Stock Price Associations with Expected and Unexpected Earnings

45 Pages Posted: 16 Dec 2014

See all articles by Adrian Kubata

Adrian Kubata

IESEG School of Management

Terry J. Shevlin

University of California-Irvine

Christoph Watrin

University of Muenster - Accounting Center

Date Written: December 15, 2014

Abstract

Prior research fails to explain why theoretically predicted magnitudes of earnings response coefficients (ERCs) and price-to-earnings ratios (P/E ratios) differ from their empirical counterparts. Therefore, we (re)investigate the associations between earnings innovations, persistence of expected earnings, investors’ expectation revisions, and the magnitudes of P/E ratios and ERCs, respectively. In doing so, we compare the traditional price model with our extended price model, which is based on a new model of investors’ expectation formation, simultaneously incorporating the following assumptions: (i) expected earnings are less than purely persistent; (ii) only the value-relevant fraction of an earnings innovation triggers future expectation revisions; (iii) expected earnings’ time series is nonstationary but integrated of order 1; and (iv) the persistence of expected earnings is negatively correlated with the value-relevant magnitude of earnings innovations, i.e. high persistence in expected earnings requires a low level of expectation revisions. We first show on a theoretical level that under these assumptions: (a) P/E ratios and ERCs differ in their magnitudes and it thus becomes necessary to distinguish between these two constructs in modelling price-earnings relations; (b) ERC magnitudes are negatively associated with the persistence of expected earnings, contradicting both theoretical implications of the traditional price model which predicts a positive association as well as empirical evidence; (c) expected magnitudes of P/E ratios (ERCs) range between 10-60 (0-7). We second test our model empirically. The empirical results are consistent with our predictions, closing the gap between theoretically predicted and empirically estimated P/E ratio and ERC magnitudes, respectively.

Keywords: Capital markets, stock prices, price-to-earnings ratio, earnings response coefficient, earnings expectations.

JEL Classification: M14, C20

Suggested Citation

Kubata, Adrian and Shevlin, Terry J. and Watrin, Christoph, Stock Price Associations with Expected and Unexpected Earnings (December 15, 2014). 2015 Canadian Academic Accounting Association (CAAA) Annual Conference, Available at SSRN: https://ssrn.com/abstract=2538541 or http://dx.doi.org/10.2139/ssrn.2538541

Adrian Kubata (Contact Author)

IESEG School of Management ( email )

Socle de la Grande Arche
1 Parvis de la Defense
Paris, Paris 92044
France

Terry J. Shevlin

University of California-Irvine ( email )

Paul Merage School of Business
Irvine, CA California 92697-3125
United States
2065509891 (Phone)

Christoph Watrin

University of Muenster - Accounting Center ( email )

Universitätsstr. 14-16
Muenster, 48143
Germany

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
169
Abstract Views
1,606
rank
218,924
PlumX Metrics