Earnings Quality and the Equity Risk Premium: A Benchmark Model

50 Pages Posted: 15 Nov 2005  

Kenton K. Yee

Mellon Capital Management

Abstract

This article solves a model that links earnings quality to the equity risk premium in an infinite-horizon consumption CAPM economy. In the model, risk-averse traders hold diversified portfolios consisting of a risk-free bond and shares of many risky firms. When constructing their portfolios, traders rely on noisy reported earnings and dividend payments for information about the risky firms. A new element of the model is an explicit representation of earnings quality based on reversing accrual errors that investors cannot observe. The model shows that earnings quality magnifies fundamental risk. Absent fundamental risk, poor earnings quality cannot affect the equity risk premium. Moreover, only the systematic (undiversified) component of earnings quality risk contributes to the equity risk premium. In contrast, all components of earnings quality risk affect earnings capitalization factors. The model ties together consumption-CAPM and accounting-based valuation research into one benchmark formula linking earnings quality to the equity risk premium and earnings capitalization factors.

Keywords: Information quality, cost of capital, risk, return, diversification, earnings, valuation

JEL Classification: M41, M43, M49, G12, G13, G14, G31, G34

Suggested Citation

Yee, Kenton K., Earnings Quality and the Equity Risk Premium: A Benchmark Model. Contemporary Accounting Research, Vol. 23, No. 3, pp. 833-877, Fall 2006. Available at SSRN: https://ssrn.com/abstract=921914

Kenton K. Yee (Contact Author)

Mellon Capital Management ( email )

50 Fremont Street, #3819
San Francisco, CA 94105
United States
415-975-3565 (Phone)

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