248407

The Explanatory Power of Earnings for Stock Returns
Author(s): Norman Strong and Martin Walker

Source: The Accounting Review, Vol. 68, No. 2 (Apr., 1993), pp. 385-399
Published by: American Accounting Association
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THE ACCOUNTING REVIEW

Vol. 68, No. 2
April 1993
pp. 385-399
The
Explanatory
for
Power
of
Earnings
Returns
Stock
Norman Strong
Martin Walker
University of Manchester, England
SYNOPSIS AND INTRODUCTION:In a thorough review of marketbased research on the informationcontent of accounting earnings, Lev
(1989) concludes that the explanatoryvalue of earningsfor stock returns,
and therefore the usefulness of earnings disclosures, tends to be embarrassinglylow. A numberof nonmutuallyexclusive explanationshave been
advanced for these disappointingresults, including:(1) poor specification
of the estimating equation, such as a failureto allow for cross-sectional
variation in the regression parameters; (2) inappropriatechoice of the
assumed proxy for expected earnings; (3) the availabilityof more timely
sources of the value-relevantinformationin earningsstatements (Beaveret
al. 1980); and (4) poor informationalproperties(quality)of reportedearnings because of biases induced by accounting measurementpractices or
creative "abuses" of the earnings measurementprocess.
Lev (1989)speculated that the last of these explanationswas the most
likely cause of the poor statistical performance consistently found in
returns-earningsresearch. In contrast, the present study shows that a
considerable improvementin statistical performancecan be achieved by
workingwith a more general specificationof the returns-earningsrelation.
Lev's article has resulted in serious questioning of the contributionof
market-based research, but we believe that the present study provides
grounds for a more positive assessment.
We use a panel regression approach to examine the association between annualstock price returnsand reportedearningsfigures of industrial
companies in the United Kingdom.We combine several recent advances in
We are grateful to members of the Centre for Empirical Research in Accounting and Finance at the University of Manchester for comments on this research. An early version of the paper was presented at the 1991
Finance and Market Based Accounting Research Conference held at the University of Manchester; we are
grateful for comments received from participants at that conference. John O'Hanlon and Peter Pope made a
number of helpful suggestions on a previous version of the paper. We would particularly like to acknowledge
the comments of the editor, an associate editor, and the anonymous referees; their comments resulted in a substantial improvement in the focus and exposition of the paper. The financial support of the ICAEW and the
ESRC (grant number R000233813) is also gratefully acknowledged.
Submitted August 1991.
Accepted December 1992.
385
386
TheAccountingReview,April1993
market-based acounting research design to produce a specification of the
relation between earnings and price changes that subsumes the following
key features:
1. Contemporaneous earnings yield is included in addition to the deflated first difference in earnings that is normally included in models
of the returns-earnings relation.
2. Regression parameters are allowed to vary both cross-sectionally
and over time.
3. Parameter values are allowed to vary across components of earnings to accommodate differences in the degree of persistence; in
particular, we model the explanatory power resulting from attempts
by accountants to distinguish extraordinary and exceptional items
from the other components of earnings.
We introduce these features in a general model in a way that allows us
to assess the incremental explanatory power of each individuallyas well as
the joint effects of two or more combined. Each methodological improvement contributes significantly to our ability to explain security price
changes, and we show that the best fit is achieved by incorporating all
three features in a single general model. In moving from the standard
model, which regresses a measure of abnormal returns on earnings
changes, to the most general model, the adjusted R-squared increases
from 0.10 to 0.38.
Key Words: Stock returns, Earnings yield, Earnings disaggregation, Panel
regression.
Data Availability: A list of the sample firms is available from the authors
upon request. The rest of the data are available from
sources identified in the text.
HE article is organized as follows. We introduce the general earnings response

model in section I and provide details of the sample of observations and definitions of variables in section II. Section III contains a statistical analysis of the
variables included in the study. The principal results are reported in section IV, and we
offer our conclusions in the final section.
Tp
L. Earnings Response Models

The standard model of the relation between abnormalreturns and accounting earnings can be represented as:
CARi,=a
RbEit-=Eib
1i)
where:
a= an intercept parameter to be estimated,
b = a slope parameter to be estimated (generally referred to in the literature as
the earnings response parameter),
Strong and Walker-Power of Earnings
387
CARi= the cumulative abnormal return of company i in period t,

Ei,=the earnings of firm i in period t,
Vit-1=the market value of equity at the start of period t, and
ui= a conventional, mean zero, disturbance term.
Recent advances in the market-based accounting literature have attempted to
extend this basic model in a number of ways. Theoretical work by Ohlson (1989) has
suggested that earnings yield might be added as a second independent variable to allow
for transitory components in earnings, and Easton and Harris (1991)have furtherhighlighted the potential of the yield variable to explain stock returns.' In addition, a number of recent studies based on U.S. data have documented statistically significant variations in the earnings response coefficient, both across firms and over time. Kormendi
and Lipe (1987)and Collins and Kothari(1989)show that earnings response coefficients
are positively related to the persistence of earnings and exhibit cross-sectional and
intertemporal variation. Easton and Zmijewski (1989), adopting a random coefficients
regression model, and Board and Walker (1990), employing a fixed coefficients
(dummy-variable)regression approach, support these findings. Other studies have
shown that it may be possible to increase the explanatory power of earnings response
models by identifying various components of earnings as separate independent variables (see, e.g., Lipe 1986).
Collectively, these considerations suggest the following generalization of equation
(1):
CAR,= a,+t(bi+b
Vit-
X1=
+ C+(c
+c+)
i=1
1
(2)
Vit-
where:
a,= a time-varying intercept parameter,
Ej,=the jth component of the earnings of firm i in period t,2
bJ and bi= firm-varyingresponse parameters associated with the change in Et
c8 and ca- firm-varyingresponse parameters associated with the level of E
cj and c=are firm-varyingresponse parameters associated with the level of
Em;,,
and other variables are as defined previously.
Equation (2) adds an intercept term that is allowed to vary over time to equation
(1). In addition, the model disaggregates earnings into I components and allows the
response parameters to vary across components and over time. Finally, equation (2)
'The standard earnings response model represented by equation (1) assumes that earnings follow a
randomwalk. The potentialvalue of including an earnings yield variablecan be seen, if we instead assume that
earnings follow a first-orderautoregressiveprocess of the form,
El, - j&=,(Ejj - A)+e;,.
Then expected earnings in period t is, u+ (E,CAR,,=a+
b( -1)
u), and the returns-earningsrelation becomes,

+b_
__ ___
'vir1 it-1Vi-
+b(1-0)
u,.
2
Throughoutthis article, superscriptsare used exclusively to denote earningscomponentsand the parameters associated with these components. Thus, E2 denotes the second earnings component, not earnings
squared.
388
The Accounting Review, April 1993
incorporates a yield variable for each component of earnings, with the response parameter being allowed to vary across firms, over time, and across components.3 In its most
general form, the model requires estimation of (I x 7 + 3 x T) parameters,where T is the
number of years for which data are available. For 200 firms and 20 years of data per
firm, the estimation of 1,460 parameters from 4,000 observations would be required.
We present empirical evidence for equation (2) and for several restricted versions
that were carefully selected to highlight the incremental effects of: (1) allowing for
cross-firm variation in the parameters,(2) introducing the yield variable into the specification, and (3) separately identifying the exceptional and extraordinarycomponents of
earnings. Following suggestions in a number of recent studies, we also present results
for raw returns as well as for abnormal returns as the dependent variable.
II. Sample Selection and Data Definitions
The study is based on a random sample of 416 companies selected from the 1987 list
of all U.K.-quotedindustrial companies in Datastream.4From this starting sample, we
selected all companies with December to April financial year-ends.5 We carefully
checked the sample to exclude any companies that changed their accounting year-end
during the relevant period. Further companies were excluded by the following data
requirements:(1)At least 10 consecutive years of accounting data had to be available on
Datastreamwithin the period 1971 through 1986 and (2)we also required a complete set
of 16 years of returns data on the London Business School Share Price Database
(LSPD).The 16 years correspond to the 10 years for which the accounting data was
available, plus five years preceding the first year of accounting data (used to estimate
the market model for the first year of the study) and one year following the last year of
accounting data.
These criteria generated a final study sample of 146 U.K.-quoted companies and
2,036 observations. Though slightly biased toward the larger companies, the size distribution of the sample at the end of 1980, when all sample firms were trading, was
reasonably representative of the population of firms recorded as being traded at the end
of 1980 by the LSPD. Sixty percent of both the sample and the population of companies
fell in the size range of ?2 through ?38 million ($4.8 through $91.2 million). However,
the percentage of companies with a market capitalization of less than ?2 millon was
only 10 percent in the sample, compared to 20 percent in the entire population. At the
other end of the size distribution, 30 percent of the sample firms had a market capitalization greater than ?38 million, compared to only 20 percent in the population. The
industrial composition of the sample is reported in table 1 and is reasonably representative of the population of industrial companies in the United Kingdom.
The values of two return metrics were computed for each company year of data.6
An econometric restriction implicit in equation (2) is that the cross-firm and intertemporalsources of
parametricvariation are assumed to be additive in their effects.
4 Datastreamis an extensive on-line system of data bases covering, inter alia, domestic (United Kingdom)
and internationalcompany accounts.
I In the regression analysis, the months Januaryto April were grouped with the preceding December in
defining period t.
6 The statistical analysis used abnormalreturn calculatedaccording to the capital asset pricing model as a
third returnmetric. The results were virtuallyidentical to those for the marketmodel abnormalreturnand are
not separately reported.
389

Table I
Industrial Composition of the Study Sample
IndustrialClassification
Percent
Industrialand building material

Contracting,construction
Electricals and electronics
Miscellaneous mechanical engineering
Other capital goods
Brewering, catering, and leisure
Food
Newspaper, publishing, and printing
Stores and other retailing
Health and household products
Chemicals and oil
Shipping and transport
Miscellaneous industrials
Overseas trade
17
9
4
16
21
9
7
10
10
7
5
10
7
6
2
11.6
6.2
2.7
11.0
14.4
6.2
4.8
6.8
6.8
4.8
3.4
6.8
4.8
4.1
1.4
146
100
Total
MMCARis the cumulative monthly market model abnormal return from May of year t
through April of year t+ 1, and RETURNis the cumulative monthly stock return from
May of year t through April of year t + 1.7 Both return metrics implicitly assume that the
earnings news for year t (for a December year-end company) is released no earlier than
May of year t and no later than April of year t+ 1.
The empirical analysis focuses on three components of earnings: earnings before
exceptional and extraordinary items, denoted E' and referred to as "pre-exceptional
earnings"; exceptional earnings, denoted E2; and extraordinaryearnings, denoted E3.
The following importantaggregationsof these earnings components are also examined:
Ordinary earnings
E I+ E2,
(3)
E1 + E2 + E3.
(4)
and
All-inclusive earnings
In the United Kingdom, ordinary earnings comprise the reported earnings number
on which earnings per share calculations are currently based.8
7 The dates for estimating benchmark returns, for cumulating (abnormal) returns, and for deflating earnings components refer to December year-end companies. For company financial years ending January to April,
dates are successively adjusted forward by one month. The market model abnormal return was calculated by
fitting the market model to the continuously compounded company and market returns (Financial Times All
Share Index) for the 60 months immediately prior to year t. The abnormal returns from May of year t to April of
year t + 1 were then derived as the prediction errors from the market model, conditional on the realized value of
the market index for that month. All return data were taken from the LSPD.
* The distinctions between pre-exceptional, exceptional, and extraordinary earnings were established in
the early 1970s by the United Kingdom's Accounting Standards Committee (ASC) and were formalized in
Statement of Standard Accounting Practice 6 (SSAP6) in 1974. Extraordinary items were defined as "those
items which derive from events or transactions outside the ordinary activities of the business and which are
both material and expected not to recur frequently or regularly. They do not include those items which, though
390
TheAccountingReview,April1993
Corresponding to the definitions, the following five accounting variables were

assembled from Datastream company accounts data for each company year:
El + E2=Ordinary earnings (Datastreamitem 175),
E2= Exceptional items (Datastreamitem 194),
E3= Extraordinaryitems (Datastreamitem 193),
EI=Earnings before Exceptional Items (Datastream items 175 minus
194), and
El + E2+ E3= All-inclusive earnings (Datastreamitems 175 plus 193).
For each of these earnings components, we then defined and calculated the "deflated
first difference" as the value of the component in year t minus the value in year t -1
divided by the market capitalization on April 30 of year t (May 31 for Januaryyear-end
companies, etc.). We also calculated an earnings yield variable for each component as
the value of the component reported for year t divided by the market capitalization on
April 30 of year t. Dummy variables were constructed to allow the regression parameters to vary both across firms and over time in accordance with equation (2).9 The time
dummies allow for a different response parameter for each year (corresponding to an
average coefficient for all firms in that year). The (time-invariant)firm dummies allow
for a different response parameter for each firm.10
III. Data Analysis
Before conducting the panel regressions, we completed a number of separate
analyses on the materiality of the earnings components, the correlation structure of the
main variables involved in the study, and the time-series properties of the three earnings components.
Materiality of the Earnings Componentsin Relation to Market Capitalization
This was assessed by examining the key descriptive statistics of the three components of all-inclusive earnings yield (see table 2). The pre-exceptional earnings yield
averaged about 13 percent over the sample period, with a standard deviation of 20 percent. There was no marked skewness. The median values and the 25th and 75th per-
exceptional on account of size or incidence (and which therefore may require separate disclosure), derive from
the ordinary activities of the business. Neither do they include prior year items simply because they relate to a
prior year." This definition implicitly considers exceptional items as arising from the ordinary activities of the
business and requiring separate disclosure because of their size or incidence.
Successive surveys of published accounts showed that SSAP6 succeeded in rapidly establishing the
required practice of separate disclosure of extraordinary and exceptional items and the practice of calculating
earnings per share figures according to earnings after exceptional but before extraordinary items (see, e.g.,
ICAEW 1977, sec. 7). However, several surveys also showed considerable inconsistencies in the way similar
items were accounted for by different companies, the main difficulty being that of deciding whether a
particular item derived from the ordinary activities of the business. In an attempt to reduce the incidence of
such inconsistencies, the ASC issued a revised version of SSAP6 in 1986. To avoid complications caused by the
changed definition of extraordinary items, we restrict our attention to the period preceding the revision.
9 Judge et al. (1985, chap. 13) gives a helpful discussion of the basic technique.
10We found that 37 companies reported extraordinary items in fewer than six years. In regressions with
extraordinary items separately identified, the corresponding firm-varying regression parameters were
restricted to be constant across these companies. A similar procedure was followed for 21 companies that
reported exceptional items in fewer than six years.
391
LO
CD
LO
c= -
Q5
0
c;
LO
~M
e o
6
Ir
'-
N
O e
co
Cry~~~~~C
I
.P.0
a-
E~I
c6
co
c'
aP0~~~~~?E:ocG
L4
cX
N0
C-
la
0~x
-d
N
U
LO
0
'-4
392
Table 3
Median Time-Series Correlations of MMCAR and RETURN
with the Independent Variables
DependentVariable
IndependentVariables
MMCAR
RETURN
Pre-exceptionalearnings yield
0.39
0.34
Pre-exceptionalfirst difference
Exceptional earnings yield
0.44
0.37
Exceptional first difference
0.00
-0.04
-0.01
-0.01
Extraordinaryearnings yield
0.01
0.06
Extraordinaryfirst difference
0.17
0.16
Note: The variables comprise the three components of all-inclusive earnings, each expressed in levels and
first-differenceform. Each is deflated by opening equity capitalization. N=all 146 companies.
centiles of the exceptional and extraordinaryearnings yields show that many of these
reported values are close to zero-50 percent are less than or equal to 1 percent in
absolute value. It is also noteworthy that the extraordinaryitems have a negative skew,
in contrast to the positive skew of exceptional items, which suggests a tendency to
report large positive items as exceptional and large negative items as extraordinary.
CorrelationStructure
The median time-series correlations of MMCARand RETURNwith the three earnings yield and three first-difference variables are given in table 3. The median value of
the correlations for the two pre-exceptional variables are both appreciablygreaterthan
zero. Moreover, the 25th percentiles of the distributions are also positive. In contrast,
the correlations of the variables for the extraordinaryand exceptional items tend to be
much lower. The median correlations for the two exceptional earnings variables are
close to zero; although positive for the two extraordinaryearnings variables, they are
appreciably lower than the corresponding correlations for pre-exceptional earnings.
The median time-series correlation matrix for the six independent variables (table
4) exhibits four significant features:
1. The median correlations between the exceptional and extraordinary variables
(levels and first differences) are all close to zero.
2. The median correlation between the first difference of pre-exceptional earnings
and the pre-exceptional earnings yield, at 0.64, is moderately high.
3. The two exceptional variables have a tendency to be negatively correlated with
the two pre-exceptional earnings variables. The extraordinary variables, however, exhibit a positive association. These are the kind of associations one would
expect if exceptional and extraordinary items are used to "smooth" reported
earnings per share.
4. The median correlation between the yield and difference variables is high for
both exceptional and extraordinaryitems. Multicollinearity could prove to be a
problem here.11
"In particular,it would be quite possible for the yield and differencesvariablesto be jointlysignificantbut
for both individual t-statistics to be insignificant.
393
StrongandWalker-Powerof Earnings
Table 4
Median Time-Series Correlation Matrix of the Main Independent Variables
Pre-Exceptional Exceptional Exceptional Extraordinary Extraordinary

Difference
Yield
Difference
Yield
Difference
Pre-exceptionalyield
Pre-exceptionaldifference
Exceptional yield
0.64
-0.36
-0.39
-0.22
0.14
0.09
-0.52
0.04
0.11
0.74
Exceptional difference
0.00
0.01
0.01
0.01
0.74
Extraordinaryyield
Note: The variables comprise the three components of all-inclusive earnings, each expressed in levels and
first-differenceform. Each is deflated by opening equity capitalization. N=all 146 companies.
Time-SeriesProperties
The first-orderserial correlations of the three main earnings variables (undeflated
levels) are shown in table 5. In contrast to pre-exceptional earnings, which exhibit
strong positive serial correlation with a median value of 0.63, the exceptional and extraordinary items exhibit a median serial correlation close to zero. Moreover,the 75th percentiles of the distributions for the exceptional and extraordinary items lie below the
25th percentile of the corresponding distribution for pre-exceptional earnings. As an
alternative test for persistence, we estimated the first-orderserial correlations for the
corresponding first differences. The median first-difference correlation for pre-exceptional earnings is - 0.01, close to zero. For exceptional and extraordinaryearnings, the
corresponding median correlations are -0.41 and -0.35, respectively, which shows
strong evidence of mean reversion."2
The results suggest that pre-exceptional earnings exhibit a high degree of persistence but that the other two components are highly transitory. In conformance with the
ideas of Kormendi and Lipe (1987) and Collins and Kothari (1989), these persistence
comparisons lead us to hypothesize that, on average, the relation between stock price
movements and extraordinary items should be broadly similar to the corresponding
relation for exceptional items. Moreover, both of these relations should differ from the
corresponding relation for pre-exceptional earnings. Because of these considerations,
our general model separately identifies the exceptional and extraordinarycomponents
of earnings by allowing the response parameters to vary across components.
IV. Regression Results
The main findings of the study are reported in two subsections. The first shows the
improvements in explanatory value achieved by successively moving toward the general econometric specification previously outlined. The second examines the signs and
significance levels of the parameter estimates generated by our most general econometric model.
12
We also employed nonparametricproceduresto test whetherthe distributionof the first-orderserialcorrelations differed between the three earnings variables.Kolmogorov-Smirnovand Kuiperstatistics, based on
the empirical distributionfunction, rejectedthe null hypothesis that the distributionof first-orderserial correlations for pre-exceptionalearnings is the same as that for either exceptional or extraordinaryearnings, at a
significance level of 0.1 percent. The same test statistics were unable to reject the null hypothesis that the
distributions of first-orderserial correlations for exceptional and extraordinaryitems are the same (at well
above standard significance levels).
394
Table 5
First-Order Serial Correlations of the (Undeflated) Earnings Variables
25th
Percentile
Median
75th
Percentile
0.63
0.85
0.31
Pre-exceptional earnings
Exceptional earnings
-0.17
0.01
0.24
Extraordinary earnings
-0.09
0.05
0.29
Table 6
Between Models
of
the
Differences
A Summary
for Which Adjusted R2 are Reported in Table 7
Model
Number
TimeVarying
Parameters
FirmVarying
Parameters
Levels
Variable
Included
MO
Ml
M2
M3
M4
M5
M6
M7
M8
M9
M10
No
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
No
No
No
No
Yes
No
Yes
Yes
Yes
Yes
Yes
No
No
Yes
No
No
Yes
No
Yes
Yes
Yes
Yes
Earnings
Disaggregated
No
No
No
Yes-tEIl,
IE21, JEI1
No
Yes-tElJ, tE2l, tE3l
Yes-tE'J, tE2l, JE31
No
Yes-tElJ, tE2+EI3
Yes-tE'+E2J, tE3l
Yes-tElJ, tE2l, tE3l
Model Selection
The 11 models for which results are reported are presented in figure 1 and
summarized in table 6. The starting point for our analysis is MO,the basic earnings
response model given by equation (1). This model was fitted to the entire (pooled)
sample of observations with the first difference in all-inclusive earnings as the
independent variable. The resulting R-squared values are reported in table 7 and
provide a benchmark for comparison with the more refined models, Ml to M10.
The first refinement is given by model Ml, which allows the regression parameters
of the basic model to vary over time. A number of researchers have established
theoretical grounds for time-series variation in the earnings response parameter (see,
e.g., Board and Walker 1990; Collins and Kothari 1989). In addition, the earnings
response parameter will vary over time if the expectation benchmark for earnings is
more accurate in some years than in others.
A comparison of the findings for Ml with those for MOreveals a marked improvement in R-squaredunder both MMCARand RETURN.The improvement for MMCAR
Strong and Walker-Power
of Earnings
395
Figure 1
A Summary of the Panel Regression Models
Given below is the full set of regression equations used in the research. All equations were estimated with
both annual cumulative abnormal return (MMCAR) and annual unadjusted return (RETURN) as the
dependent variable (denoted below as RiJ. The components of earnings identified are pre-exceptional
earnings, El, exceptional earnings, E2, and extraordinaryearnings, El. Where appropriate,the equations
are given in increasing order of generality.
3
E (El,,-El,-,)
ri
R,,=a+b
(MO)
+ui
'1it-1
-E1)
(El,R,,=a,+b,
+u,,
(Ml)
3
E El,
1 3E',,-E',-,)
+ u,,
R,, = a.,+b, j 1
+ct i-1
(M2)
V'it- Vl.-1
Ri =at+
(bf
(M3)
it+
+
hi-
(E',,-E',-,
R,=a,
j1
+(b,+b)
(M4)
+(u,,
3
R,=,
R., =a, +
EJ,
SC
33
EJfEi-EJi
V,.~~-1
=1
E (b',+tb>)
u,+ ,
Ec
V,,_1
}s1
V,
( M6)
Vi=2
3
E',t- E',,S )
1: (E
El,,
+ + (c,+c,
U(b(+b)
CJj-
iJ-I-
V=
Ri,=a,+ (b,+b,)
E~bJ
R,.=a.+
+u,,
(M7)
Vit-1
E
E~~~~
it +
Eitji
, + C+ (
+ (c,'+ c,)
R,,-,+(,+b)
=1
~~+
C_+
Vit-I
f,
(M8)
+u
(c,3+c3
Vit -I Vt1-
+(b,3+b,)
" + U1,
"
(M9)
v-it-i~ ~~~33StEi-
II~a+~b+~
C'+(c)
t+c +
+Uh
(M1O)
396
Table 7
Adjusted H-Squared Values of the Models
Dependent Variables
RegressionModels
MMCAR
RETURN
MO
0.1028
0.1943
0.2083
0.2195
0.2386
0.2412
0.3059
0.2737
0.3142
0.3359
0.3823
0.0659
0.3753
0.3920
0.3940
0.4141
0.4134
0.4758
0.4796
0.5069
0.5240
0.5454
Ml
M2
M3
M4
M5
M6
M7
M8
M9
M10
Note: The independent variables comprise various disaggregationsof all-inclusive earnings, in first difference or levels form or both. These are deflatedby opening equity capitalization,and various degrees of
temporal and cross-sectional variation are modeled.
is broadly consistent with the findings of previous studies based on U.S. data. A more
dramatic increase in R-squared occurs with RETURN as the dependent variable
because, in addition to the factors that cause the regression parameters to vary under
MMCAR,a considerable proportion of the time-series variation in individual company
returns is "explained"by the market;in model Ml, the temporal variation in the market
return is captured by the time-varying intercept.
The remaining results for models M2 to M10 in table 7 incorporate various combinations of refinements over and above those capturedby model Ml. These results allow
us to assess the individual and joint effects of incorporating (1) firm variation in the
independent variable response parameters,(2)earnings yield variables, and (3)earnings
disaggregation. We first consider the individual effects of these three additional refinements, then the joint effects of incorporating two or more of the refinements.
Comparing the findings for models M2, M3, and M4 with those for model Ml
shows that moderate improvements in R-squaredare achieved by all three methodological refinements under both MMCARand RETURN.Conventional analysis of covariance (F-) tests confirmed that the increases in R-squaredof models M2, M3, and M4
over Ml are significant at the 1 percent level under both MMCARand RETURN.13
Models M5, M6, and M7 show the joint effect of introducing two of the three model
refinements. Analysis of covariance tests were performed to compare these models
with their nested counterparts in models M2, M3, and M4.14These tests showed that
significant improvements in explanatory power at the 1 percent level are achieved for
both dependent variables in M5 over M2 and M3, M6 over M3 and M4, and M7 over
M2 and M4.
13
See Harvey (1990, 61-64) for further details.

A model is a nested version of another if it can be derived by imposing appropriate restrictions on the
parameters of the other model. See Judge et al. (1985, chap. 21), for details,
14
397
The effect of incorporating all three methodological refinements into our general
model was assessed by comparing model M10 with models M5, M6, and M7. Analysis
of covariance tests rejected M5, M6, and M7 in favor of model M10 at a significance
level of 1 percent for both MMCARand RETURN.Thus, adding any one of the three
methodological refinements yields a further significant improvement in explanatory
power. Overall, these tests identify M10 as the most appropriate model of the relation
between returns and earnings. Moreover, the improvement in explanatory power generated by moving from the basic earnings response model, MO,to the general model,
M10, suggests that the low R-squaredvalues reported in the research surveyed by Lev
(1989) can, to a significant extent, be attributed to the restrictive research designs in
early studies.
Finally, for sake of completeness, we investigated the comparative explanatory
value of three alternative forms of earnings disaggregation via comparisons of model
M10 with models M8, which aggregates exceptional and extraordinaryitems but separates these from pre-exceptional earnings, and M9, which distinguishes between ordinary and extraordinaryearnings. Examination of M8 is motivated by our earlier results
on the time-series properties of the three earnings components; examination of M9
follows from the standard accounting practice in the United Kingdom of separating
extraordinaryitems from ordinary earnings. Conventional analysis of covariance tests
selected M10 over both M8 and M9 under both MMCARand RETURNat a significance
level of 1 percent. These results suggest that the market-pricingprocess for exceptional
items is different from the pricing process for both pre-exceptional earnings and extraordinary items.15
Parametert-Values and Hypothesis Tests
Since the number of parametervalues generated by M10 is large (869),the analysis
focuses on hypothesis tests relating to the average value of the parametersacross firms
and over time. Table 8 shows the significance of the average values, across firms and
time, of the regresssion slope parameter estimates generated by fitting model M10.16
The results are similar under both dependent variables.17 The significance of both preexceptional earnings yield and pre-exceptional first difference suggests that the specification of the conventional earnings response model is improved by incorporating a
yield variable.
None of the other four variables is significant at conventional levels under either
MMCARor RETURN,a result apparently contradicting the earlier finding that model
M10 provides a better fit to the data than model M8. One possible reason for this lack of
significance is the multicollinearity noted in the discussion of table 4. To test this, we
conducted further t-tests for the joint significance of the yield and first-difference pa1S For completeness, we also ran the alternative regression to M8 and M9 by aggregating pre-exceptional
earnings (El) and extraordinary items (E3) but separating exceptional earnings (E2). The R-squared for this
regression was 0.3066 for MMCAR and 0.5012 for RETURN.
16 Bernard (1987, 13) discusses the severe problems for hypothesis testing that arise from cross-sectional
dependency in the residuals when models impose cross-sectional homogeneity in the response coefficient. By
allowing for cross-sectional variation, M10 should substantially reduce the problem of cross-sectional dependence.
17 The remaining problem of serial correlation in the residuals could lead to upwardly biased t-values when
RETURN is the dependent variable. However, the similarity of the findings for RETURN and MMCAR is reassuring.
398
Table 8
Average Values of the Regression Slope Parameters for Model M1O
Dependent Variable
IndependentVariable(s)
Pre-exceptionalearnings yield
MMCAR
RETURN
1.59**
1.67**
Pre-exceptionalearnings difference
1.85**
1.92**
Exceptional earnings yield
1.48
0.49
2.51
Exceptional earnings difference
-0.37
Extraordinaryearnings yield
Extraordinaryearnings difference
0.60
Exceptional earnings yield and difference
2.00*
Extraordinaryearnings yield and difference
0.11
3.85
0.90
-0.60
2.17**
-0.05
Note: The test determines whether the average firm slope parametercorresponding to a particularindependent variable (or variables) is significantly different from zero when the slope parameter for an
individual firm is given by its firm-varyingcomponent for those years the firm was in the sample. All
tests used the full variance-covariancematrix of parameterestimates from model M10.
rameters for both exceptional and extraordinary earnings (see table 8). The important
additional result to emerge is rejection of the null hypothesis that the exceptional yield
and difference variables taken jointly are, on average, insignificantly different from
zero.18
V. Conclusions
The evidence in this study suggests that a significant improvement in the statistical
performance of models of earnings and returns can be achieved by allowing for timeseries and cross-sectional variation in the regression parameters, by including an earnings yield variable along the lines suggested by Ohlson (1989), and by partitioning allinclusive earnings into pre-exceptional, exceptional, and extraordinary components.
The evidence that the pre-exceptional earnings yield variable is statistically significant
on average further suggests that pre-exceptional earnings exhibit both permanent and
transitory features and that models of the relation between earnings and returns that
focus exclusively on the deflated first difference of earnings are misspecified,
18 Shortly before publication we found that DatastreamItem 175 excluded certain exceptional items in
some of our sample company years. We re-estimatedthe models using DatastreamItem 182, which includes all
exceptional items. Model M10 still emerged as the best model with R-squaredvalues marginallyhigher than
those reportedin table6. The pre-exceptionalearnings yield variablewas more significant than reportedabove
and was the only variable to be statistically significant on average. Further details are available from the
authors on request.
Strong and Walker- Power of Earnings
399
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The Explanatory Power of Earnings for Stock Returns

Author(s): Norman Strong and Martin Walker

THE ACCOUNTING REVIEW

HE article is organized as follows. We introduce the general earnings response

L. Earnings Response Models

Strong and Walker-Power of Earnings

CARi= the cumulative abnormal return of company i in period t,

Then expected earnings in period t is, u+ (E,CAR,,=a+

u), and the returns-earningsrelation becomes,

The Accounting Review, April 1993

Strong and Walker-Power of Earnings

Industrialand building material

Corresponding to the definitions, the following five accounting variables were

Strong and Walker-Power of Earnings

The Accounting Review, April 1993

Exceptional first difference

Pre-Exceptional Exceptional Exceptional Extraordinary Extraordinary

The Accounting Review, April 1993

Strong and Walker-Power

The Accounting Review, April 1993

See Harvey (1990, 61-64) for further details.

Strong and Walker-Power of Earnings

The Accounting Review, April 1993

Exceptional earnings yield

Exceptional earnings difference

Exceptional earnings yield and difference

Extraordinaryearnings yield and difference

Strong and Walker- Power of Earnings

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