The Relation between Incremental Subsidiary Earnings and Future Stock Returns in Japan

Abstract

Japanese firms report both parent-only and consolidated financial statements. Because of the unique business environment in Japan, there is a widely held view that parent-only data provides a better means for assessing the value of the entire firm. We find that both parent-only and subsidiary earnings are important in predicting future consolidated earnings. However, while stock prices accurately reflect the persistence of parent-only earnings, the Japanese stock market appears to underestimate the persistence of subsidiary earnings, causing a significant positive relation between changes in subsidiary earnings in year t and stock returns in year t+1. This relation between subsidiary earnings and future stock returns does not persist beyond year t+1. Taking a long (short) position in firms with large, positive (negative) changes in subsidiary earnings results in an average annual abnormal return of 7.06% with positive returns in 12 of the 13 years in the test period.

Keywords: Consolidated earnings, Parent-only earnings, Market efficiency, Mishkin model, Japan

JEL Classification: G14, G15, M41, N25