How Do Accounting Variables Explain Stock Price Movements? Theory and Evidence

Abstract

This paper provides theory and evidence showing how accounting variables explain cross-sectional stock returns. Based on Zhang (2000), who relates equity value to accounting measures of underlying operations, we derive returns as a function of earnings yield, equity capital investment, and changes in profitability, growth opportunities and discount rates. Empirical results confirm the predicted roles of all identified factors. The model explains about 20% of the cross-sectional return variation, with cash-flow-related factors (as opposed to changes in discount rates) accounting for most of the explanatory power. The properties of the model are robust across various subsamples and periods.

Keywords: Stock return, Accounting variables, Earnings yield, Profitability (ROE), Capital investment, Growth opportunity

JEL Classification: M41, G12, G14