Research paper review . How do earnings relate to stock returns?
Research Paper Review
“How do earnings numbers relate to stock returns?”
By D. Craig Nichols and James M. Wahlen
Written by Tra My Nguyen
Student ID 24458
Submission date 27 March 2014
Submitted to Mr John Mulenga
Financial Statement Analysis Module
Review’s layout:
I. Main contribution the research paper
II. Summary of the findings
Research Paper Review
The research paper summarized the theory and empirical evidence on the relationship between accounting earnings of a firm and its stock returns.
The theory was developed based on Beaver’s (1998) three-links relating earnings to stock returns.
The first link assumed that the current accounting earnings reflect the current wealth creation of the firm and help predict its future earnings.
The second link assumed that the current accounting earnings together with predictions of future earnings provide insight into the firm’s dividend-paying ability, that is, shareholders’ expectations of future dividends.
The third link uses the expectations of future dividends to determine the present value of the future dividends, which ultimately represents the stock returns.
So all in all, the three-links theory uses the current accounting earnings as a basis for prediction of future earnings, which then indicates the expectation of future dividends, which is believed to represent the present value of stock returns.
The empirical evidence was developed using data from 1988 through 2002. The researchers replicated and extended the three classic studies related to the relationship between earnings and stock returns. All the findings served as empirical evidence for the three-links theory.
The first study, Ball and Brown (1968), aimed at showing the impact of annual earnings changes (increase or decrease) on the annual stock returns changes. The study was further extended to also examine the impact of changes in operating cash flows of a firm on its stock returns. The results showed that the
“How do earnings numbers relate to stock returns?”
By D. Craig Nichols and James M. Wahlen
Written by Tra My Nguyen
Student ID 24458
Submission date 27 March 2014
Submitted to Mr John Mulenga
Financial Statement Analysis Module
Review’s layout:
I. Main contribution the research paper
II. Summary of the findings
Research Paper Review
The research paper summarized the theory and empirical evidence on the relationship between accounting earnings of a firm and its stock returns.
The theory was developed based on Beaver’s (1998) three-links relating earnings to stock returns.
The first link assumed that the current accounting earnings reflect the current wealth creation of the firm and help predict its future earnings.
The second link assumed that the current accounting earnings together with predictions of future earnings provide insight into the firm’s dividend-paying ability, that is, shareholders’ expectations of future dividends.
The third link uses the expectations of future dividends to determine the present value of the future dividends, which ultimately represents the stock returns.
So all in all, the three-links theory uses the current accounting earnings as a basis for prediction of future earnings, which then indicates the expectation of future dividends, which is believed to represent the present value of stock returns.
The empirical evidence was developed using data from 1988 through 2002. The researchers replicated and extended the three classic studies related to the relationship between earnings and stock returns. All the findings served as empirical evidence for the three-links theory.
The first study, Ball and Brown (1968), aimed at showing the impact of annual earnings changes (increase or decrease) on the annual stock returns changes. The study was further extended to also examine the impact of changes in operating cash flows of a firm on its stock returns. The results showed that the