Earnings Quality and Price Quality
29 Pages Posted: 17 Aug 2002
Date Written: July 2002
Several papers have considered the relevance or quality of earnings by examining its relationship to prices, implicitly assuming that the quality of prices (or the market in which prices are set) remains constant. However, the quality of prices can vary across firms and over time, and irrational trading can contribute to such variation. In view of the possible importance of irrational trading we relax this assumption and reconsider the relevance of earnings. We construct a firm-specific measure of speculative intensity based on autocorrelation in daily trading volume adjusted for the amount of information available, and find that irrational trading has a significant positive impact on returns. However, after controlling for irrational trading, our results confirm a key result of previous research that earnings numbers still matter but departs from other work that suggests that earnings relevance has declined. We find that the explanatory power of earnings surprises has not declined, the influence of irrational trading has increased, and so the omission of irrational trading explains the previously documented decline in earnings relevance. This result is robust to excluding loss observations, which is another potential explanation for previous results.
Keywords: irrational trading, measuring speculation, earnings quality, earnings response coefficients
JEL Classification: G12, G14, G10, M41
Suggested Citation: Suggested Citation