Earnings Quality and Stock Returns
Posted: 28 Feb 2005
An exclusive focus on bottom-line income misses important information about the quality of earnings. Accruals (the difference between accounting earnings and cash flow) are reliably, negatively associated with future stock returns. Earnings increases that are accompanied by high accruals, suggesting low-quality earnings, are associates with poor future returns. We explore various hypotheses - earnings manipulation, extrapolative biases about future growth, and under-reaction to changes in business conditions - to explain accruals' predictive power. Distinctions between the hypotheses are based on evidence from operating performance, the behavior of individual accrual items, discretionary versus nondiscretionary components of accruals, and special items. We check for robustness using within-industry comparisons, and data on U.K. stocks.
JEL Classification: G12, G14, M41, M43
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