How Do Earnings Numbers Relate to Stock Returns? A Review of Classic Accounting Research with Updated Evidence
D. Craig Nichols and James M. Wahlen
SYNOPSIS: An extensive body of academic research in accounting develops theory and empirical evidence on the relation between earnings information and stock returns. This literature provides important insights for understanding the relevance of financial reporting. In this article, we summarize the theory and evidence on how accounting earnings information relates to firms stock returns, particularly for the benefit of students, practitioners, and others who may not yet have been exposed to this literature. In addition, we present new empirical evidence on the relation between earnings and returns by replicating and extending three classic studies using data from 1988 through 2002. Specifically, we first demonstrate the relation between earnings changes and stock returns, replicating Ball and Brown (1968), and we compare that relation to the relation between changes in cash flows from operations and stock returns. Second, we demonstrate the impact of earnings persistence on stock returns, extending findings from studies such as Kormendi and Lipe (1987), and highlighting the effects of differences in persistence across earnings increases and decreases. Third, we provide evidence to assess the efficiency with which the capital markets impound quarterly earnings information into share prices, showing that the post-earnings-announcement-drift results of Bernard and Thomas (1989) extend to recent data.
E
INTRODUCTION arnings (or more precisely, accounting net income) represents the bottom-line accounting measure of firm performance. A firms earnings number is an accrual accounting measure of the firms profit or loss from business activities and events during a quarter or annual period. A firms earnings number represents an accounting measure of the
References: 04_Nichols-Wahlen.pmd 285 11/8/2004, 11:03 AM 286 Nichols and Wahlen compensation. The Accounting Review 73 (April): 235–253. Hayn, C. 1995. The information content of losses. Journal of Accounting and Economics 20: 125–153. Healy, P., and J. Wahlen. 1999. A review of the earnings management literature and its implications for standard setting. Accounting Horizons 13 (December): 365–383. Kormendi, R., and R. Lipe. 1987. Earnings innovations, earnings persistence, and stock returns. Journal of Business 60: 323–345. Kothari, S. P. 2001. Capital markets research in accounting. Journal of Accounting and Economics 31: 105– 231. Lee, C. M. C. 1999. Accounting-based valuation: Impact on business practices and research. Accounting Horizons 13: 413–425. ———. 2001. Market efficiency and accounting research: A discussion of “Capital markets research in accounting,” by S. P. Kothari. Journal of Accounting and Economics 31: 233–253. Lev, B. 1989. On the usefulness of earnings and earnings research: Lessons and directions from two decades of empirical research. Journal of Accounting Research (Supplement): 153–192. Libby, R., R. Bloomfield, and M. Nelson. 2002. Experimental research in financial accounting. Accounting, Organizations and Society 27: 775–810. Lipe, R. 2001. Lease accounting research and the G4+1 proposal. Accounting Horizons 15 (September): 299– 310. Nelson, M. 2003. Behavioral evidence on the effects of principles- and rules-based standards. Accounting Horizons 17 (March): 91–104. Ohlson, J. 1995. Earnings, book values, and dividends in equity valuation. Contemporary Accounting Research 11: 661–688. Scott, W. 2003. Financial Accounting Theory. Third edition. Toronto, Ontario: Prentice Hall. Watts, R., and J. Zimmerman. 1986. Positive Accounting Theory. Upper Saddle River, NJ: Prentice Hall. Accounting Horizons, December 2004 04_Nichols-Wahlen.pmd 286 11/8/2004, 11:03 AM