Stock Price Associations with Expected and Unexpected Earnings (ERC)

Basic data for this project

Description

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. In order to provide an answer to this controversy we extend the traditional price model by the following assumptions: (i) the persistence of expected earnings is negatively correlated with the value-relevant magnitude of earnings innovations which triggers expectation revisions, i.e. high persistence in expected earnings requires a low level of expectation revisions; (ii) expected earnings follow a first order autoregressive process which is nonstationary but integrated of order 1, i.e. ARIMA(1,1,0). We show on a theoretical level that under these assumptions: (a) P/E ratios and ERCs differ in their magnitudes and are negatively correlated with each other. 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 prior results. P/E ratios remain positively associated with the persistence of expected earnings, however, are negatively associated with the value-relevant magnitude of earnings innovations; (c) theoretically predicted magnitudes of P/E ratios (ERCs) range between 10-60 (0-7). The empirical results are consistent with our predictions, closing the gap between theoretically predicted and empirically estimated P/E ratio and ERC magnitudes, respectively.