Extracting Sustainable Earnings from Profit Margins

49 Pages Posted: 24 Oct 2012

See all articles by Eli Amir

Eli Amir

Tel Aviv University

Eti Einhorn

Tel Aviv University

Itay Kama

University of Michigan, Stephen M. Ross School of Business

Date Written: October 23, 2012

Abstract

Revenues and expenses are fundamentally proportional to one another, but are likely to be disproportionally affected by transitory items or economic shocks. We build on this observation and propose a new measure of sustainable earnings based on deviations from normal profit margins. While some other sustainable earnings metrics attempt to identify transitory components on a line-by-line basis, our measure, referred to as the intensity of core earnings, uses ratio analysis to extract the transitory portion of earnings from all line items. We find that the intensity of core earnings, as measured here, is positively associated with earnings persistence, better earnings predictability, and stronger market reaction to unexpected earnings. We also find that our measure is positively associated with post-earnings announcement excess stock returns. Comparing our measure with an accrual-based measure of earnings quality, we find that, in general, the two metrics provide distinct incremental information relative to one another and in some instances our measure is better than an accrual-based measure in assessing earnings quality.

Keywords: Earnings Quality, Sustainable Earnings, Profit Margins, Ratio Analysis, Earnings Persistence, Analysts Forecast

JEL Classification: G14, M41

Suggested Citation

Amir, Eli and Einhorn, Eti and Kama, Itay, Extracting Sustainable Earnings from Profit Margins (October 23, 2012). European Accounting Review, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2166019

Eli Amir

Tel Aviv University ( email )

312 Recanati Bldg.
69978 Tel Aviv
Israel
+972 3 640-8510 (Phone)
+972 3 640-7738 (Fax)

Eti Einhorn

Tel Aviv University ( email )

P.O. Box 39010
Ramat Aviv, Tel Aviv, 69978
Israel

Itay Kama (Contact Author)

University of Michigan, Stephen M. Ross School of Business ( email )

701 Tappan Street
Ann Arbor, MI MI 48109
United States
734-763-4538 (Phone)

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