[This study adds to recent research that assesses the value implications of earnings changes. Stock price changes associated with reported earnings innovations (typically assessed by estimating earnings response coefficients) have been characterized as related to the persistence of earnings, which is defined as the revision in expected future earnings that is implied by a current earnings innovation. Permanent earnings innovations are associated with higher multipliers than transitory ones. This stream of research stems from Kormendi and Lipe (1987) and Easton and Zmijewski (1989). These studies characterize earnings persistence as a stationary, firm-specific phenomenon that describes the evolution of earnings over time. They estimate parameters of earnings persistence from time-series data on earnings and then show that the market's pricing of earnings innovations are related to the persistence measures. Typically, this evaluation involves ex post information, so the approach is not relevant for investors' ex ante determination of pricing multipliers. This article reports three findings on the pricing of annual earnings changes. First, pricing multipliers can be evaluated contemporaneously by other information published in annual financial statements along with earnings. An investor who seeks to assess persistence and the price effect of a reported earnings change can do so by referring to other information in the financial statements. Second, in contrast to previous research, this study shows that the earnings persistence indicated by financial statements is not a fixed attribute, but changes over time and tends to revert to the mean of all firms. Correspondingly, pricing multipliers follow a similar pattern, which requires their periodic updating through financial statement analysis. Third, the multiplier of earnings changes is also related to information published in the previous year's annual report. To the extent that previous accounting reports provide forecasts of earnings that are already incorporated in prices, multipliers are lower.]

[The paper demonstrates empirically that earnings prepared according to Generally Accepted Accounting Principles (GAAP earnings) have properties necessary to serve as a substitute for dividends in equity valuation analysis. Dividends reduce subsequent GAAP earnings, and "intrinsic" equity prices calculated by forecasting earnings are thus reduced by current dividends. This behavior is in accordance with the Miller and Modigliani principle-the displacement property-which states that the payment of dividends reduces prices, dollar for dollar. Further, the paper demonstrates that if this displacement is accommodated in calculating equity prices from forecasted GAAP earnings, those prices exhibit the dividend irrelevance property, that is, calculated prices are insensitive to future dividends. Forecasted GAAP earnings cannot be substituted for dividends, dollar for dollar, but the two are substitutes in the sense that the replacement value of expected dividends reduces forecasted earnings, dollar for dollar.]

This paper adds to recent evidence on market inefficiency in processing information in earnings reports. It documents that short positions taken in sample stocks which did not report earnings by the date expected during the sample period, 1971–1976, would have been abnormally profitable, before transaction costs. This is because late reports, on average, revealed bad news which was not anticipated in market prices prior to the report date. The magnitude of the average abnormal returns is in the order of 1.0% over 20 days but is larger for smaller firms in the sample and positively related to the length of the reporting delay. The paper also documents that long positions taken in stocks reporting early with good news would have generated abnormal returns of approximately 1.0% on average over a 20-day holding period.

A claim is commonly made that cash flow and accrual accounting methods for valuing equities must always yield equivalent valuations. A recent paper by Lundholm and O'Keefe 2001, for example, claims that, because of this equivalence, there is nothing to be learned from empirical comparison of valuation models. So they dismiss recent research that has shown that accrual accounting residual income models and earnings capitalization models perform, over a range of conditions, better than cash flow or dividend discount models. This paper demonstrates, with examples, that the claim is misguided. Practice inevitably involves forecasting over finite, truncated horizons, and the accounting specified in a model — cash versus accrual accounting in particular — is pertinent to valuation with finite-horizon forecasting. Indeed, the issue of choosing a valuation model is an issue of specifying pro forma accounting, and so, for finite-horizon forecasts, one cannot be indifferent to the accounting.

A claim is commonly made that cash flow and accrual accounting methods for valuing equities must always yield equivalent valuations. A recent paper by Lundholm and O'Keefe 2001, for example, claims that, because of this equivalence, there is nothing to be learned from empirical comparison of valuation models. So they dismiss recent research that has shown that accrual accounting residual income models and earnings capitalization models perform, over a range of conditions, better than cash flow or dividend discount models. This paper demonstrates, with examples, that the claim is misguided. Practice inevitably involves forecasting over finite, truncated horizons, and the accounting specified in a model — cash versus accrual accounting in particular — is pertinent to valuation with finite‐horizon forecasting. Indeed, the issue of choosing a valuation model is an issue of specifying pro forma accounting, and so, for finite‐horizon forecasts, one cannot be indifferent to the accounting.

It is common to apply multipliers to both earnings and book value to calculate approximate equity values. However, applying a price‐earnings multiplier or a price‐to‐book multiplier typically produces two valuations and the analyst is left with the question of how to combine them into one valuation. This paper calculates weights that combine the valuations and shows that these weights vary over the difference between earnings and book value, doing so systematically over time. When earnings are small compared to book value, the weights are different from when earnings are large relative to book value, and they vary in a nonlinear way over the difference between the two. The weights also combine forecasts of future earnings, based on earnings and book value separately, into one composite forecast. The paper calculates a second set of weights to ascertain how the two numbers are combined to forecast one‐year‐ahead earnings and three‐years‐ahead earnings. The calculated weights are applied out of sample to ascertain their predictive ability against other benchmarks.

Financial ratios, Price-Earnings Ratio, Market-to-Book ratios, Earnings Growth

Voluntary Disclosure, Earnings forecasts, Selective dissemination, Informational content

Stephen H. Penman, A Comparison of the Information Content of Insider Trading and Management Earnings Forecasts, The Journal of Financial and Quantitative Analysis, Vol. 20, No. 1 (Mar., 1985), pp. 1-17