An Analysis of Intertemporal and Cross-Sectional Determinants of Earnings Response Coefficients

Journal
of Accounting
and Economics
11 (1989) 143-181.
North-Holland
AN ANALYSIS OF INTERTEMPORAL AND CROSS-SECTIONAL DETERMINANTS OF EARNINGS RESPONSE COEFFICIENTS* Daniel W. COLLINS
University of low, Iowa Ci+, IA 52242, USA Duke lJniversi{v, Durhum, NC 37706, USA
S.P. KOTHARI
University of Rochester, Rochester, NY 1462 7, USA Received November 1987. final version received February 1989
Stock price change associated with a given unexpected earnings change (the earnings response coefficient) exhibits cross-sectional and temporal variation. We predict and document evidence that the earnings response coefficient is a function of riskless interest rates and the riskiness, growth and/or persistence of earnings. The earnings response coefficient also varies cross-sectionally with the holding period return interval. Collectively, our results explain the previously reported differential earnings response coefficient with respect to size. Moreover, by including the factors noted above, the empirical specification of the earnings/returns relation is significantly improved.
1. Introduction Considerable research has focused on the relation between security returns and unexpected earnings to assess the information content of the latter. Typically, inferences regarding the information content of earnings are based on the significance of the slope coefficient (b) and explanatory power (R*) of the following linear model estimated cross-sectionally and/or over time: CAR,, = a + bUXi, + ejt, where CAR if is some measure of risk-adjusted over period I, UX;, is a measure of unexpected return for security i cumulated earnings (appropriately scaled),
*This paper has benefited from workshop discussions at the University of Chicago, Iowa, Michigan, Minnesota, MIT, Ohio State, Rochester, the Stanford Summer Camp, and the International-Symposium on Forecasting at Boston. We acknowledge R. Ball, V. Bernard, L. Brown, S. Choi. P. Easton. J. Fellineham. G. Foster. T. Harris, P. Healv R. Kormendi, R. Leftwich, S. Linn. T. Linsmeier. B. Lipe. RrLundholm, J. Ohlson, B. Ricks, M. Weisbach, P. Wilson, R. Young, J. Zimmerman, M. Zmijewski, and especially R. Watts and S. Penman (the referee) for their comments on earlier versions of the paper. We are particularly grateful to Johannes Ledolter and Mike Rozeff for extended discussions.
01654101/89/$3.5001989,
Elsevier Science Publishers
B.V. (North-Holland)
144
D. W. Collins and S. P. Kothari, Variation in earnings response coefficients
and ei, is a random disturbance term assumed to be distributed N(0, u,). The slope coefficient, b, is called the earnings response coefficient (ERC).l Generally, the returns/earnings relation is investigated using either an events study or an association study method. The event studies infer whether the earnings announcement, per se, causes investors to revise their cash flow expectations as revealed by security price changes measured over a short time period (typically, 2-3 days) around the earnings announcement. Examples include Foster (1977), Hagerman, Zmijewski, and Shah (1984), and Wilson (1986, 1987). In essence, the focus is on whether earnings announcements convey information about future cash flows. In an association study, returns over relatively long periods (fiscal quarters or years) are regressed on unexpected earnings or other performance measures such as cash flows [Raybum (1986)] or replacement cost earnings [Beaver, Griffin, and Landsman (1982)] estimated over a forecast horizon that corresponds roughly with the fiscal period of interest. Association studies recognize that market agents learn about earnings and valuation-relevant events from many nonaccounting information sources throughout the period. Thus, these studies investigate whether accounting earnings measurements are consistent with the underlying events and information set reflected in stock prices. Typically, causality is not inferred. Rather, the focus is on whether the earnings determination process captures in a meaningful and timely fashion the valuation relevant events. Regardless of the perspective used, the bulk of the extant empirical literature assumes the returns/earnings relation is homogeneous across firms. The slope b in eq. (1) is treated as a cross-sectional and temporal constant. Recent studies relax this assumption to improve eq. (1)s specification and explanatory power [see, e.g., Beaver, Lambert, and Morse (1980) Ohlson (1983), Miller and Rock (1985) Kormendi and Lipe (1987), and Easton and Zmijewski (1989)]. By combining alternative valuation models with different earnings process assumptions these studies provide important insights into factors that explain variation in ERCs. This study provides further insights into factors contributing to differential ERCs in an annual association study context. In contrast to the previous work, we examine temporal as well as cross-sectional determinants of ERCs. The temporal variation in ERCs is hypothesized to be negatively related to the risk-free interest rate. We expect cross-sectional variation in ERCs to be positively related to earnings persistence and negatively related to firms systematic risk. In addition, we hypothesize that ERCs are positively related to growth opportunities that are not likely to be fully captured by persistence
In using the term response we do not imply causality. The term is used in a generic sense to measure the degree of comovement between security returns and shocks to an earnings series without necessarily implying that the latter cause the former. The distinction is made clearer below.
145
estimated using time series models. Our empirical results are consistent with all these predictions. We also demonstrate empirically that the earnings/returns relation varies with firm size, where size is a proxy for information environment differences.* Differences in information environment affect the extent to which price changes anticipate earnings changes [Collins, Kothari, and Rayburn (1987) and Freeman (1987)]. Once differences in the information environment are controlled by varying the return holding period, there is little difference in the extent to which price changes covary with earnings changes across firm size. This explains the differential magnitude of ERCs as a function of firm size documented in Burgstahler (1981), Freeman (1987), and Collins et al. (1987). Our analysis also suggests that association studies that use a holding period corresponding to a firms fiscal period (or between earnings announcement dates) understate the earnings/returns association. Holding periods that begin at an earlier point in time and span a longer time horizon enhance the earnings/returns association relative to the conventional twelve-month holding periods, particularly for larger firms. In section 2 we identify the determinants of ERCs using a simple dividend capitalization model where accounting earnings are assumed to be related to future dividends. In section 3 we discuss how noise in accounting earnings measurement and variation in the information environment affect the estimation of ERCs. We also propose ways to deal with these problems empirically. Section 4 identifies the sample used in our empirical analysis. Section 5 demonstrates differences in the strength of earnings/returns relation for large versus small firms as one varies the return holding period. Section 6 is broken into two parts: first, variation in the earnings/returns relation over time and its association with long-term risk-free interest rates are documented; second, cross-sectional variation in the earnings/returns relation and its association with risk, earnings persistence and/or growth are documented. Section 7 summarizes our findings and discusses some of the implications of our results for past and future research. 2. Equity valuation and determinants of earnings response coefficients This section outlines discounted present value relation between current current periods earnings an equity valuation model in which price is the of future expected dividends. By specifying a positive earnings and future expected dividends, we relate the shock to unexpected stock returns via the ERC. We
Information environment is defined broadly to include all sources of information relevant to assessing firm value. It includes government reports on macroeconomic conditions, industry reports and trade association publications, firm-specific news in the financial press and reports issued by analysts and brokerage houses in addition to accounting reports, and vertical and intra-industry information transfers via sales and industry reports.
146
then discuss the cross-sectional and temporal determinants of the ERCs which provide the basis for our empirical investigation. Finally, we compare the determinants of the ERCs identified in this study with those in the related literature.
2.1. Equity valuation and the earnings response coefJicient The price of security i at time t may be written as
P,,= ft E,(%+k)
k=l
Tfil + E(fL+,)l>~ {l/i1
where E,( Di,+k) = expectation at time t of dividends to be received at the end of period t + k, and E( R i1+7) = expected rate of return on the security from the end of t + T - 1 to the end of t + 7. In writing eq. (2), the future expected rates of returns are assumed known and the only uncertainty about future prices is due to reassessments through time of expected future dividends. These assumptions, together with the other assumptions underlying the Sharpe-Lintner Capital Asset Pricing Model (CAPM), are sufficient for the multiperiod CAPM to hold [Fama (1977)]. To derive the ERC, we assume accounting earnings are related to future dividends and, hence, unexpected earnings cause investors to revise their expectations of future dividends leading to security price changes. Future expected dividends are assumed to be related to current earnings according to E,(&+k) = hir+kXr, A,r+k 0, k=1,2 ,..., oo, (3)
where X,, is firm is reported accounting earnings for period t. While the assumption in eq. (3) is ad hoc, it is useful in generating empirical predictions tested later in the paper. Moreover, the dividends/earnings relation in eq. (3) underlies, at least implicitly, the empirical analysis in numerous previous studies, including Ball and Brown (1968), Freeman (1987), Kormendi and Lipe (1987), and Easton and Zmijewski (1989). The precise values of the hittks will depend on the particular time series process that earnings follow as a function of the firms investment and dividend policies. The next section demonstrates how alternative earnings process assumptions affect the Xitiks and the ERCs. Substituting eq. (3) into (2):
D. W. Collins and S. P. Koihari, Variation in earnings response coeJicients
141
The unexpected eq. (4) as R;zor uR,,=
return
associated
with unexpected
earnings
is derived
using
Et-i(R,,)
= [P;,-
E,-i(Pi,)
+ Di,-
E~-~(D,,)I/PL~-~
U&/ft-~> f~ E(&+,)I (5) {L[1 1 [ it+k+ >

x*, + Z
k=l
7=1
where UX,, = X,, - E,-,( X,,) is the unexpected earnings in period t. Eq. (5) relates unexpected earnings to unexpected returns and the coefficient on unexpected earnings scaled by price is the ERC (the bracketed term).
2.2. Determinants
of the earnings response coe@cient is inversely related to the assume complete knowledge the multiperiod CAPM, we in each period:
Eq. (5) reveals that, ceteris paribus, the ERC expected rate of return on a security. Because we of future expected rates of returns consistent with can substitute the Sharpe-Lintner CAPM relation
E(h) = R/t + [E(R,,,) R/t]6,. -
(6)
Using the CAPM eq. (6) and further assuming that pi, is either constant through time or highly positively autocorrelated through time, we conclude that the ERC is a decreasing function of a securitys systematic risk. In valuation terms, the higher the systematic risk the smaller the present value of a given increase in expected future dividends caused by unexpected earnings. The ERC is affected positively by the hit+k s which relate current earnings to future dividends. If the earnings time series has a high persistence (i.e., current periods earnings shocks tend to persist in the future and affect future earnings expectations), then dividend expectations will be revised more than if earnings shocks have low persistence. Thus, the higher the earnings persistence the higher the hrr+k~. The effect of persistence on ERC can be shown more formally in the context of a specific earnings process. Earnings persistence is typically measured by estimating an ARIMA time series earnings process [e.g., Kormendi and Lipe (1987)]. If earnings follow an IMA(l, 1) process, earnings expectations for all future periods will be revised by (1 - fl)a,, where a, = X, - E,_,( X,) and 0 is the moving average process parameter. Thus, revisions in earnings expectations are an increasing function of (1 - e), the persistence of an IMA(l, 1) process. Because dividends are assumed a positive fraction of earnings, greater persistence will lead to larger revisions in dividend expectations and the ERC will be larger. Implications of persistence under alternative earnings process
148
D. W. Collins and S. P. Kothari, Variation in earnings response coeflcients Table 1 Persistence factors under different Persistence factor k periods in future ARIMA earnings processes
Earnings
process 0)
AE,(X,+,) 1
ARIMA(O.l, [random
or
=+ku, k=l k>l forall
Sum of the present value of A E, ( X, + k )s over all k time periods, discounted at interest rate of rb
walk] 1) -@.a, 0
ARIMA(O,O,
[Miller and Rock
(19W1
ARIMA(O.1, [Beaver,
1)
(1-B)u,
Lambert,
and Morse (1980)] ARIMA(1,O.O) ++1 [Easton Zmijewski and (1989)]
1-O r a, L-1
(1+ r)/r
ARIMA(2,l.O)
[ Kormendi
Lipe (1987)]
and
4, = (1 + +,)a,
k= 1
1 - &/(l
+ r) -$5/Q
+ r>*
-1 I
a,
u, = X, - E,_ i( X,) is the shock in period
ts earnings, Earnings
follow an ARIMA
time series
prYess. Following Kormendi and Lipe (1987) and Flavin (1981), the present value of the revisions in earnings expectations caused by (I, over an infinite horizon for an ARIMA( p, d, q) process is a function of the AR( c$) and MA( 8) paramenters as follows:
One plus the bracketed term in the last column for that particular earnings specification.
gives the theoretical
earnings
response
coefficient
assumptions used in previous studies are presented in table 1. Assuming constant discount rates and an isomorphic relation between future earnings expectations and future dividend expectations, one plus the right column in table 1 presents the theoretical ERC for each of the alternative earnings processes. The theoretical ERC is the price change induced by a one-dollar shock to current earnings and is equal to one plus the present value of the revisions in expected future earnings caused by this shock. Therefore, the ERC
D. W. Collins and S.P. Kothari, Variation in earnings response coejficients
149
is expressed in terms of the autoregressive [AR(+)] and moving average [MA( 0)] parameters of the alternative ARIMA earnings specifications according to the formula adapted from Kormendi and Lipe (1987) and Flavin (1981). Many valuation models express firm value as the sum of the present value of dividend stream from investments yielding a normal rate of return and growth in future dividends stemming from the existence of investment opportunities that are expected to yield an above normal rate of return [see, e.g., Fama and Miller (1972, ch. 2)]. The normal rate of return is the rate of return commensurate with the riskiness of investments in a competitive industry. Growth because of investing in projects that yield above normal rates of return in generally referred to as economic growth. Ceteris paribus, the future earnings and dividend streams will be larger in the presence of growth opportunities than absent such opportunities. Hence, if the current earning surprise is informative of the growth opportunities, the hil+k~ are expected to be a positive function of growth opportunities. In the context of classic valuation models [e.g., Miller and Modigliani (1961)] current earnings may not necessarily reveal growth opportunities because in these models only future investments are assumed to earn above normal rates of returns. Realistically, however, current earnings are a result of investments in both growth and no-growth projects. Accordingly, growth opportunities include investments in new as well as existing projects where the profit rate (m) differs from the normal rate of return (r). Current earnings are likely to signal useful information about the changing spread between 7r and r for the current investments as well as for future investments. Moreover, current earnings and current dividends may jointly signal managements private information about growth opportunities on future investments. For example, Easton (1985) finds a negative relation between current dividends and future dividends after controlling for the current earnings effect. This is consistent with lower current dividend payout signalling higher future dividends because of earnings invested in projects where 7~> r. A key question that remains is whether time series persistence estimates fully and accurately capture economic growth opportunities. We believe this is problematic for at least two reasons. First, time series analysis cannot distinguish between correlation in successive earnings numbers brought about by mere expansion (i.e., earnings reinvestment through time or increases in external financing) versus economic growth. The latter has shareholder wealth implications while the former does not. Second, and perhaps more important, ARIMA models typically assume parameter stability. Therefore, any trend term that picks up earnings expansion and/or growth is constrained to be a constant. This is a limiting assumption, particularly when estimates are based on annual data for a 20-30-year time frame [see Kormendi and Lipe (1987)]. Given a competitive environment and dynamic macroeconomic conditions, economic growth opportunities are likely to be short-lived. Accordingly, fixed
150
D. W. Collins und S.P. Kothnri, Variation in earnings response coefficients
parameter ARIMA estimates derived from lengthy time series represent some sort of a weighted average of changing growth opportunities over time. Because we expect the persistence estimates from time series models to be deficient in accurately reflecting current growth opportunities, we include a proxy for the latter as an additional determinant of ERCs. In addition to the three cross-sectional determinants of the ERC, we hypothesize interest rates as a temporal determinant of the ERC. To derive a temporal relation between interest rates and the ERC, we assume that the expected rates of returns in the future periods vary over time. That is, E(Rit+7) can vary over t. We further assume that the current risk-free interest rate is highly positively autocorrelated with the future risk-free interest rates. Because the risk-free interest rates are a component of E(R,,+,), the higher the current risk-free interest rate the higher the expected rate of return on the security in the future periods. Therefore, we predict a negative relation between interest rates and the ERC through time.3 In hypothesizing the negative temporal association between interest rates and the ERC, we deviate from the assumption underlying the discounted cash flow model and the multiperiod CAPM that all the future E( R,,,,) are known at time t and, thus, cannot vary with t. However, relaxing this assumption generates an interesting empirical prediction and is consistent with the evidence that both nominal and real interest rates change through time [see, e.g., Ibbotson and Sinquefield (1985)]. If the ERC is derived using continuous time valuation models like Merton (1973) or by allowing uncertainty in future commodity prices and the future investment opportunity sets [Long (1974)], the effect of interest rate variation through time on the ERC will enter into the model more directly. These extensions are beyond the scope of this paper, but are fruitful avenues for future research. To summarize, we identify four factors contributing to cross-sectional and temporal differences in the ERC. The ERC is positively related to earnings persistence and economic growth opportunities. The ERC is negatively related to the securities future expected discount rates. The discount rate is made up of (i) the risk-free interest rate, R,, and the market risk premium, and (ii) the firms CAPM beta risk. Because R, and the market risk premium are the same for all firms, they obviously are not a source of cross-sectional variation in ERCs. The ERCs are negatively related to the interest rate levels through time and the CAPM beta risk in the cross-section.
3We use a partial equilibrium analysis to examine the interest rate effect on the ERG. Interest rate changes affect, among other things, the saving/investment decisions of individuals and corporations which, in turn, affect the firms future cash flows. Incorporating these effects on cash flows and their present values to derive a relation between interest rates and the ERCs requires a complete equilibrium analysis that is beyond the scope of this paper. We essentially ignore the saving/investment and associated cash flow implications of interest rate changes in making our predictions.
D. W. Collins und S. P. Kothari,
Vuriation
in eurnings response coefficients
151
Previous studies identify persistence and systematic risk as the determinants of ERCs. The Garman and Ohlson (1980) and Ohlson (1983) earnings capitalization models suggest that ERCs are positively related to the extent to which current periods unexpected earnings lead to revisions in future periods dividends and earnings (i.e., earnings persistence) and inversely related to the systematic risk of earnings. Miller and Rock (1985) derive the effect of earnings persistence and systematic risk using a two-period model. Kormendi and Lipe (1987) and Easton and Zmijewski (1989) derive ERC determinants using a discounted cash flow valuation model. The primary difference between their analysis and ours is that they derive the ERC by assuming a specific time series earnings process, namely, an autoregressive earnings process. Both these studies provide evidence that persistence has a positive effect on ERCs and Easton and Zmijewski (1989) report a modest negative relation between beta risk and ERCs. However, neither study explicitly considers the effect of growth on the ERCs. Effectively, the impact of growth opportunities on ERCs is assumed to be fully captured by their earnings persistence measures. Our previous discussion and subsequent empirical analysis reveal that persistence estimates are unlikely to capture economic growth fully. 3. Estimation problems and methodological considerations
3.1. Error in measuring unexpected earnings and returns The covariance between (UR,,) can be summarized unexpected returns as follows: (UR ir) and unexpected earnings
cov(W,Jx,,) =f(
P ersistence,
c+>
(->
(+I
c-1
interest rates ).
temporal variation
risk, growth,
cross-&tional variation
Empirically, at least two other factors affect the estimated COV(UR,~,UX,~) and, hence, the estimated ERC: (a) noise in reported accounting earnings as an indicator of future expected dividends and (b) the firms information environment. The above two factors lead to error in measuring UX,,. Empirical proxies for UX,, contain error because: (i) Accounting earnings measure firms future dividend paying ability with error. The market uses other variables in addition to accounting earnings in forecasting future expected dividends and in this sense unexpected accounting earnings is a noisy predictor of revisions in future expected dividends. (ii) The markets earnings expectation at a given
152
point in time differs from a simple time series earnings expectation proxy. The presence of competing (and more timely) sources of information in addition to reported earnings renders the time series earnings expectation a noisy measure of UXi, [see, e.g., Collins et al. (1987) and Freeman (1987)]. Measurement error in a UXi, proxy attenuates the ERC and makes it difficult to detect the influences of the ERCs determinants. The bias in an estimated ERC can be substantial. Indeed, evidence in Beaver et al. (1980) suggests that ERCs estimated at the individual security level using a time series earnings expectation proxy for UX,, understate the true or theoretical ERCs by as much as 70-80%, on average. If we could obtain a better measure of the markets earnings expectation at time r - 1, the measurement error problem in a proxy for UXi, would be reduced. However, empirically this is difficult. While analysts forecasts are better than time series proxies [Brown et al. (1987a, b)], they are not available in a machine-readable form over the time period examined in this study and they are generally available only for the larger, more widely held firms. An alternative approach to reduce the measurement error problem is to set t - 1 (i.e., the beginning of the holding period) at a point such that the time series proxy (in our case, a random walk specification) approximates the markets earnings expectation. We adopt the latter approach by varying the return window. Varying the return window ensures that a particular UX,, proxy matches up closely with the true (but unobservable) market earnings expectation and provides a specification check on previous work relating earnings changes to security returns. This allows us to u e the same earnings expectation model across all firms (which is typically done in empirical work) and find the point in calendar time when that particular proxy best approximates the markets earnings expectation for a particular firm. This ensures that the estimated response coefficient fully captures the markets valuation of unexpected earnings. Varying the return window also allows us to assess how this affects the earnings/returns association as measured by adjusted R* across firm size.4 In addition to error in UX,, proxy, cross-sectional differences in the information environment contribute to nonrandom variation in the earnings/ returns relation. If firm size is a proxy for information environment differences, then different size firms will exhibit different ERCs on measuring UXjrs over a fixed holding period for all firms [see, e.g., Collins et al. (1987)]. In this sense returns measured over fixed holding periods contain error. Holding the earnings expectation model and the return cumulation period constant across all firms can result in a spurious association between firm size and ERCs in an
41f returns are the dependent variable and we vary the length of the holding period from one model to another, then the adjusted Rs are no longer comparable since the total sum of squares will differ from one model to another.
D. W. Collins and S.P. Kothari, Variation in earnings response coeficients
153
annual association study. This spurious correlation occurs because of differences in the lead-lag structure in the earnings/returns relation caused by the information environment differences for large versus small firms. Moreover, if the lead-lag relation between returns and earnings changes is ignored and time series proxies for UX,, are used, then association studies will severely understate ERCs.
3.2. Reverse regression and the return response coejicient We use multiple regressions to test whether various factors identified earlier are related to the ERCs. To address the measurement error problem, we employ reverse regression [see Maddala (1977) Learner (1978), Klepper and Learner (1984), and Beaver, Lambert, and Ryan (1987)]. Specifically, we regress earnings changes on returns and a series of terms representing interactions between returns and risk, growth and/or persistence, and interest rates. We adopt this approach over various grouping procedures in direct regression for several reasons.5 First, using a UX;, proxy as the dependent variable reduces the attenuation bias that exists when ERCs are estimated at the individual security level using eq. (1). Second, having returns on the RHS allows us to conveniently test for differences across firm size in the lead-lag relation by incorporating both contemporaneous and earlier periods returns as explanatory variables. Finally, with returns on the RHS, we can vary the length of the return holding period for different firms (i.e., combine varying portions of contemporaneous and leading returns into one metric). As noted earlier, by varying the length of the return window we control for cross-sectional differences in information environment because the return period is expanded until the markets expectation of current periods earnings is approximated by the prior years earnings (i.e., earnings change is now unexpected).6 One consequence of using reverse regression is that we estimate the return response coefficient (RRC) rather than the ERC. The reciprocal of RRC is an estimate of the ERC in the simple regression context. This interpretation is
See Beaver et al. (1980) for a discussion of alternative grouping procedures in direct regression to mitigate measurement error in I/X,, proxies. Beaver, Lambert, and Ryan (1987) discuss reasons for preferring reverse regression over these grouping procedures. 6This approach assumes implicitly that the market is able to forecast accurately the prior years earnings number well in advance of its actual release. Thus, using the prior years earnings as a basis for predicting the current years earnings (even though the former has not yet been released) only assumes that the market makes an unbiased assessment of what the number will actually be. To the extent this assumption does not hold, it weakens the earnings/returns association when return cumulation begins in an earlier period. Evidence in Beaver et al. (1980), Collins et al. (1987), and Freeman (1987) suggests that the market anticipates earnings changes from t - 1 to t well before earnings for t - 1 are reported.
154
D. W. Collins and S.P. Kothari, Variation in earnings response coefficients
based largely on the evidence in Beaver, Lambert, and Ryan (1987). In section 2 we posited that the ERC is related to four factors: earnings persistence (+), growth (+), risk (-), and interest rates (-). In reverse regressions, these functional relations are inverted. That means the RRC increases in risk and interest rates and decreases in earnings persistence and growth. These predictions are expected to hold when earnings changes are scaled by price which is the scaling variable according to the analysis in section 2 and in Christie (1987). However, if earnings changes are scaled by previous years earnings as in Beaver et al. (1980) and many other earnings association studies, then RRC is likely to exhibit lesser association with the four determinants for reasons discussed in section 3.3.3. The inverse of the estimated RRC is the upper bound for ERC. Therefore, attempts to infer the earnings process or to place other economic interpretations on the inverse of the estimated RRC must be approached with caution. Accordingly, we interpret the RRCs conservatively and use significance tests only to judge whether its determinants have the predicted signs. 3.3. I. Empirical measures of returns The analysis in section 2 suggests that the appropriate R,, - E,_,( Ri,). We use R,, (return inclusive of dividends) first approximation for three reasons: return metric is throughout as a
(1) E,_ t( R,,) is an ex ante measure of expected return, but ex ante measures of riskless rates and risk premia are not readily available. Most studies use an ex post measure of E,_ i( R,,) conditional on the realized market return for period t which introduces error into the return metric. (2) Relative to the temporal and cross-sectional variability in R,,, the variability in E,_,( Rjt) is small. Hence, the use of R,, - E,_i( Rjt) essentially amounts to using Ri,. (3) Beaver et al. (1980) and Beaver, Lambert, and Ryan (1987) report that the earnings/returns relation is essentially the same whether one uses R,, inclusive or exclusive of dividends or market model prediction errors. 3.3.2. Proxy for unexpected earnings While measure price or reasons the model in section 2 is in terms of a generic unexpected earnings (UX), our empirical analysis uses annual earnings change (scaled by previous years earnings) as a proxy for UX. There are at lease three for this choice.
(1) Many annual earnings/returns association studies use a random walk model as a proxy for the markets earnings expectation as of the beginning of the year. Thus, annual earnings change is the appropriate proxy for unexpected earnings.
155
(2) Unexpected
earnings using more sophisticated ARIMA models require a relatively long data history (20-30 years) to estimate parameter values. This would restrict our sample severely and reduce the range of size and risk profiles which are determinants of the ERCs. We do, however, use an IMA(l, 1) model to estimate earnings persistence for a subset of our sample firms with the requisite data and these results are reported below. (3) The two empirical procedures described above (i.e., reverse regression and expanding the return holding period) reduce the potential measurement error that results from using annual earnings changes as a proxy for VX,,. ?? _._.3. Scaling factor for earnings changes Although the specification of ERC in section 2 suggests the appropriate scale variable for AX is Pt_l, we also report results when AX, is scaled by X ,_I.7 This is to demonstrate the sensitivity of our findings with respect to a popular alternative scale variable and to enhance the comparability of our results with previous studies that have used A X,/X,_ 1 variable to investigate the earnings/returns relation [e.g., Beaver et al. (1980) Burgstahler (1981) Beaver, Lambert, and Ryan (1987) and Collins et al. (1987)J. Another reason for using A X,/X,_, variable is to test the implication following from the assumption in Ohlson (1983) and Beaver et al. (1980) that the earnings capitalization rate (p) is a temporal constant. If this assumption is true, then the slope in the earnings/returns relation is smaller by a factor of l/p when AX, is scaled by X,_ 1 versus Pt_l, where p is the temporal constant earnings multiple that incorporates interest rates, risk, growth, and earnings persistence. That is, ERC when AX, scaled by X,_ 1 = (ERC when A X, scaled by P,_l)/p. Thus, with constant capitalization rates, scaling by X,_ 1 eliminates (or reduces substantially) both cross-sectional and temporal dispersion in ERCs. Thus, factors such as risk, persistence, growth, or interest rate should possess little explanatory power in the earnings/returns relation. We hasten to note that these predictions are conditional on the descriptive validity of the assumptions underlying the Beaver et al. (1980) or Ohlson (1983) models. These results may not obtain empirically for at least three reasons: (1) p is likely to vary with changes in risk-free interest rates or risk premia. Casual observation suggests that P/E ratios are relatively high (low) during low (high) interest rate periods. Therefore, in a relation between
Because annual earnings remainder of the paper.
change
is used as proxy
for UX, we use AX instead
of UX in the
Some argue that price is not an appropriate deflator and conclude, at least implicitly. that some other deflator like previous years earnings is a more appropriate deflator [see. e.g., Lustgarten (1982)].
156
D. W. Collins and S.P. Kothari, Variaiion in earnings response coefficients
(2)
nominal returns and earnings changes, ERCs are likely to vary over time even when scaling by X,_ i. While price is expressed as a multiple of expected or current earnings, the prices/earnings relation is unlikely to be deterministic. A more realistic prices/earnings relation would be
where qit is a random disturbance. Thus, when scaling by Xt_i, it is not obvious that the effect is simply to render the ERC smaller by a factor of l/p as shown earlier. Measurement error in the earnings variable is another factor affecting the (3) magnitude of the ERCs through time. This is particularly true when reported earnings for t - 1 are negative. (We, like others, delete such observations from our empirical analysis.) In summary, we make clear-cut predictions about the sign of the relation between ERCs and risk, persistence, growth, and interest rates when AX, is scaled by Pt_l. However, when scaling by X,_ 1 the only clear prediction is that the relation between these factors and ERC will be zero if the assumption of constant temporal capitalization rate on earnings holds. If this assumption does not hold, then the predicted relations between these factors and ERCs noted in section 2 will be attenuated or may even change sign. 4. Sample selection and descriptive statistics
4.1. Sample selection
We initially identify a sample of firms from the Compustat Industrial Annual and the Compustat Research Annual tapes with a December 31 fiscal year-end and a minimum of three years of earnings data for each year t from 1968 to 1982 (a total of 15 years). The December 31 fiscal year-end criterion is imposed to facilitate data analysis and enhance comparisons with previous studies that have imposed this restriction [e.g., Beaver et al. (1980) and Kormendi and Lipe (1987)]. From the Compustat sample, only firms listed on the NYSE are included for further analysis. We limit the sample to NYSE firms because we use monthly return data to estimate systematic risk and also use monthly returns to obtain buy-and-hold returns over varying holding
Identifying firms from the Compustat Research Annual tape reduces the severity of the survivorship bias inherent in sampling only from the Compustat Industrial Annual tape. Also, data for firms delisted because of mergers, acquisitions, and takeovers are available on the research tape for the years prior to their mergers, etc. We increase the sample size by approximately 20% by using the research tape.
157
periods. The CRSP monthly returns tape contains only NYSE-listed firms. We use monthly return data to estimate systematic risk because beta estimates using daily returns data are biased and inconsistent [Scholes and Williams (1977)]. The subset of NYSE firms for which monthly return data are available on the CRSP tapes for eight consecutive years ending in year t + 1 is included in the final sample. Monthly returns for the five years up to the end of year t - 2 are used in estimating the firms systematic risk (market model betas) and returns over varying lengths of time for the next three years (i.e., years t - 1 to t + 1) are used in the regression analysis. These criteria yield a sample of 9776 firm-year observations. The number of observations in each year varies from 519 in 1968 to 730 in 1978. 4.2. Descriptive statistics Descriptive statistics for the sample are presented in table 2. Since the sample selection criteria result in only firms with NYSE listing, the sample firms are above average in their equity market values relative to all publicly traded stocks. The mean firm size is $860.4 million. However, a large standard deviation ($2644.2 million) of the sample distribution of market values and the minimum and maximum market values of equity of the sample firms suggest there is considerable variation in firm size within our sample. This is important because one of our objectives is to assess whether ERCs are a function of firm size and to demonstrate that this variation is sensitive to the definition of the return holding period. Each securitys systematic risk is estimated by regressing monthly returns over sixty months on the CRSP equally weighted market return index. The sample mean beta is 0.92 which suggests that the sample is slightly less risky than the average security listed on the NYSE. This is expected because the sample selection criteria are biased towards including larger NYSE firms and previous evidence suggests that firm size and beta are inversely related [see, for example, Banz (1981)]. Summary statistics for the percentage change in earnings variable (%AX,) are based on 9045 firm-year observations because we exclude observations with a negative denominator or observations with I%AX,l > 2008. The reduction in sample size is due largely to firms reporting losses (negative denominator) and thus represents an asymmetric loss in the sample. This is a problem that is common to all the research studies using the %AX, variable. On average, firms in our sample report an annual increase of 7.85% in their earnings over the years 1978 to 1982. The second earnings variable, change in earnings deflated by price (A Xt/P1_r), is free from the negative denominator
The decision to exclude observations with consistent with previous research in this area. ISA X,( > 200% may seem arbitrary, but it is
158
D. W. Collins and S.P. Kothari, Variation in earnings resporwe coeJ%ents Table 2
Summary
statistics
for market
value of equity, risk, and change firm-years from 1968-82.= Standard deviation 2644.1
in earnings:
Sample
of 9776
Variable Market value of equityb Risk (beta) Percentage change in earnings Change in earnings scaled by price
N 9776
Mean 860.4
Median 245.3
Minimum 1.86
Maximum 47,888
9776 9045
0.92 7.85%
0.87 8.63%
0.40 43.22%
- 0.37d - 200.0%
3.01 198.0%
9718
0.82%
0.77%
10.94%
- 97.85%
99.76%
Initially any firm listed on the Compustat Industrial Annual or the Compustat Annual Research tape with a December 31 fiscal year-end and a minimum of three years of earnings data during 1968-82 is included in the sample. From this sample, the subset for which monthly return data are available for eight consecutive years ending in 1969-83 is included in the sample analyzed in this study. bMarket value of equity is defined as the beginning of the year share price times the number of shares outstanding; in millions of dollars. Market model beta estimated by regressing monthly returns over five years on the NYSE equally weighted index. dMarket model betas of three securities are negative. Percentage change in earnings, WAX,, is change in earnings per share from year t - 1 to r divided by the earnings per share for year t - 1, all adjusted for stock splits and dividends. A total of 731 observations with negative denominators or \%A X,1 z 200% are excluded. Change in earnings scaled by price, A X,/P,_ Lr is change in earnings per share from year t - 1 to t divided by share price at the beginning of year t. A total of 58 observations with IAX,/P,_,l> 100% are excluded.
problem. Therefore, it has a larger sample of 9718 firm-year observations. Observations with (AX,/P,_,I > 100% are excluded which causes a small reduction in sample size from 9776 to 9718 observations. The sample mean and standard deviation for the distribution of AX/P,_, are 0.816% and 10.94%. 5. Firm size, information environment, and holding period returns As noted earlier, a contemporaneous regression of annual returns on earnings changes understates the ERC and the degree of understatement varies
Once again, the decision to exclude observations with /A X,/P,_ ,( > 100% is arbitrary, but, as can be seen from table 2, these observations are more than nine standard deviations away from the mean. Inclusion of these observations in the sample would likely have an undue influence on the estimated regression coefficients.
159
with firm size. If firm size is correlated with risk, growth, and persistence (which seems likely), then failing to control for differences in the lead-lag structure of returns and earnings will confound tests for differences in the earnings/returns relation due to the factors identified earlier. To demonstrate the relation between firm size and the lead-lag structure, we regress earnings changes (scaled by Pt_l X,_,) on security returns from or the contemporaneous and lagged fiscal year according to the following model:
where, consistent with previous research, R;, measured from April of year t is to March of year t + 1 and R it-is measured in an analogous fashion. I Results in the first two rows of table 3, using all stocks in the sample, reveal that coefficients on both current and lagged years returns are of comparable portion of the events magnitude and highly significant. l2 Thus a nontrivial contributing to accounting earnings changks in the current period are captured in security returns from an earlier period. To ascertain whether the degree to which lagged returns explain earnings changes varies with firm size, we partition our sample into three equal-sized groups by ranking firms each year according to the beginning of year equity market vales. Results of estimating eq. (8) for the small, medium, and large firm groups are reported in the lower portion of table 3. Lagged years returns possess significant explanatory power for all three size groups. However, the magnitude and significance of f1 in relation to f2 suggest that R,+,is more important in explaining earnings changes for large versus small firms, which is consistent with Collins et al. (1987) and Freemen (1987). While the above analysis suggests that the earnings/returns association is enhanced by including returns from an earlier time frame, the results do not identify exactly how far back one should go. This is difficult to specify a priori and will vary as a function of the timing of valuation relevant economic events, the nature of a firms information environment, and how quickly economic events are captured in the accounting earnings numbers. Basically, then, it becomes an empirical issue. To shed some light on this issue, we regress earnings changes on returns where the return measurement is started at varying points in time and extended over varying time frames. We always use buy-and-hold returns. Specifically, we vary the start of the return cumulation process from January of fiscal year t - 1 to June of fiscal year t and allow the length of the holding
*The t-statistic may be overstated because cross-dependencies are ignored. downward adjustments the p-value is likely to be less than 0.01.
However,
even after
160
D. W. Collins and S.P. Kothari, Variation in earnings response coejicients Table 3
Pooled
time series cross-sectional
regression of earnings changes security returns: 1968-82.a
on contemporaneous
and lagged
Dependent variable
I Firm sizeb All All Small Medium Large Small Medium Large NC 9718 9045 3215 3251 3252 2725 3126 3194 ( t-s&)d 0.001 (3.04) 0.034 (7.18) 0.005 (1.87) - 0.002 (- 1.09) 0.000 (0.33) 0.032 (2.92) 0.024 (3.14) 0.045 (7.37)
,. (r-skgd 0.038 (10.56) 0.256 (16.78) 0.031 (3.86) 0.045 (9.43) 0.044 (11.69) 0.213 (6.90) 0.255 (10.54) 0.311 (13.94)
,. ( t-s:2at)d 0.058 (16.82) 0.310 (21.47) 0.083 (10.79) 0.043 (9.34) 0.033 (9.31) 0.384 (12.93) 0.293 (12.70) 0.231 (10.99) Adj. R2 3.56% 6.90 3.68 4.61 5.72 6.76 7.28 7.97
AT/p,-,
%AX, AX/p,-, AX/p,-, AX/p,-, %AX, %AX, %AX,
Sample selection criteria are given in footnote a to table 2. A X,/P,_, is change in EPS from year t - 1 to t divided by share price at the end of year t - 1. A total of 58 observations with IA X,/P,_ II > 100% are excluded. %A X, is change in EPS from year t - 1 to t divided by the EPS for year t - 1. A total of 731 observations with negative denominators or Is&A z 200% are excluded. X,1 R ,,- L is raw return from April of year t - 1 to March of year t and R,, is raw return from April of year r to March of year r + 1. bAll the sample firms are ranked every year on the beginning-of-the-year market values of equity and assigned to the small, medium, and large firm portfolios in equal numbers. N is number of firm-year observations in each regressions. N is not equal in each regressions because of asymmetric reduction in sample due to negative denominators or outliers. dt-statistic of 1.96 implies a p-value of 0.05 and t-statistic of 2.58 implies a p-value of 0.01 using two-tailed tests.
period to range from 12 to 18 months.13 For example, when returns are measured over 14 months, the first 16month period is from January of year t - 1 through February of year t and the 18th 1Cmonth period begins in June of year t and extends through July of year t + 1. Since size is hypothesized to affect the lead-lag structure between returns and earnings changes we estimate regressions separately for small, medium, and large firm groups. The entire analysis is performed using both earnings
t3We also used periods longer maximized using returns measured report these results. than 18 months, but the earnings/returns association is over periods shorter than 18 months. We, therefore, do not
161
change variables, i.e.., AXJP,_, and %AX,, as the dependent variable. Since the dependent variable is the same across all models, adjusted R2 is the criterion used for identifying the starting point and length of cumulation period that maximizes the earnings/returns association.4 Obviously our results are sample- and period-specific and only indicate the sensitivity of the earnings association tests to the length of the holding period return. Hopefully, these results will guide future research in specifying return holding periods in association study contexts. Adjusted R2s from the regressions of SAX, on returns measured over alternative periods for the large and small firm portfolios are plotted in figs. 1 and 2.15 Fig. 1 reveals that the length and starting month of the return measurement have a dramatic effect. For example, the typically selected 12-month April to March return period results in an adjusted R2 of 2.41% which suggests a weak association between large firms price and earnings changes. However, when the 12-month period begins in January the explanatory power jumps to 6.49%. The maximum adjusted R2 of 10.94% is attained when a 15-month period starting in August of year t - 1 is used. Thus, the explanatory power for large firms increases substantially by increasing the length of the holding period from 12 to 15 months and by measuring returns from August of year t - 1 instead of April of year t. The same return measurement period maximizes the models explanatory power for medium size firms and overall the results are quite similar to those in fig. 1. Turning to fig. 2, for small firms, adjusted R2 is maximized once again using a 15-month period but beginning in November of year t - 1. This is consistent with the regression results for large and small firms reported in table 3 and the evidence in Freeman (1987) and Collins et al. (1987). The maximum adjusted R2 for small firms is 9.34%. Comparing figs. 1 and 2 demonstrates clearly the systematic differences between large and small firms in the extent to which alternative holding periods dominate the conventional April-March or January-December periods. There are many fewer holding periods that dominate a January-December holding period for small firms as compared to large firms. The association between earnings and price changes is maximized for holding periods (of fixed
14Conclusions based on adjusted Rs are not affected by our choice of reverse regression. This follows because in case of simple regression adjusted R* is unchanged when the independent and dependent variables are interchanged [see Maddala (1977, pp. 77-79)]. Our discussion of the sensitivity of the degree of association to length and cumulation period of returns ignores magnitudes of slope coefficients from all the regressions. The magnitude of the slope coefficient is maximized when adjusted R* is maximized since R* is an increasing function of the estimated slope when it is positive. To improve the visual clarity of the graphs, figs. 1 and 2 do not plot adjusted Rs when returns are measured over 17 and 18 months. The results for A X,/P,_ I are virtually identical to those reported here.
D. W. Cohs
und S. P. Kothari, Variation in eurrtings response coeficients
15 Month Holding Period Aug, t-l
- Ott, t
Jan,
t -
Dee, t
0
0
I
1 at-
I
6 1
I
12 1
I
16
-J
t --__
Beginning -
month for the return
holding
period
12
month return holding period
4
-El-
15
13 14
month return holding period month return holding period
16
Fig. 1. Large-firm changes in period
sample results: Association of various holding period returns with earnings t. Month 1 is January of fiscal year t - 1 and month 18 is June of fiscal year f.
163
15 Month Holding Period Nov, t-1 Jan. t+l
Jan, I - Dee,
t -
Mar. I+1
6
I-
12 1
16
c------Beginning +I+ 12
t --__ holding period
month for the return +

il15
13
16
14
_ month
return holding period
Fig. 2. Small-firm changes in period
sample results: Association of various holding period returns with earnings t. Month 1 is January of fiscal year t - 1 and month 18 is June of fiscal year t.
164
length) that begin at an earlier point in time for large firms compared to small firms.16 To summarize, a conventional 1Zmonth return period understates the earnings/returns association, particularly for larger firms. The association is maximized when returns are measured over 15 months starting from August of year t - 1 for large and medium firms and November of year t - 1 for small firms. All further analysis is performed using returns measured over the 15-month intervals appropriate for each size grouping. In the remainder of the analysis the AX,/P,_, variable is defined as AX, scaled by price at the beginning of the appropriate 15-month return interval for each firm. This ensures that the scale variable is consistent with the model in section 2. 6. Determinants
of earnings response coefficients: Empirical evidence
6.1. Interest rates and temporal differences in response coeflcients Based on the model in section 2, the rate at which earnings are capitalized into prices is inversely related to the risk-free interest rate. From an empirical standpoint the capitalization rate would be a function of current as well as expected future interest rates or the term structure of interest rates. We use yields on long-term U.S. Government bonds reported in Ibbotson and Sinquefield (1985) as a proxy for the risk-free interest rate and assume that the term structure is flat. While this may not be descriptively valid, it simplifies the analysis and biases against finding a temporal relation between interest rates and the RRCs.18 The correlation between long-term U.S. Government bond yields and the RRCs from annual regressions of earnings changes on returns measures the
t6A potential limitation of extending the return interval to include lagged periods returns is that part of the price change in f - 1 is likely to capture shocks or changes in accounting earnings for that period. If there is positive serial correlation in successive earnings changes this may create a correlated omitted variables problem and overstate the coefficient on the lagged periods return. This potential problem can be addressed by including lagged earnings changes as an additional explanatory variable. Nayar and Rozeff (1988) explore this issue using an earnings/returns specification and sample virtually identical to ours. They find only modest negative partial correlations between successive earnings changes and the coefficient on lagged returns remains positive and highly significant with lagged earnings changes included as an additional explanatory variable. We also used one-year T-bill rates with slightly weaker These results are available from the authors upon request. but similar results as reported here.
Even if we were to identify the term structure of interest rates, it is not obvious how to use that information in relating the response coefficient to interest rates. It seems that some kind of a weighted average interest rate is called for where the weights are proportional to the expected levels of interest rates and inversely proportional to their timing. We do not know the extent of improvement in the relation between interest rates and RRCs that would result from such an exercise and leave it for future research.
D. W. Collins and S.P. Kothari, Variation in earnings response coeficients Table 4 Product annual moment and rank order correlations between long-term return response coetlicients estimated by re essing security retums.a. Fr Government bond yields annual earnings changes
165
and on
Correlation between interest rates and return response coeffrcientse Earnings variable A x,/P,-, s&Ax, AX/P,-, %AX, change Return periodd Product moment (p-value) 0.68 (0.005) 0.50 (0.060) 0.73 (0.002) 0.55 (0.034) Rank order (p-value) 0.84 (0.001) 0.55 (0.035) 0.85 (0.001) 0.50 (0.056)
January-December January-December 15 months 15 months
Long-term Government bond yields used as proxies for risk-free interest rates are taken from Ibbotson and Sinquefield (1985). bAnnual return response coefficients (n,s) are estimated from the following annual reverse regressions: %A X,, or A X,,/P,,_ 1= %, + yl, R,, + E,,. The sample selection criteria employed to obtain data for these regressions are given in footnote a to table 2. A X,/P,_ 1 is change in EPS from year t - 1 to t divided by share price at the beginning of the relevant return period (i.e., 12- or 15-month period). A total of 58 observations with /A X,/P,_ 1 I> 100% are excluded. %AX, is change in EPS from year t - 1 to t divided by the EPS for year f - 1. A total of 731 observations with negative denominators or IBA X,1 > 200% are excluded. Return period refers to the independent variable in the annual regressions. R,, is raw return on security i over the relevant return period. dReturn period January-December is 12 months starting from January of fiscal year t for each security. The 15-month return period starts in November of fiscal year t - 1 for the small firms and starts in August of fiscal year t - 1 for the medium and large firms, All correlations are based on 15 annual observations for the period 1968 to 1982.
sensitivity of the earnings/returns relation to interest rate fluctuations. Since we estimate reverse regressions, correlations are expected to be positive. Also, as noted earlier the correlation is expected to be weaker when the dependent variable is SAX,. Product moment and rank order correlations between the RRCs and interest rates (i.e., bond yields) are summarized in table 4. Because interest rates are as of the beginning of the year, RRCs are estimated using returns measured over 12 months beginning in January. However, to be consistent with the evidence that covariation between earnings and price changes is maximized using returns measured over 15month periods, we also report correlations based on RRCs estimated using 15-month returns. Using 15month returns and A X,/P,_ 1, product moment (rank order) correlation between the response coefficient and interest rates is 0.73 (0.85) which has a p-value of 0.002 (0.001). This evidence is consistent with the hypothesized relation between interest
166
rates and RRCs. The p-values are small despite only 15 annual observations (1968-82) used to estimate correlations. Correlations using response coefficients based on 1Zmonth returns are comparable to those based on 15-month returns. As expected, the correlations when %AX, is the dependent variable in the earnings/returns relation are smaller compared to those using A X,/P,_,. Using 15-month returns and SAX,, product moment (rank order) correlation between the response coefficient and interest rates is 0.55 (0.50) which has a p-value of 0.034 (0.056). These results are consistent with interest rate fluctuations having less influence on response coefficients estimated with the previous years earnings as the scale factor on AX,. However, the correlations are still consistently positive and statistically significant. Thus, the sensitivity to interest rates is reduced but not eliminated by using earnings as the scale factor. A likely reason for the association is that the response coefficient for year t also reflects the effect of any interest rate change during the year on the returns on all securities. 6.2. Risk and growth expectations as determinants of the return response coeficient This section analyzes the factors explaining cross-sectional differences in the earnings/returns relation. First, we test the effects of risk and growth (and/or persistence) using the entire sample of firms identified earlier. To estimate firm-specific persistence using time series analysis requires a lengthy earnings history. Since this requirement reduces our sample by about one-half, we report the effects of persistence on the earnings/returns relation in the following section using only the subsample that meets the necessary data requirements. We use common stock betas estimated from monthly returns as a proxy for the riskiness of earnings. The market value to book value of equity relative to the median market value to book value ratio of all the sample firms in each year is used as a proxy for the firms economic growth opportunities. The difference between the market value and book value of equity when measured relative to the market average roughly represents the value of investment opportunities facing the firm [Smith and Watts (1986)]. The market to book value ratio depends upon the extent to which the firms return on its existing assets and expected future investments exceeds its required rate of return on equity. Since future earnings are affected by the growth opportunities, the higher the market to book value of equity ratio, the higher the expected earnings growth. We use the market to book value of equity ratio as of the beginning of each year t as a proxy for expected growth. This proxy for growth, however, is also likely to be affected by earnings persistence. That is, high market to book value of equity ratio is likely to be associated with high
D. W. Collins and S. P. Kothan.
Variation m earnings response coeficients
167
persistence as well. Therefore, on the basis of our regression results we cannot conclude unambiguously that ERC is affected by growth. Rather, a relation between market to book ratio of equity and ERC will suggest that growth and/or persistence affect ERC. To assess the effect of risk and growth on the RRC, the following model is estimated in year t from 1968 to 1982:
A X,,/P,,-
or %AX,, = yo,+ Ed,, + Y~$W * R,, + Y&~ * R,,+ c.
(9)
where R,, = return measured over the appropriate U-month period for the small, medium, and large firms, MB,, = market to book value of equity ratio, calculated at the beginning of year t,19 84, = market model systematic risk.20
The coefficient on R,,, yl, is expected to be positive. When AX, is scaled by P r_l, y2 is hypothesized to be negative because, in the reverse regression, the RRC is decreasing in growth. The effect of risk on the RRC is expected to be positive. When scaling by X,_, we make no predictions on the signs of the latter two coefficients for the reasons noted in section 3.3.3. The results of estimating eq. (9) are reported in table 5. The top number across from each independent variable is the sample mean of the parameter estimates from the 15 yearly cross-sectional regresssions, and the t-statistic is calculated from the standard error of the sampling distribution of parameter estimates. Since statistical inferences are based on standard errors from the
When book value of equity was negative (4 firm-year observations). MB,, was set equal to zero. This is done because negative MB,, values do not have an economic interpretation in the context of the regression model being estimated. To avoid undue influence of very large values of MB,, on the regression coefficient estimates, MB,, > 5 values are set equal to 5 (less than 5% firm-year observations). All the results are insensitive to truncating extreme values at MB,, = 3, 4, or 6. *We also estimated eq. (9) and all other models in the remainder of the paper by nominally classifying firms into high and low growth or risk portfolios. That is, we did not use the market to book ratios or beta as a continuous variable. In the regressions, the independent variables were dummies for risk or growth times R,,. The dummies were assinged a value of 1 for high growth firms or high risk firms, and 0 for low growth or low risk firms. The high/low classification was redetermined in each year. Similarly, when interest rate and persistence were included among the independent variables, high interest rate years or high persistence firms were assigned a value of 1 and 0 otherwise. The primary motivation for using dummy variables instead of continuous variables was that these variables are likely to be measured with error. All the results using dummy variable times returns instead of the continuous variable times returns are virtually indistinguishable from those reported in this paper. All these results are available to interested readers.
168
D. W. Collins and S.P. Kothari, Variation in earnings response coefficients Table 5
Effect of risk and growth expectations on the response coefficient from an earnings/price Annual regression analysis from 1968-82.a AX,,/P,,-, or %A&, =
YO, + x,R,, + YW+% * 4, + n,B,, * R,, + E,,
relation:
Expected dependent Independent Intercept Return Growth Risk (R,,) (MB,, * R,,) (R,, * R,,) + + variable AX/p,-,
sign when variable is BAX,
Time series mean (t-statistic) of estimated coefficientsb AX/p,-, - 0.001 (0.21) %AE, 0.023 (0.62) 0.661** (11.09) -0.57** ( - 4.69) - 0.067 (- 1.70)
+ ? ?
0.080** (4.92) -0.021** ( - 4.31) 0.028* (2.67)
Sample selection criteria are given in footnote a to table 2. AX,/P,_, is change in EPS from year t - 1 to t divided by share price at the beginning of the U-month return period. A total of 58 observations with [A X,/P,_ II > 100% are excluded. %A X, is change in EPS from year t - 1 to t divided by the EPS for year t - 1. A total of 731 observations with negative denominators or [%A X,1 > 200% are excluded. R,, is raw return on security i over the relevant return window. R,, is measured over a 15-month period beginning in November of year r - 1 for the small firms and over a 15-month period beginning in August of year t - 1 for the medium and large firms. MB,, is the market to book value of equity ratio calculated at the beginning of each year t. /3,, is the market mode1 systematic risk estimate obtained by regressing 60 monthly returns ending in year t - 2 on the CRSP equally weighted return index. bSignificance at OL 5% is indicated by one asterisk (*) and at Q = 1% by two asterisks (**). One = tailed t-tests are performed when sign of the coefficient is predicted. Otherwise, two-tailed tests are performed.
time series sampling distribution of the regression coefficients, they are free from the cross-sectional dependence problem described in Bernard (1987). Results using the A X,/P,_, variable are uniformly consistent with our hypotheses. The ur coefficient on return is positive and significant. v2 on the growth/return interaction is equal to -0.021 and reliably negative as predicted. Similarly, the response coefficient increases in risk as seen from the coefficient estimate of 0.028 which is significant at 1% level. The evidence suggests risk and growth (and/or persistence) significantly impact the RRC when earnings change is scaled by price. The coefficient estimates on the return and growth variables from the regression using %AX, as the dependent variable have the same sign as when AX, is scaled by P,_l. The coefficient for which a prediction can be made, j$ is positive and highly significant. The coefficient on the growth/return interaction (j$) too is significant and negative. Thus, when X,_, is the scale variable, the RRC is significantly influenced by growth (and/or persistence). The risk/return interaction (7s) is not significantly different from zero. This result
169
is consistent with the effect of risk on cross-sectional dispersion in the earnings/returns relation being attenuated when scaling by X,-r. To provide additional evidence on variation in the return response coefficient, we estimate the following pooled cross-sectional regression:
+YA * R;,+ rJ, * R,,+ &,t,

where Db8 to D,, are dummy variables taking on a value of 1 for data from year t and 0 otherwise and I, is the long-term risk-free interest rate in year t. All other variables are as defined earlier. We do not include R,, as an independent variable because, when annual dummies are included, Ri, and I * Ri, are almost perfectly correlated. Note that I is a cross-sectional constant in any given year which means I * R,, is a scalar multiple of Ri, in any given year. Use of annual dummy variables reduces cross-correlation because the dummies control the effects of economy-wide changes in earnings in each year.21 Results in table 6 reveal that for the AX,/P,_, variable, all the estimated coefficients have their predicted signs and are statistically significant. The coefficient on the interest/return interaction term is highly significant regardless of the scale variable. This indicates that the capitalization rate on earnings and the sensitivity of price changes to earnings changes is not an intertemporal constant as was assumed in Beaver et al. (1980) and Ohlson (1983).22 When AX, is scaled by X,_, all coefficients have the same sign as when scaling by PI_ 1. The coefficients on growth (and/or persistence) and interest rate interaction variables are significant, but the risk coefficient is insignificantly different from zero. The adjusted R2 is 12.73% using the AX/P,_, variable and 17.98% using the %AX, variable. By comparison, when we estimate the regression with an intercept and R, as the only explanatory variable where R, is measured over the conventional window of April, to March,+, for all firms, the adjusted R2 is 2.47% using AX/P,_, and 4.01% when using %AX,. Clearly, there is a substantial improvement in the explanatory power of the model that incorporates year dummies and risk, growth (and/or persistence), and interest rate terms to account for variation in the response coefficients.
*tGeneralized least squares would control for the remaining cross-correlation ticity problems, but with only 15 annual observations the variance-covariance estimated for a sample of several hundred firms in each year. and heteroskedasmatrix cannot be
**Because of the high collinearity between the return and the interest/return interaction variables we cannot unambiguously attribute the significance of the interest rate variable to the RRCs sensitivity to interest rate variation through time. However, results in table 6 and table 4 put together provide compelling evidence that the RRC is related positively to interest rates through time.
170
D. W. Collins and S.P. Kothari,
Variation in earnings response coefficients Table 6
Effect
of risk, growth earnings/returns
expectations, and interest rates on the response coefficient relation: Pooled regression analysis using data from 1968-82.*
from
an
AX,,/p,,~,or%AX,,=y,+u,,D,,+
+Y~~D~~+Y~MB,,*R,,+Y~P,,*R,~+Y~~*R,~+~~
Expected dependent Independent Intercept

D6X D69 D 70
sign when variable is
Estimated
coetlicient
( r-statistic)b %AX,
Dependent
variable
variable - 0.059** (- 15.58) 0.054** (9.50) 0.062** (11.03) 0.060** (10.82) 0.062** (11.27) 0.076** (14.00) 0.083** (15.28) 0.090** (16.31) 0.030** (5.75) 0.066** (12.61) 0.067** (12.89) 0.080** (15.40) 0.069** (13.26) 0.027** (5.10) 0.050** (9.56)
(MB,, * R,,)
-0.272** (- 16.62) 0.273** (11.30) 0.276** (11.52) 0.250** (10.49) 0.280** (11.77) 0.451** (19.43) 0.504** (21.90) 0.467* (19.88) 0.180** (7.97) 0.331** (14.86) 0.356** (16.11) 0.413** (18.54) 0.338** (15.38) 0.119** (5.39) 0.230** (10.35) - 0.042** (-4.75) PO.013 ( - 0.53) 0.062** (17.78) 17.98% 9045
D71
D 72 D 73 D 74
45
D 76 D 77 D 7R D 79 D 80
43,
Growth Risk Interest Adjusted

N
? ? ?
- 0.024** (- 11.70) 0.018** (3.36) 0.012** (15.36) 12.73% 9718
(P,, * K,,) (I, * R,,)

R*
+ +
For table footnotes
see next page.
D. W. Collins and S.P. Kothari, Variation in earnings response coefficients Table 6 (continued)
171
Sample selection criteria are given in footnote a to table 2. A X,/P,_, is change in EPS from year t - 1 to f divided by share price at the beginning of the 15-month return period. A total of 58 observations with /A X,/P,_ II > 100% are excluded. %A X, is change in EPS from year t - 1 to t divided by the EPS for year I - 1. A total of 731 observations with negative denominators or ISA X,1 > 200% are excluded. R,, is raw return on security i over the relevant return window. R,, is measured over a 15.month period beginning in November of year r - 1 for the small firms and over a 15-month period beginning in August of year [ - 1 for the medium and large firms. MB,, is the market to book value of equity ratio calculated at the beginning of each year 1. /I$, is the market model systematic risk estimate obtained by regressing 60 monthly returns ending in year t - 2 on the CRSP equally weighted return index. I, is the long-term Government bond yield in year t. DhX through dummies which are set = 1 for observations from D,, are annual intercept respective years 68 through 81 and area set = 0 otherwise. hSignificance at a = 5% is indicated by one asterisk (*) and at a = 1% by two asterisks (**). One tailed r-tests are performed when sign of the coefficient is predicted. Otherwise two-tailed t-tests are performed.
To summarize, variation in the earnings/returns relation is explained by differences in risk, growth (and/or persistence), and interest rate factors when earnings changes are scaled by Pt_l. The relation between earnings changes and returns appears to be less sensitive to risk differences when the scale factor is last years earnings. Analysis in section 5 revealed that differences in the earnings/returns relation are related to firm size which is hypothesized to reflect differences in information environment. We show below that for both definitions of the earnings change variable firm size is nor incrementally useful in explaining variation in the RRC once we adjust the holding period return to account for differences in the information environment and growth and risk factors are included in the model. In table 7 we report results of estimating the following model in each year t from 1968 to 1982:
AX,,/f,-1 or %A-%, ~0 + YS,, + ~ztMB,t * R,, + Y3rPirR,, = *

+ y,,Size,, * R,, + qf, where Size;, = 1 for the medium and large firms and 0 for the small firms where firms are reclassified every year. all other variables are as defined earlier. For both specifications of the earnings change variable, v4 is not significantly different from zero. The size coefficient is - 0.008 (t-statistic = - 0.78) when P1_ 1 is the scale variable and it is 0.022 (t-statistic = 0.44) when X,_, is the deflator. Once again, when AX, is scaled by Pt_l all of the other coefficients
172
D. W. Collins and S.P. Kothari, Variarion in earnings response coefficients Table 1
Effect of risk, growth expectations, returns relation:
and firm size on the response coefficients Annual regression analysis from 1968-82.a
from an earnings/
AX,,/P,,~,~~%AX,,=~O,+Y,,R,,+~~,MB,,*R,,+Y,,B,,*R,,+~,,S~~~,,*R,,+F,, Expected dependent Independent Intercept Return Growth Risk Size (R,,) (MB,, * R,,) (I$, * R,,) (Size,, * R,,) + _ + ? + ? ? ? variable AX/p,-, sign when variable is %AX, Estimated coefficient (r-statistic) %AX, 0.023 (0.64) 0.651** (10.98) ~ 0.060* * (- 5.10) - 0.059 (-1.54) 0.022 (0.44)
Dependent A X,/P,- 0.001
variable
( - 0.17)
0.089* (4.69) - 0.021** (-4.59) 0.025* (2.26) - 0.008 ( - 0.78)
Sample selection criteria are given in footnote a to table 2. A X,/P,_, is change in EPS from year 1 - 1 to I divided by share price at the beginning of the 15-month return period. A total of 58 observations with \AX,/P,_,I > 100% are excluded. %A X, is change in EPS from year t - 1 to 1 divided by the EPS for year t - 1. A total of 731 observations with negative denominators or I%AX,( z 200% are excluded. R,, is raw return on security i over the relevant return window. R,, is measured over a 15-month period beginning in November of year t - 1 for the small firms and over a 15-month period beginning in August of year I - 1 for the medium and large firms. MB,, is the market to book value of equity ratio calculated at the beginning of each year t. p,, is the market model systematic risk estimate obtained by regressing 60 monthly returns ending in year I - 2 on the CRSP equally weighted return index. Size,, = 1 for the medium and large firms and 0 for the small firms. Significance at a = 5% is indicated by one asterisk (*) and at a = 1% by two asterisks (**). One tailed r-tests are performed when sign of the coefficient is predicted. Otherwise two-tailed r-tests are performed.
have the predicted sign and are statistically significant. Scaling by X,_, attenuates the influence of risk on the RRC. Growth (and/or persistence) continues to be significantly associated with the RRC when X,_, is the scale variable. Overall, the results are consistent with there being no theoretical justification for incremental explanatory power of the firm size variable on including risk and growth (and/or persistence) variables to explain cross-sectional variation in the relation between earnings and returns. 6.3. Persistence and response coeficients In demonstrating estimating earnings a relation persistence between persistence and ERC, the error in and the error in the proxy for unexpected
D. W. Collins and S.P. Kothari, Variation in eumings response coefficients
173
earnings variable (VX) pose a nontrivial problem. The problem arises because the error in estimating earnings persistence using an ARIMA model at the individual firm level can be large. Moreover, this error is likely to be related to the error in the proxy for UX. If ERC is estimated using eq. (1) it varies inversely with the measurement error in the lJXi, proxy and a spurious correlation between estimated persistence and estimated ERC could result simply because estimation errors in the two variables are correlated. We analyze the relation between persistence and response coefficients differently from previous research and in a way that reduces the correlated measurement error problem noted above. We first estimate IMA(l, 1) persistence factors of those firms with a complete earnings history on the Compustat tape. This data restriction cuts our original sample approximately in half. We then test the interaction of the estimated persistence variable with returns (8, * R,,) along with other interaction terms in the cross-sectional regression equation described earlier in eq. (10) and table 6.23 Since we estimate RRCs rather than ERCs, the coefficient on persistence is predicted to be negative. Moreover, the dependent variable is the scaled annual earnings change rather than the ERCs. Since the dependent variable in our analysis is not conditional on the individually estimated IMA(1,l) models, potential spurious correlation because of measurement error is reduced. The limitation of estimating persistence using reported earnings, as noted earlier, is that the estimate is confounded by earnings growth. Thus, the persistence estimates also reflect economic growth and this adversely affects our ability to separately document the growth and persistence effects.24 Because both persistence and growth proxies are included in the regressions, coefficients on each reflect each variables incremental effect on the RRC. If both proxies are measuring the same underlying construct, then incremental association of each variable with the RRC implies that neither proxy fully captures the underlying construct. Unfortunately, this cannot be verified empirically. The results of adding the earnings persistence variable to the model for the reduced subsample of firms are reported in table 8. When the dependent variable is A X,/P,_ 1 the coefficient on persistence is significantly negative as predicted (-0.051 with a t-statistic of -4.91). For this specification, all the other factors that are hypothesized to affect the earnings/returns relation (i.e., growth, risk, and interest rates) have the predicted sign and are statistically
23Because estimated @s could be positive or negative, we use (1 - 0) instead of -0 as the multiplier in the persistence/return interaction variable. This ensures that the multiplier is always positive and the higher the (1 - 0) value the higher the persistence. (1 - 0) is the persistence factor for an IMA(1, 1) process as seen, for example, in Beaver et al. (1980) or table 1. 24Altematively, as we have noted earlier, the results in the earlier tables could be reflecting effect of persistence and growth on the RRC rather than the effect of growth alone. the
Table 8 Effect of risk. growth, earnings/returns A X,,/P,, persistence, and interest rates on the response coefficient relation: Pooled regression analysis using data from 1968-82.a from an
1or %JX,, = y. + Y~RL~,~ + yxl4 + x MB,, * R,, + YzP,, R,, + * + ~3 4 * R,, + x,4 * R,, t r
Expected dependent sign when variable is %AX, Estimated AT/p,-, - 0.065** (- 13.17) 0.062** (8.98) 0.074** (10.71) 0.064** (9.26) 0.059** (8.56) 0.077: (11.21) 0.093** (13.49) 0.116** (16.28) 0.012 (1.75) 0.073** (10.67) 0.072** (10.58) 0.086** (12.51) 0.079** (11.61) 0.030** (4.34) 0.062** (9.10) coefficient (t-statistic)
%AX,
Dependent
variable
Independent Intercept D68 D69 D 70

D71
variable
AT/p,-,
- 0.327** (- 15.86) 0.333** (11.73) 0.372** (13.17) 0.286** (10.09) 0.263* (9.17) 0.491** (17.21) 0.579** (20.43) 0.630** (21.48) 0.132** (4.70) 0.371** (13.06) 0.396* (14.05) 0.459** (16.23) 0.441** (15.64) 0.153** (5.49) 0.333** (11.86) - 0.066** (- 5.46) 0.17u** (4.85) 0.059** (10.19) 0.062 (1.36) 27.33% 4587
D 72 D,, D 74 D75 D 76 D 77 D 7* D 79 D80

DUl
Growth Risk Interest Persistence Adjusted N R2
(MB,, * R,,) (P,, * R,,) (I, * R,,) (0, * R,,)
? +
? ? ?
- 0.024** (-8.23) 0.049** (5.85) 0.01s** (12.95) - 0.051** ( - 4.91) 19.43% 4841
For table footnotes
see next page
D. W. Collins and S. P. Kothari, Variation in earnings response coefficients Table 8 (continued)
175
Initially any firm listed on the Compustat Industrial Annual or the Compustat Annual Research tape with a December 31 fiscal year-end and complete earnings data during 1968-82 is included in the sample. From this sample, the subset for which monthly return data are available for eight consecutive years ending in 196943 is included in the sample analyzed in this study. A X,/P,_ 1 is change in EPS from year t - 1 to t divided by share price at the beginning of the 15-month return period. A total of 58 observations with Id X,/P,_, 1 100% are excluded. z %A X, is change in EPS from year r - 1 to t divided by the EPS for year t - 1. A total of 731 observations with negative denominators or l%AX,1 > 200% are excluded. R,, is raw return on security i over the relevant return window. R,, is measured over a 15-month period beginning in November of year I - 1 for the small firms and over a 15-month period beginning in August of year t - 1 for the medium and large firms. MB,, is the market to book value of equity ratio calculated at the beginning of each year t. /I,, is the market model systematic risk estimate obtained by regressing 60 monthly returns ending in year t - 2 on the CRSP equally weighted return index. I, is the long-term Government bond yield in year r. Dbx through dummies which are set = 1 for observations from OR1 are annual intercept respective years 68 through 81 and are set = 0 otherwise. 8, is the persistence coefficient measured as (1 - 0) from an IMA(l.l) process. Significance at a = 5% is indicated by one asterisk (*) and at a = 1% by two asterisks (**). One-tailed r-tests are performed when sign of the coefficient is predicted. Otherwise two-tailed r-tests are performed.
significant. When the dependent variable is %AX, the coefficient on persistence has a positive sign, but is statistically insignificant. Again, this can be explained, in part, by the scaling factor, X,-r, which itself is a function of the same parameters that determine the persistence measures. Finally, the explanatory power of the model applied to the reduced sample is considerably higher than for the full sample with an adjusted R2 of 19.43%, when AX,/P,_, is the dependent variable and 27.33% for %AX,. The corresponding adjusted R2s for the full sample from table 6 are 12.73% and 17.98%. The significance levels of the various estimated coefficients reported in table 8 could be overstated because the OLS standard errors ignore cross-correlation among data. We, therefore, estimate a model similar to eq. (9) in each year from 1968 to 1982. The only difference is that we now include a persistence/return interaction variable as well. These results are reported in table 9. Statistical inferences are drawn from the sample mean and standard error of the coefficient estimates from the 15 yearly cross-sectional regressions. Results using the A X,/P,_ 1 variable are uniformly consistent with the hypothesized relation between the RRC and risk, growth, and/or persistence factors. The coefficient on the persistence variable is -0.069 (t-statistic = -2.95) which is negative at a 5% significance level. When %AX, is the dependent variable, the coefficients on risk and persistence are not reliably different from zero, but the coefficient on growth is negatively related to the RRC at 5% significance level. Overall, the results indicate that risk, growth, and/or persistence are significant determinants of the RRCs when earnings changes
176
D. W. Collins and S.P. Kothari, Variation in earnings response coefficients Table 9
Effect
of
risk, growth expectations and persistence on the response coefficients earnings/returns relation: Annual regression analysis from 1968-82.a * X,/P,,-
from
an
I or Ax,, = for + YIN + Y,,MB,,* 8, + nd,, * R,, + ~a,@,4, + E,I R,, *

Expected dependent sign when variable is %AX, Estimated *X,/p,-, - 0.003 (-0.36) coefficient (~tatistic)~ %AX, 0.23 (0.47) 0.695** (4.08) - 0.053* (-2.31) 0.081 (0.84) - 0.039 (-0.38) _____
Dependent
variable
Independent Intercept Return Growth Risk Persistence
variable
* x,/P, -
(R,,) (/JB,, * R,,) (P,, * R,,) (6, * R,,)
+ _
+ ? ? ?
0.153** (4.55) - 0.017** (-4.14) 0.051* (2.01) -0.069**
+ _
( - 2.95)
Sample selection criteria are given in footnote a to table 8. A X,/P,- 1 is change in EPS from year t - 1 to t divided by share price at the beginning of the 15-month return period. A total of 58 observations with )A X,/P,_ II > 100% are excluded. %A X, is change in EPS from year t - 1 to t divided by the EPS for year t - 1. A total of 731 observations with negative denominators or l%A X,1 > 200% are excluded. R,, is raw return on security i over the relevant return window. R,, is measured over a 15-month period beginning in November of year t - 1 for the small firms and over a 15-month period beginning in August of year I - 1 for the medium and large firms. MB,, is the market to book value of equity ratio calculated at the beginning of each year 1. @,, is the market model systematic risk estimate obtained by regressing 60 monthly returns ending in year t - 2 on the CRSP equally weighted return index. 0, is the persistence coefficient measured as (1 - 8) from an IMA(1, 1) process. bSigniticance at a = 5% is indicated by one asterisk (*) and at o = 1% by two asterisks (**), One-tailed r-tests are performed when sign of the coefficient is predicted. Otherwise two-tailed r-tests are performed.
are scaled by price. However, these factors have less influence on RRCs when earnings changes are scaled by last years earnings. Table 10 summarizes how the explanatory power of the earnings/returns relation is enhanced by varying the return interval and by incorporating terms that capture the effects of risk, growth, and/or persistence and interest rates on the RRC. The first two columns report adjusted R*s from models estimated with the full sample, while the last two columns present similar results for the subsample with complete data throughout our sample period. Comparing the first two rows of table 10 we see that the explanatory power of a model where earnings changes are regressed on returns more than doubles when we
D. W. Collins and S. P. Kothari, Variation in earnings response coefficients Table 10
111
Effect of varying the return interval and additional independent variables on the explanatory power of the regression of earnings changes on returns: Regressions using data from 1968-82. Adjusted R2 from earnings returns regression using
Row (1) (2) (3a)
Return interval and independent variables 12-month April to March returns 15-month retumsd
Full sample Dependent A x,/P,-, variable %Ax,
Firms with data for all 15 years Dependent AX/L, 2.11% 8.37 variable %AX,
2.47% 6.32
4.01% 9.87
2.96% 13.04
15-month returns with proxies for risk, growth, and interest rates 15-month returns with proxies for risk, growth, persistence, and interest rates 15-month annual proxies growth, interest returns with dummies and for risk, and rates
8.14
10.09
11.29
13.22
(3b)
11.63
13.71
(4a)
12.73
17.98
19.05
27.31
(4b)
15-month returns with annual dummies and proxies for risk, growth, persistence, and interest rates
19.43
27.33
Sample selection criteria for the full sample are given in footnote a to table 2 and for the sa?ple consisting of firms with complete data for 15 years are given in footnote a to table 8. When full sample is used, there is no proxy for persistence included as an independent variable. Table values are adjusted Rs from regressing either A X,/P,_ 1 or % X, on the set of variables indicated in the left-hand column, dThe 15-month returns that are associated with the earnings change in period I are measured from August,_ 1 to November, for large and medium firms and November,_, to February,+ 1 for small firms.
use a 15month return holding period beginning in August of t - 1 for large/medium size firms and November of r - 1 for small firms. Adding terms that proxy for varying levels of risk, growth and/or persistence, and interest rates (row 3 versus row 2) increases the explanatory power by an additional 10-30S%. Finally, adding annual dummies to capture the year-to-year differences in average earnings changes contributes an additional 50-708 to the adjusted R2 of the pooled model (row 4 versus row 3).
178
D. W. Collins and S.P. Kothari, Variation in earnings response coeJicients
Comparing the first and last row of table 10 shows the dramatic improvement achieved by varying the return interval and allowing nonconstant intercept and slope terms in the earnings/returns relation. For the full sample the adjusted R2 increases by 415% when the dependent variable is A X,/P,_, and by 348% when the dependent variable is %AX,. The comparable improvements for the reduced sample of firms with complete earnings data throughout the 15 years of our study were 821% and 823%. Despite these dramatic improvements in overall explanatory power it is obvious that a substantial amount of variation (roughly, 70-80s) in accounting earnings changes is unrelated to security returns. This suggests there is ample room for further refinement in the earnings/returns relation and/or that accounting earnings contain a large noise component that is irrelevant to valuing the firm.
7. Summary
and implications
for future research
This paper extends the empirical literature on the differences in the relation between earnings and security returns. Using a simple discounted dividends valuation model we hypothesize that the earnings response coefficient varies negatively with the risk-free interest rate and systematic risk; and it varies positively with growth prospects and earnings persistence. This analysis predicts cross-sectional and temporal variation in the amount of price change associated with earnings changes. Our empirical analyses suggest methodological refinements that have implications for past and future association study research. We examine the implications of differences in the information environment which are characteristic of the security market. Specifically, we show that conventional association study methods that measure returns over the fiscal 1Zmonth period, or the degree of association befrom April, to March,_ r, seriously understate tween price changes and earnings changes in an annual association study context. The price/earnings association improves dramatically on starting the measurement period earlier than the contemporaneous fiscal period. Varying the return measurement period for different size firms controls for the information environment differences among the large and small firms and also explains the previous finding that the degree of price change to earnings change varies with firm size. Empirical evidence is consistent with the predictions that the ERC increases in growth and/or persistence and decreases in interest rates and risk. Because the proxies used for growth and persistence could potentially reflect the effect of both variables, we cannot conclude unambiguously that growth and persistence affect ERC individually. To reduce the errors-in-variables problem, we use reverse regression to document the effect of differences in persistence and/or growth, risk, and interest rates on the response coefficient.
179
7.1. Implications for future research

Evidence in this paper has several implications for interpreting the findings in previous research and for future research. First, in both association study and events study contexts, ignoring the sources of cross-sectional and temporal variation in ERC can result in statistically less precise parameter estimates and downward biased test statistics on the response coefficients [see Maddala (1977, ch. 17)]. In addition, the explanatory power of the model would be reduced. Second, in certain contexts researchers include various nonearnings measures to proxy for such constructs as the amount of predisclosure information, political costs, or contracting costs. Popular variables include firm size and debt to equity ratios. As noted by Christie (1987) and Easton and Zmijewski (1989) these other explanatory variables may have significant coefficients simply because they are correlated with the cross-sectional variation in ERC. A priori, there is strong reason to suspect this is true for size and debt to equity ratios. 25 The finding that the earnings/returns relation varies over time as a function of the risk-free interest rate suggests that temporal pooling of observations must be approached with caution unless interest rates are included in the model. Finally, to the extent the number and quality of competing information sources differ cross-sectionally, a researchers ability to document and interpret differences in ERCs is clouded when the information environment differences are left uncontrolled. Return measurement over periods beginning earlier than the fiscal year is proposed as one approach to control for the information environment differences. 7.2. Future extensions Our analysis suggests a number of extensions. First, the evidence that differences in the earnings/returns relation are related to interest rate differences over time suggests the present analysis can be extended to include variables that predict such changes. Possible explanatory variables include inflation, money supply, federal budget deficits, and trade deficits. In addition, financial policy and investment opportunity set variables could be examined in greater detail as possible determinants of both cross-sectional and temporal differences in the ERCs.
25Easton and ZmiJewski (1989) find a positive relation between firm size and earnings persistence. Moreover, both theoretically and empirically, debt/equity ratios and betas are positively associated. This implies a negative relation between leverage and ERC. Therefore, research designs that restrict the ERC to be constant and include either size or leverage in the regression equation are likely to find significant coefficients on these variables because they proxy for sources of cross-sectional variation in the ERCs.
180
Another extension of our analysis of ERCs and interest rates would be to analyze differences in the market risk premia through time and their impact on the earnings/returns relation. Possible proxies for ex ante risk premia are suggested in Merton (1980) Keim and Stambaugh (1986), and French, Schwert, and Stambaugh (1987) among others. Hopefully, extensions along these lines will enhance specification of the earnings/returns relation and yield more powerful tests of the information content of accounting numbers.
References
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D. W. Collins and S. P. Kothari, Variation in earnings response coefficients

D. W. Collins and S. P. Kothari, Variation in earnings response coefficients

D. W. Collins and S. P. Kothari, Variation in earnings response coefficients

Tfil + E(fL+,)l>~ {l/i1

D. W. Collins and S. P. Koihari, Variation in earnings response coeJicients

The unexpected eq. (4) as R;zor uR,,=

U&/ft-~> f~ E(&+,)I (5) {L[1 1 [ it+k+ >

E(h) = R/t + [E(R,,,) R/t]6,. -

[Miller and Rock

and Morse (1980)] ARIMA(1,O.O) ++1 [Easton Zmijewski and (1989)]

u, = X, - E,_ i( X,) is the shock in period

gives the theoretical

D. W. Collins and S.P. Kothari, Variation in earnings response coejficients

D. W. Collins und S.P. Kothnri, Variation in earnings response coefficients

D. W. Collins und S. P. Kothari,

in eurnings response coefficients

D. W. Collins and S. P. Kothari, Variation in earnings response coefficients

D. W. Collins and S.P. Kothari, Variation in earnings response coeficients

D. W. Collins and S.P. Kothari, Variation in earnings response coefficients

D. W. Collins and S. P. Kothari, Variation in earnings response coefficients

Because annual earnings remainder of the paper.

for UX, we use AX instead

D. W. Collins and S.P. Kothari, Variaiion in earnings response coefficients

D. W. Collins and S. P. Kothari, Variation in earnings response coefficients

D. W. Collins and S.P. Kothari, Variation in earnings resporwe coeJ%ents Table 2

D. W. Collins and S. P. Kothari, Variation in earnings response coefficients

D. W. Collins and S.P. Kothari, Variation in earnings response coejicients Table 3

time series cross-sectional

regression of earnings changes security returns: 1968-82.a

D. W. Collins and S. P. Kothari, Variation in earnings response coefficients

und S. P. Kothari, Variation in eurrtings response coeficients

15 Month Holding Period Aug, t-l

month for the return

month return holding period

month return holding period

month return holding period month return holding period

month return holding period

Fig. 1. Large-firm changes in period

D. W. Collins and S. P. Kothari, Variation in earnings response coefficients

15 Month Holding Period Nov, t-1 Jan. t+l

t --__ holding period

month for the return +

month return holding period

month return holding period

month return holding period

month return holding period

return holding period

Fig. 2. Small-firm changes in period

D. W. Collins and S. P. Kothari, Variation in earnings response coefficients

January-December January-December 15 months 15 months

D. W. Collins and S. P. Kothari, Variation in earnings response coefficients

D. W. Collins and S. P. Kothan.

Variation m earnings response coeficients

or %AX,, = yo,+ Ed,, + Y~$W * R,, + Y&~ * R,,+ c.

D. W. Collins and S.P. Kothari, Variation in earnings response coefficients Table 5

sign when variable is BAX,

0.080** (4.92) -0.021** ( - 4.31) 0.028* (2.67)

D. W. Collins and S. P. Kothari, Variation in earnings response coefficients

+YA * R;,+ rJ, * R,,+ &,t,

D. W. Collins and S.P. Kothari,

0.080 (4.92) -0.021 ( - 4.31) 0.028* (2.67)

- 0.024 (- 11.70) 0.018 (3.36) 0.012** (15.36) 12.73% 9718

0.153 (4.55) - 0.017 (-4.14) 0.051* (2.01) -0.069**