) except that the
return on the market is also included as an explanatory variable.14 The motiva-
tion for including the market return variable is threefold: (i) The average
cross-correlation among the residuals will be closer to zero when the market
return is included as an independent variable. The standard error of the sample
mean of the earnings response coefficients will then be less biased due to
cross-sectional correlation, which will enable us to perform more reliable statist-
ical significance tests of the average earnings response coefficient. (ii) If some of
the price movement is not explained by the earnings variable, but is related to
the market return, then potentially statistically more precise estimates of the
earnings response coefficients are possible by including the market return
variable [see Sloan (1993) for evidence]. The standard error of the average
earnings response coefficient is therefore likely to decrease with the inclusion of
the market return variable as an additional independent variable. (iii) Since
many researchers use market- and risk-adjusted returns in estimating the
earnings response coefficient [e.g., Kormendi and Lipe (1987)], our analysis
facilitates comparison with their results.
Table 4 reports results of including R,,_,,, as an additional explanatory
variable, where R,, _ I. t is the CRSP equal-weighted return including dividends
from t - 5 to t, obtained by summing monthly returns over the period from
t - t to t. The results in table 4 are similar to those reported in table 2. The
average earnings response coefficient increases from 1.96 when no leading-
period return is included to 4.49 when the three-year leading return is included.
The average and median earnings response coefficients are smaller than those in
table 2 at all lengths of leading-period returns. The standard errors of the
average earnings response coefficients are very similar to the corresponding
standard errors reported in table 2.
The average coefficient on the market return, yZr, is the estimated relative risk
(beta) of the average stock in the sample. At first glance, it is puzzling to find the
average security in our sample is considerably less risky than the market,
especially when leading-period returns are included. For example, the average
jZr is 0.92 for the annual contemporaneous regression and it is only 0.66 when
three-year leading returns are included. It is likely that glr and fZr are affected by
14An alternative approach would be to regress market and risk adjusted returns on correspond-
ingly adjusted earnings. Our approach is econometrically preferable to the alternative two-stage
approach which is likely to yield biased estimates [see Beaver (1987)]. Moreover, in the alternative
two-stage approach the test period would be shorter than that examined here. The reason is that the
two-stage approach entails estimating the market model parameters separately for the security-
return-generating process and the earnings-generating process. This estimation will use up data over
the initial few years from 1950 which then cannot be included in the test period.
162 S.P. Kothari and R.G. Sloan, Information in prices about,future earnings
Table 4
relatives on earnings deflated by price and market return including dividends. Earnings measure-
ment interval is one year and price relatives are for the contemporaneous one year and for periods r
that include leading years. Annual earnings data from 1950-88. Sample sizes from 2,319 to 2,721
5=1 5=2 r=3 r=4
Minimum - 1.64 - 2.87 _ 17.40 - 9.60

10th percentile 0.56 0.31 0.11 - 0.03
Median 0.86 0.71 0.65 0.60
90th percentile 1.06 1.04 1.32 1.18
Maximum 4.70 5.39 9.66 9.41
Mean 0.84 0.69 0.61 0.58
Std. error 0.0054 0.0083 0.0167 0.0146
N 2,72 1 2,588 2.47 1 2,319
Panel B: Cot$icient on earninys
Minimum - 31.61 - 48.58 28.23 - 38.51

10th percentile - 0.09 0.22 0.27 0.22
Median 1.36 2.80 3.25 3.43
90th percentile 4.82 7.90 9.33 10.26
Maximum 60.55 100.16 91.52 81.90
Mean 1.96 3.59 4.3 1 4.49
Std. error 0.0662 0.095 1 0.1095 0.1104
Panel C: Coeficient on rhe market return
Minimum 10.56 ~ 7.23 ~ 9.48 - 4.93

10th percentile 0.25 0.13 ~ 0.04 - 0.05
Median 0.82 0.65 0.55 0.51
90th percentile 1.74 2.13 1.60 1.58
Maximum 8.15 5.58 24.34 10.62
Mean 0.92 0.75 0.68 0.66

Std. error 0.0151 0.0154 0.0222 0.0186
“Sample selection: Any firm that has earnings data on the Compustat Annual Industrial or
Research tape for five consecutive years during 1950-88 and return data for the earnings measure-
ment years and the three leading years is included. The return observations contain overlapping
periods when one or more years of leading-period returns are included.
bEarnings yield X,/P,_, = primary annual earnings per share before extraordinary items and
discontinued operations for year t. divided by the price at the beginning of the return measurement
Price relative P,/P,_, = one plus the buy-and-hold return, inclusive of dividends, over the years
t - T to t. R,,_,,, = CRSP equal-weighted return including dividends over years t - T to t.
‘The model is estimated by modeling the residuals from the ordinary least squares regressions as
a first-order autoregressive process and then ordinary least squares parameters are reestimated
using transformed variables. The estimated slope coefficients are deflated by (1.039Y’ to control for
bias stemming from using dividend-reinvested returns.
a positive correlation between the market return and the earnings variable,
particularly when leading-period return is included. To verify that the sample
firms’ average beta risk is not unusually small, we reestimate firm-specific
regressions without the earnings variable included as an independent variable.
That is, we estimate the market model for each firm using annual returns. The
average market model beta of the sample firms then is 1.01.
4.3.4. Sensitivity to alternative estimation procedures and statistical tests
This section assesses whether our inferences are sensitive to alternative es-
timation procedures and statistical tests. We estimate ordinary least squares
coefficients without making an adjustment for autocorrelated errors. Since the
ordinary least squares estimates are unbiased, the average coefficients should be
similar to those reported earlier. The average coefficients when one to three
leading years’ returns are included are 4.67, 5.07, and 5.67.
Earlier in this section, we tested whether the average estimated coefficient
equals its predicted value using a t-test. An alternative test is based on the
sample distribution of the firm-specific estimated t-statistics. For each firm
a t-statistic is calculated to test the null hypothesis that the firm’s earnings
response coefficient equals the predicted value of 6.83. By aggregating these
t-statistics, we then calculate a Z-statistic to test the null hypothesis that the
average estimated coefficient equals its predicted value of 6.83 [see, e.g., Heady,
Kang, and Palepu (1987) for a description of this test]. This test weights each
coefficient by the precision with which it is estimated, as compared to an equal
weight in the t-test of the sample mean coefficient. The estimated Z-statistic also
rejects the hypothesis that the estimated average coefficient equals its predicted
value when none to three leading-year returns are included.
4.3.5. EfSect of’ the post-earnings-announcement drift in abnormal returns
In this section we perform tests to incorporate the implications of the

post-earnings-announcement drift in abnormal returns [see Bernard and
Thomas (1989) for recent evidence] for earnings response coefficient estimates.
We are motivated to perform this analysis by the previous, anomalous empirical
evidence, rather than rational, economic reasoning. Under the maintained
hypothesis of market efficiency, the Capital Asset Pricing Model, and constant
expected rates of returns, future returns should not be related to the current
period’s earnings surprise. We estimate (2) with a three-year leading-period
return, but also include return over approximately a nine-month period beyond
the earnings announcement dates (i.e., one year beyond the fiscal year-end). The
estimated average earnings response coefficient increases to 6.92 and the median
to 5.56. Much of this increase occurs when return over the first three months
164 S.P. Kothari and R.G. Sloan, Information in prices about ,futureearnings
following the earnings announcement is included in the analysis. This is consist-

ent with Bernard and Thomas (1989), who report that the drift is pronounced
over a three-month post-earnings-announcement period and virtually all of it
occurs over a 180-trading-day period (i.e., about nine months).
5. Conclusions and implications
We examine the implications of returns anticipating future earnings changes

for price-earnings relations. Returns tend to lead earnings changes because the
historical cost accounting measurement process is not designed to fully reflect
expectations of future net cash flows on a timely basis. As a result the commonly
estimated price-earnings regression of contemporaneous annual returns on
earnings changes is misspecified and the earnings response coefficient estimates
are biased towards zero. We argue that including the leading-period return
should ameliorate the missspecification and the estimated earnings response
coefficients should increase.
Our empirical results are consistent with this prediction. We provide evidence
that earnings response coefficient estimates are sensitive to the inclusion of
leading-period returns. The coefficient more than doubles as leading-period
returns are included in the price-earnings regression. The resulting average
earnings response coefficient estimate is consistent with the previously
documented time series properties of annual earnings. We also estimate pricee
earnings regressions using returns and earnings measured over longer
contemporaneous windows. The results suggest that longer measurement inter-
vals yield less biased estimates of earnings response coefficients, but this ap-
proach is not as effective as including the leading-period return. The reason is
returns measured over longer intervals do not completely incorporate earnings
anticipation, unless, of course, the measurement interval coincides with the life
of a firm.
In this study we focus on earnings response coefficients estimated using
returns measured over a fairly long interval (e.g., one quarter or longer). Some
researchers estimate a short-window earnings response coefficient using two-
day earnings-announcement period returns and a proxy for the market’s earn-
ings expectation at the start of the two-day return window. Even if accurate
proxies for the market’s earnings expectation were available, we expect the
short-window coefficients to differ from the long-window ones because the
nature of earnings information probably changes in event time. The two-day
announcement period information is likely to include the effects of restructuring
charges, accounting changes, plant closings, etc. which could be less persistent
(i.e., nonrecurring) than information about earnings released in earlier time
periods.
This study has several implications for related research. First, our findings
have implications for the research seeking to explain cross-sectional variation in
earnings response coefficients. The observed cross-sectional variation in earn-

ings response coefficients, estimated using contemporaneous, annual measure-
ment interval data, could stem from variation in the degree to which prices
lead earnings as well as ‘true’ variation in earnings response coefficients (e.g.,
due to variation in earnings persistence and expected return). More meaningful
inferences, therefore, are possible if the effects of these two sources of variation
are isolated and controlled. A fruitful avenue for future research would be to
explore cross-sectional differences in the degree to which prices lead earnings as
a function of the nature of a firm’s production, investment and financing policies
as well as accounting method choices. Industry membership and a firm’s life
cycle phase could serve as instruments for these cross-firm differences. Recent
evidence in Rao (1991), Anthony and Ramesh (1992), and Lang (1991)
suggests that a firm’s life cycle phase (e.g., a newly-public, growth firm
versus a mature firm) affects the priceeearnings relation and earnings response
coefficients.
A second avenue for future research would be to examine whether the
importance of leading-period returns is reduced by incorporating financial
statement information in addition to earnings. Lev and Thiagarajan (1991) and
Ou and Penman (1989) are recent examples of studies that document significant
information content (i.e., association with returns) of financial statement data in
addition to earnings. This suggests that conditioning earnings expectation on
other balance sheet and income statement data items, footnote disclosures (e.g.,
information on loss contingencies), and finally ‘management’s outlook’ type of
information will be helpful in forecasting earnings changes. Focusing only on
the earnings number is likely to overstate the degree to which returns anticipate
the information in a firm’s financial statements.
Finally, there has been considerable recent interest in identifying the reasons
for the observed low contemporaneous priceearnings association documented
in previous research using quarterly or annual earnings data [e.g., Lev (1989)
and Easton et al. (1992)]. ‘Low earnings quality’ sometimes is offered as the
primary reason [e.g., Lev (1989)]. Low earnings quality is generally claimed to
be due to ‘the impact of accounting techniques and occasionally management
manipulation’ [Lev (1989, p. 175)]. Evidence in this paper suggests that antici-
pation of future earnings changes impounded in returns is an important deter-
minant of the price-earnings association that has been relatively unexplored.
Moreover, we do not think that information impounded in security prices about
future earnings changes is an indication of ‘earnings quality’ and/or ‘deficiency’
of historical cost measurement. In this regard, we emphasize that unless we
understand the role of accounting earnings or financial statement information in
the context of security markets, competing sources of information, and bond-
holder-shareholder or management-shareholder contracts, it would be pre-
mature to conclude that we should alter the accounting mesurement process to
improve the contemporaneous price-earnings association.
Appendix
The objective is to assess whether the earnings response coefficient spuriously

increases with the inclusion of leading-period return, by examining the effect of
including leading-period return in the price-earnings regression when prices are
assumed not to lead earnings. If, under this stylized setting, the earnings response
coefficient estimate is unaffected by including return over the leading period,
then concern that the observed increase in earnings response coefficient esti-
mates is spurious is mitigated.
We begin with a stylized, constant price-earnings ratio model that can be
obtained by assuming constant expected returns, earnings follow a random
walk, and returns do not anticipate future earnings changes. The price-earnings
relation then is given by (firm-specific subscript is suppressed):
P,IP,-I = Yo + i’lX,lP,-1 + Et, (A.11

where P,/P,_ 1 is return inclusive of dividends over period t, X,/P,_ 1 is earnings
over period t deflated by price at the end of period t - 1, and ‘pi = (1 + l/r). We
assess whether the slope coefficient is expected to differ from (1 + l/r) when (A.l)
is modified to include leading-period returns in the dependent variable.
We initially assume firms do not pay dividends. Earnings through time thus
reflect the effect of reinvesting all earnings in each period. The empirical analog
of the price-earnings eq. (A.l) is estimated, then the earnings response coefficient
estimate, pi, is
j1 = COWIP,-~, P,lP,-l)var(X,lP,-l) (A.21
and
E(Y,) = (1 + l/r),
which means a one-period, contemporaneous price-earnings regression yields

an unbiased earnings response coefficient estimate.
On including leading periods’ return, the price-earnings regression becomes
P,lP,-, = ?i’o + ;‘lX,IP,-, + E,, (A.3)
where E($,) = (1 + l/r) in the absence of any bias. The estimated coefficient
from (A.2) is
4
, 1 = coWIPt-,, P,lP,-,)lvar(X,lP,-,)
= covc(x,~p,-1)(p,-llp,-,)~(p~lp,-l)(p,-llp,-,)1
(A.4)
varC(X,/P,- 1 HP,- I P-,)1
S.P. Kothari and R.G. Sloan. Irzformarion in prices about future earnings 167
Focusing on the numerator of (A.4) the covariance term is simplified by noting

that (i) X,/P, _ 1 and P, _ 1/P, _r are uncorrelated because prices, by assumption,
do not lead earnings, and (ii) price relatives are serially uncorrelated. Therefore,
the covariance term is expanded as
- E(X,l~,-,)E(P,l~,-,)CE(P,,/P,_,)12.
To simplify the above expression, we substitute:
UX,IP,- 1 I= r,
W/P,- I) = (1 + r),
var(P, /PI _ 1) = 13,
EC(P,/P,- 1)21 = [a2 + (1 + rJ21,
E[(Pl/P,_,)2] = [a2 + (1 + r)‘]‘.
After substituting and rearranging terms, we obtain
covc(x,lp,- 1 )(P,- 1/Pt-71,(P,lPt- 1w- 1 P-,)1
=cov[X,/P,_,,P,/P,_,]*{[l +r2/a2][02+(1 +r)2]r-1
- (r2/c2)(1 + r)‘+ “1. (A.5)
The denominator of (A.4) is simplified similarly to obtain
= var(X,/P,_ 1)* { [l + r2/r7’][f12 + (1 + r)‘lr-l
- (r2/a2)( 1 + r)2(r- lb}. 64.6)
The ratio of (A.5) to (A.6) yields the earnings response coefficient estimate whose
expectation is
WI) = E{cov[XtIPt-l, ~,lp,-ll/var(X,l~,-l)} = yl, (A.7)
which means there is no bias introduced by including leading-period returns.

168 S.P. Koihari and R.G. Sloan, hfomation in prices about ,furure earnings
In the more realistic case of firms paying dividends, earnings through time
represent earnings on the initial equity and earnings on the increase in equity
through earnings retention (i.e., less than 100% dividend payout). The return
variable, on the other hand, assumes dividends are reinvested and thus is
unaffected by dividend payments (except for a small effect of the assumption
with respect to the rate of return on reinvested dividends). Under these circum-
stances, the estimated coefficient is
(A.81
Eq. (A.8) is simplified by decomposing with-dividend returns into capital ap-

preciation and dividend yield as follows:
P,lP,-r 2 (p,/p,_,)( 1 + dividend yield)‘, (A.9)
where pt /pt r = buy-and-hold return exclusive of dividends (i.e., capital appreci-

ation) and dividend yield = geometric average realized dividend yield over
T periods. Using (A.8) it is easy to see that q1 is biased upwards because only the
covariance is affected by the dividend yield, whereas the variance term in the
denominator is the same as before. Specifically, if leading-period returns are not
included, then
?I = COWIP,-~, p,lP,- 1 )/var(X,lP,- 1 ), (A.lO)
and if leading-period returns are included, then
T1 = COV(X,IP~-~,P,lp,-,)lvar(X,lp,-,) (A. 11)
= ~~~C(X,IP,-,)(P,-,~P,-,),(~,/P,~,)(P,-,/P,-,)(~ + dividend yielW’1

varC(X,lp,-l(p,-llp,-,)l
Eq. (A.1 1) can be simplified to show that
E(yl) = yT[I + dividend yield]‘-‘, (A.12)
where dividend yield is the realized dividend yield over one period, which is
assumed constant through time. Eq. (A.12) reveals that the earnings response
coefficient estimate will be biased upwards and the bias is approximately equal
to the compounded dividend yield over the leading-return period. We adjust the
estimated earnings response coefficients for the bias stemming from using
returns inclusive of dividends.
S.P. Korhari and R.G. Sloan, Information in prices about &we earnings 169
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Journal of Accounting and Economics 15 (1992) 143-171.

Information in prices about future earnings

Implications for earnings response coefficients*

Received April 1990, final version received February 1992

0165-4101/92/$05.00 0 1992-Elsevier Science Publishers B.V. All rights reserved

Rit = YOi + yli UEi* + &it 9 (1)

returns are as important as contemporaneous returns in terms of their sensitivity

2. Implication of accounting principles for earnings response coefficients

In an efficient market, price changes reflect the revision in the market’s

underlie GAAP limit accounting earnings’ ability to contemporaneously reflect

t-3 t-2 t-1 t

we include leading-period returns. We estimate the price-earnings relation using

Pit/Pit-r = l’i0 + 7il xillpitp* + &it3

t - r to the end of t, and r > 1 so that leading-period returns are included in

3. Data, sample selection, and descriptive statistics

3.2. Sample selection and descriptive statistics

1 year 2 years 3 years 4 years

4.1. Leading-period returns' effect on earnings response coefficient estimates

f o c u s o n t h e effect o f u p t o t h r e e l e a d i n g y e a r s ' r e t u r n s (i.e., r < 4) f o r t w o

r=l r=2 r=3 r=4

Panel A: Intercept estimates

Panel B: Coefficient on earnings

We conjecture earnings response estimates are than

Earnings response sensitivity to price-earnings

‘Kormendi Lipe (1991) that collectively higher-order negative correlations

PirlPit-r = YiOr + ;(ilrXir~r.tlPit-r + &ir, (3)

Earnings measurement interval

1 qtr 2 qtrs 3 qtrs 1 year 2 years 3 years 4 years

Panel A: Intercept estimates

Mean 0.97 0.94 0.93 0.92 0.84 0.82 0.74

N 1,948 1,660 1,536 2.721 2,045 1,535 1.002

Panel B: Annualized slope coejicient estimatesd

Minimum - 7.11 - 11.29 ~ 7.41 - 21.01 - 19.59 - 33.58 - 10.80

Mean 1.58 2.28 2.97 2.56 4.23 4.90 4.91

to be larger. Any increase in earnings response coefficient estimates with the

4.3. Diagnostic tests

4.3.1. Results using returns exclusive of dividends

sample composition changes with the return measurement interval. Therefore,

4.3.2. Pooled time-series and cross-sectional regression results

We discuss results of pooled time-series and cross-sectional regressions with

“Since we report fractiles of the distribution of firm-specific coefficients, we do not exclude

4.3.3. Results of including the market return in price-earnings regressions

5=1 5=2 r=3 r=4

Panel A: Intercept estimates

Minimum - 1.64 - 2.87 _ 17.40 - 9.60

Panel B: Cot$icient on earninys

Minimum - 31.61 - 48.58 28.23 - 38.51

Panel C: Coeficient on rhe market return

Minimum 10.56 ~ 7.23 ~ 9.48 - 4.93

Mean 0.92 0.75 0.68 0.66

4.3.4. Sensitivity to alternative estimation procedures and statistical tests

4.3.5. EfSect of’ the post-earnings-announcement drift in abnormal returns

In this section we perform tests to incorporate the implications of the

following the earnings announcement is included in the analysis. This is consist-

5. Conclusions and implications

We examine the implications of returns anticipating future earnings changes

earnings response coefficients. The observed cross-sectional variation in earn-

The objective is to assess whether the earnings response coefficient spuriously

P,IP,-I = Yo + i’lX,lP,-1 + Et, (A.11

j1 = COWIP,-~, P,lP,-l)var(X,lP,-l) (A.21

which means a one-period, contemporaneous price-earnings regression yields

P,lP,-, = ?i’o + ;‘lX,IP,-, + E,, (A.3)

Focusing on the numerator of (A.4) the covariance term is simplified by noting