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.
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 change in the value of the firm to common equity shareholders during a period (apart from the effects of direct transactions with shareholders, such as paying dividends or issuing shares). A firms stock return, which equals the change in the firms market value over a period of time plus any dividends paid, represents the
D. Craig Nichols is a Ph.D. student and James M. Wahlen is a Professor, both at Indiana University Bloomington. We thank R. Ball, E. Hirst, and R. Lipe for helpful comments and discussions. We also thank I/B/E/S for providing analysts earnings forecast data.
Corresponding author: James M. Wahlen Email: email@example.com
Submitted: (please supply dates) Accepted: (please supply dates)
11/8/2004, 11:03 AM
Nichols and Wahlen
capital markets measure of the firms bottom line performance over a period of time. How do these bottom lines relate? How do accounting earnings numbers relate to stock returns? This is an important question for accountants and capital markets participants alike. Not surprisingly, the answer to this question provides deep insights into the economic relevance of financial accounting and reporting as a source of information about firm performance and value.1 Accounting academics have pursued the answer to this question since the landmark study of Ball and Brown (1968). Ball and Browns (1968) study of the association between accounting income numbers and changes in share prices in the capital markets triggered a shift in the accounting research paradigm.2 Since then, accounting academics have developed a large body of theory and assembled a wealth of empirical evidence on the relation between earnings and stock returns. In this article, our goal is to provide those who have not been previously exposed to this literature a straightforward introduction to the theory, research methods, and empirical evidence on the relation between accounting earnings and...