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Price and Return Models
Price and Return Models
Abstract
Return models (returns regressed on scaled earnings variables) are commonly ~eferred
to price models (stock price regressed on earnings per share). We provide a framework for
choosing between these models. An econom/cally intuitive rationale suggests that
models are better specified in that the estimated slope coefficients from price models,
but not return models, are unb/ased. Our empirical results confirm that price models"
earnings response coefficients are less biased. However, return models have less serious
econometric problems than price models. In some research contexts the comh;~ed use of
both price and return models may be useful.
Key words: Capital markets; Price-earnings regressions; Earnings response coeffic/ents
J E L classification: MI4; C20
1. Introduction
Researchers in accounting must often choose between return models, in which
returns are regressed on a scaled earnings variable, a n d pr/ce models, in which
* Corresponding author.
We thank Bill Beaver,Andrew Christ/c, N/ck Gonedes, Bob Holthausen, Dave Larcker, John Long,
R/chard Sloan, Charles Trzincka, Mike Rozeff,G. William Schwert, Ross Watts, J~nice Wiltett, and
especially Ray Ball {the editor) for ~.|pfu~ suggestions; Roger Edelen for excellent research a.~stance; and participants at Baruch College CUNY, the Stanford Summer Camp, University of
Glasgow, University of Manchester, Michigan State University, Universityof Pennsylvania,University of Rochester, and SUNY at Buffalo for useful comments. Financ/al support from the Bradk:y
Policy Research Center at the Simon School University of Rochester and from the John M. O~n
Foundation is gratefully acknowledged.
0165-410U95/$09.50 1995 Elsev/crSc/cnce B.V. All r/ghtsreserved
SSD/Ol 6 5 4 1 0 1 9 5 0 0 3 9 9 4
156 S.P. Kothari. J.L. Zimmerman / Journal of Accounting and Economics 20 (i 995) 155-192
stock prices are regressed on earnings per share. This paper provides an
economic and econometric framework for assessing whether to use a price
model, a return model, or both. Within the context of a typical valuation model,
we provide an economically intuitive analysis which suggests that the estimated
slope coefficient from the price model, but not the return model, is unbiased. We
then provide empirical evidence on price and return model specifications.
Finally, we draw on previous research to illustrate the contexts in which price
and return models are helpful.
Previous research. Several papers discuss the conceptual advantages and
disadvantages of price and return models. Gonedes and Dopuch (1974) argue
that return models are theoretically superior to price models in the absence of
well-developed theories of valuation. Lev and Orison (1982) describe the two
approaches as complementary, whereas Landsman and Magliolo (1988) argue
that price models dominate return models for certain applications. Christie
(1987) concludes that, while return and price models are economically equivalent, return models are econometrically less problematic. Despite the criticism,
price r,lodels persist (e.g., Bowen, 1981; Olsen, 1985; Landsman, 1986; Barth,
Beaver, and Wolfson, 1990; Barth, 1991; Barth, Beaver, and Landsman, 1992;
Harris, Lang, and Moiler, 1994).
l:~onomic intuition for the return-earnings specification. Both price and return
models begin with a standard valuation model in which price is the discounted
present value of expected net cash flows. Both models also rely on the hypothesis
that current earnings contain information about expected future net cash flows
(e.g., Beaver, 1989, Ch. 4; Watts and Zimmerman, 1986, Ch. 2; Kormendi and
Lipe, 1987; Ohlson, 1991). Since the market's expectations of future cash flows
are unobservable, empirical specifications of the price-earnings relation often
use current earnings as a proxy for the market's expectation.
Current earnings, however, reflect both a surprise to the market and a "staid
component that the market had anticipated in an earlier period. In the return
model, the stale component is irrelevant in explaining current return and thus
constitutes an error in the independent variable, biasing the slope coefficient on
earnings toward zero (e.g., Brown, Griffin, Hagerman, and Zmijewski, 1987). By
contrast, the current stock price in the price model reflects the cumulative effect
of earnings information, and thus varies due to bosh the surprise and stale
components. Therefore, there is no errors-~in-variables bias in price-model regressions. Intuitively, current earnings are uncorrelated with the information
about future earnings contained in the current stock price, the dependent
variable. Econometrically, the price model thus has an uncorrelated omitted
variable, which reduces explanatory power, but the estimated slope coefficient is
unbiased (Maddala, 1990).
Criteria for evaluating alternative models. In evaluating price and return
models, we measure the extent to which the estimated slopes and intercepts
approximate their predicted values. In particular, assuming that earnings follow
S.P. Kothari. J.L. Zimmerman / Journal of Accounting and Economics 20 (1995) 155-192
157
158 s.P. Kothari, J.L. Zimmerman / Journal of Accounting and Economics 20 (1995) 155-192
correlated. If the earnings variable is not adjusted for this predictable component, then the estimated earnings response coefficient is biased towards zero for
both price and return models (see Ali and Zarowin, 1992, and Sections 2 and
5 below).
Another limitation of our analysis is that we do not examine in detail the
economic reasons for and the econometric consequences of nonlinearities in the
price-earnings relation. These issues are beyond the scope of this paper. Basu
(1995) explains how conservatism in accounting induces an asymmetric and
nonlinear price-earnings relation. Hayn (1995) explores the consequences of
losses. Freeman and Tse (1992), Cheng, McKeown, and Hopwood (1992), Das
and Lev (1995), and Beneish and Harvey (1992) are other examples of research
examining the linearity of the price-earnings relation.
Section 2 presents the intuition underlying the argument that the earnings
response coefficient estimates from the price models are unbiased, whereas
return models yield biased estimates. Section 3 describes the data and provides
descriptive statistics, and Section 4 presents the empirical results. Section 5 explores the sensitivity of the results to several specification tests. Section 6 discusses implications for other research.
$.P. Kothari, J.L. Zimmerman / Journal of Accounting and Economics 20 (1995) 155-192 159
P~ = ~ + fiX, + et,
(1)
R e t u r n model:
P , / P , - i = + f l X j P , _ 1 + e,,
(2)
Differenced-price ,nodel:
alP, = ~ + f A X ,
+ e,,
(3)
where P, is the ex-dividend price at time t, X, is earnings for period t, 0t and fl are
the intercept and slope coefficients, and e, is an error tenn. The differenced-price
model is included because differencing often yields a stationary," series. Some of
the econometric problems in using the price model can thus be overcome by
using first differences (Christie, 1987).
It is easy to show that all three specifications are equivalent in the sense that
all three models yield a slope coefficient of I/r, where r is the (constant) expected
rate of return (Christie, 1987). T w o critical assumptions are that earnings follow
a random walk and that only the information in the current and past time series
of earnings is used by the market in setting prices, that is, prices do not lead
earnings [see Eqs. (A.1)-(A.6) in the Appendix for details]. Thus, in the context
of a stylized constant price-earnings ratio model, there is no economic difference
between the price, return, and differenced-price specifications. The choice
among the three alternatives must therefore be guided by econometric issues
(Christie, 1987} or because violation of one or more of the underlying assumptions has a differential effect across these specifications. 2
2In addition to the return model in Eq. (2},recent research on the price-earnings relation examines
two other return model specifications. While the dependent variable is always stock return,
alternative earnings variablesare earnings change deflated by price, dX,/P,- 1 and earnings change
deflated by last period's earnings, dX,/X,_ x. If the 'price is a constant multiple of earnings"
valuation model is assumed, regressions employing all of these earnings variables yield results
identical to those using Eqs. {1)--{3}.We focus only on the earnings-deflated-by-pricevariable [i.e.,
the return model (2)] because, once prices lead earnings, previous research indicates that return
model (2) outperforms the other two earnings variables in terms of bias in the estimated earnings
response coefficient{e.g.,Ohlson, 1991;Ohlson and Shroff, 1992;Kothari, 1992; Easton and Harris,
1991).
160 S.P. Kothari. J.L. Zimmerman / Journal of Accounting and Economics 20 (1995) 155-192
(4)
where, conditioning only on the past observations, AX, has a zero mean,
a constant va[iance, and is serially uncorrelated. However, when prices lead
earnings, only a portion of d X is a surprise to the market; the rest is anticipated
during periods t - 1, t - 2, and so on. If we assume that the market anticipates
earnings only two periods ahead, Eq. (4) becomes
X f -= X , - t + St + at.t_ 1 + at . t _2,
(5)
S.P. Kothari, J.L. Zimmerman / Journal of Accounting and Economics 20 (1995) 155-192
|6I
Because price reflects anticipated future earnings, the price at time t, P~. will
not be a constant multiple (1it) of current earnings, X,. Pt will exceed X,/r if the
market expects positive ee.rnings changes over the next two years (e.g., a growth
firm), whereas P, will be lower than X,/r if the market expects negative future
earnings changes. Eqs. (A.7)--(A.9)in the Appendix formalize this intuition. The
earnings response coefficient, defined as the coefficient that maps a unit surprise
into stock pric~, will be 1/r even though prices lead earnings because st is
assumed permanent.
Price specification. When prices lead earnings, the current price, in addition
to all the information in current and past earnings, contains information about
future years" earnings that is absent from current earnings. This information (i.e.,
a,+ 1., and a,+2.,) generates variation in price, Pt, but is uncorrelated with X,.
Therefore, price model (1) is missing an independent variable that would explain
the variation in P, due to the anticipated components of future periods" earnings
changes. Econometrically, this is an uncorrelated-omitted-variableproblem that
reduces the price model's explanatory power, but the estimated coefficient on X,
is unbiased (see, for example, Maddala, 1990). Eq. (A.10) in the Appendix shows
the derivation.
Return specification. Previous research shows that when prices contain information about future years' earnings changes (e.g., Brown, Foster, and
Noreen, 1985; Collins, Kothari, and Rayburn 1987; Freeman, 1987), the estimated earnings response coefficient from the return model (2) is biased toward
zero. While the Appendix contains the derivation [Eqs. (A.11) and (A.12)], the
intuition is as follows. The dependent variable, Rt, in the return model reflects
information about current and future earnings arriving over the current period.
However, the independent variable, Xt, contains information arriving over both
current and past periods. That is, X, contains both the surprise component, s,
and stale components, at.t- 1 and at.,- 2- The stale components are irrelevant in
explaining current returns (which are generated by s,), and newly anticipated
components of future earnings changes (i.e., at+ 1.t and a,+ 2.,). Since Xt's stale
components cannot explain Rt, the independent variable in the return model
measures the variable of interest with error. This errors-in-variables problem
biases the estimate of the return-model earnings response coefficient toward zero.
While we have analyzed the return model using a simple setting of prices
leading earnings, the nature of historical-cost accounting suggests a more complicated structure foi-prices leading ~rnings. Basu (1995) shows that conservatism
in accounting leads to an asymmetric nonlinear return-earn/rigs relation because
earnings are more timely in capturing bad news than good news. The explanatory
power and slope of a linear return model, therefore, are expected to be less than
those from a welbspc:.'.':.~ n,~nlinear me:lel. The nonlinearity analysis within the
context of issues discussed in Basu (1995) are beyond the scope of this study. The
main point, however, is that whether tae prices-lead-earnings phenomenon is
symmetric or not, the return model yields a biased slope.
162 S.P. Kothari, J.L. Zimmerman / Journal of Accounting and Economics ,~0 (1995) i~5-192
S.P. Kothari, J.L. Zimmerman / Journal of Accounting and Economics 20 (1995) 155-192 163
the degree of bias increases in the ratio of the variances of ut and zlx,. An
indication of some researchers" assessment of the relative magnitudes of the
variances of u, and Ax, is given by Ryan and Zarowin (1995). They conclude that
the ratio is about 13, which would imply that, in the price model, the estimated
earnings response coefficient is aboat 7% of the 'true" earnings response coefficient.
2.4. Summary
All three specifications yield unbiased coefficients (earnings response coefficients are expected to be 1/r) when prices do not lead earnings and earnings do
not contain noise. The price specification yields an unbiased earnings response
coefficient when prices lead earnings, but it yields a biased coefficient estimate in
the presence of value-irrelevant noise in earnings. The return and differencedprice specifications, on the other hand, yield biased coefficients when prices lead
earnings and also when earnings contain value-irrelevant noise.
While we provide predictions about the slope coefficient estimate from
various price-earnings specifications, our analysis primarily highlights the
differential implications of prices leading earnings for the price, return, and
differenced-price specifications. Obviously, the predictions critically depend on
the descriptive validity of the simplifying assumptions. In particular, the slope
will be smaller than 1/r if there is negative serial correlation in earnings changes
(e.g., Ball and Watts, 1972; Brooks and Buckmaster, 1976; All and Zarowin,
1992).
164 S.P. Kothari. J.L. Zimmerman / Journal of Accounting and Economics 20 (1995) 155-192
4. Empirical evidence
This section presents results of estimating the various price--earnings
models. Across all estimations, the results indicate that the price specification provides estimates of the earnings response coefficient that are closer
in magnitude to those implied by expected rates of return observed in the
marketplace. Nonetheless, as predicted by Christie (1987), tile price specification
suffers more from heteroscedasticity/misspecification problems than the return
model.
S.P. Kothari, J.L. Zimmerman / Journal of Accounting and Economics 20 (1995) 155-192 165
Table I
Descriptive statistics for price and earnings variables used in valuation, return, and differenc~-prk~
specifications of the price-earnings relation; cross-sectional and pooled regression analysis sample
and time-series regression analysis sample; annual data from 1952-1989
Variable
Mean
Std. dev.
Min.
Med.
Max.
1.97
24.41
0.09
1.14
0.13
1.77
1.81
18.23
0.20
0.60
1.10
8.88
- 4.61
0.22
- 10.48
0.06
- 11.74
- 61.25
1.79
20.25
0.09
1.06
0.15
0.88
9.33
1~.00
3.09
48.93
10.87
74.92
2.09
24.25
0.09
1.06
0.16
1.12
9.33
106.00
3.09
48.93
9.66
74.92
2.27
27.77
0.09
1.13
0.15
1.99
1.79
I8.76
0.15
0.56
1.12
9.24
- 4.61
0.25
- 8.72
0.11
-- ! 1.74
-- 61.25
Sample: The cross-sectional and pooled analyses sample includes any firm that has at least two
consecutive annual earnings and return observations. For the time-series analysis sample, a minimum of 20 consecutive annual earnings and return observations is required. X, is annual earnings
per share excluding the extraordinary items and earnings from discontinued operations. Price
relatives exclusive of dividends, P,/P,_ 1, are measured over calendar years. Only firms with
a December fiscal year-end are included in both samples. The largest and smallest 1% of observations for each variable are excluded from both samples. Earnings, X,, and prices, Pt, are adjusted for
stock splits and stock dividends when deflating by P,_ 1 and obtaining differenced variables.
4.1. Pooled time-series and cross-.'-ectional analysis
Results o f p o o l e d time-series cross-sectional e s t i m a t i o n o f '~he v a r i o u s m o d e l s
are r e p o r t e d in T a b l e 2. F o r each specification, the e s t i m a t e d intercept, earnings
r e s p o n s e coefficient, a n d adjusted R 2 o f the m o d e l are reported. O r d i n a r y least
squares (OLS) s t a n d a r d e r r o r s a n d the W h i t e (1980) heteroscedasticity-consistent s t a n d a r d e r r o r s for each p a r a m e t e r e s t i m a t e a n d the W h i t e (1980) chis q u a r e test statistic are also reported. B o t h O L S a n d W h i t e s t a n d a r d e r r o r s
likely u n d e r s t a t e the true s t a n d a r d e r r o r of the e s t i m a t e d coefficients b e c a u s e we
d o not adjust for the positive cross-correlation a m o n g the regression residuals
(Bernard, 1987). T h e r e p o r t e d s t a n d a r d e r r o r s should therefore be viewed o n l y
as descriptive statistics.
Price m o d e l T h e price specification yields a n earnings r e s p o n s e coefficient
estimate o f 6.55, with a W h i t e s t a n d a r d e r r o r o f 0.049. T h e a n n u a l expected
rate o f return implied b y the e s t i m a t e d coefficient is 15.3% l- = 1/6.55]. T h e
166 S.P. Kothari, J.L. Zimmerman / Journal of Accounting and Economics 20 (1995) 155-192
estimated intercept, 11.47, is more than 100 standard errors greater than
zero, although again the standard error is understated because we ignore
positive cross-correlation among the residuals. Recall that all specifications
predict a zero intercept. Within the context of our simple valuation model,
a nonzero intercept implies that the slope coefficient is biased. More generally,
nonzero intercepts indicate either mr~el specification problems or an omittedvariables problem. As seen from Table 2, all specifications yield highly significant intercept estimates, as in previous research (e.g., Barth, Beaver, and Landsman, 1992, Table 2; Easton and Harris, 1991, Table 1). Section 5 addresses the
question of model misspecification, including the presence of transitory earnings, nonlinearities due to small-price deflators, and correlated omitted
variables.
The White statistic for the price model, 1,025, indicates severe heteroscedasticity and/or specification problems. 5 The 42.2% adjusted R 2 from the price
model is likely to overstate the information content of contemporaneous earnings because the model is estimated in levels. Scale differences across firms in the
sample and autocorrelatcd errors, because of the use of levels, together can
contribute to the model's explanatory power (Maddala, 1990, pp. 190-d99).
R e t u r n model. Compared to the estimated slope from the price model, the
coefficient from the return model is only 0.45 (White standard error 0.112). The
magnitude of the estimated earnings response coefficient from the return specification is comparable to the 0.84 (standard error 0.02) that Easton and Harris
(1991, Table 1, first row) report using 19-year data from 1968-86. 6 The estimated
coefficient implies an unreasonably high expected rate of return of over 200%.
The White statistic, 14.2, rejects homoscedasticity of errors at an ~t level of 0.001.
The 2.3% adusted R 2 indicates relatively low information content of current
earnings. It is important to recall, however, that, if prices are forward-looking,
both the slope and the explanatory power of the return model are biased toward
zero. The adjusted R 2 therefore underestimates the information content of
current earnings.
Differenced-price model. The earnings response coefficient estimate from the
differenced-price model is 2.09 (White standard error 0.050), which is higher
than that from the return model but considerably smaller than that from the
price model. The implied expected rate of return is about 50%, which is still too
SThe significantWhite statistic can also occur if the theoretical relation betweenstock prices and
earnings differsfrom the simple valuation model assumed here (White, 1980). Only if the assumed
model is correct does the significantWhitestatistic indicates the presenceof beteroskedasticerrors
alone.
~T~ differencein the coeffmentmagnitudebetween Easton and Harris and this study is attributable to time-perioddifferencesand their use of 12-monthreturns endingin the third month after tbe
fiscal year-end versus our use of returns measuredover the fiscal year.
S.P. Kothari, J.L. Zimmerman / Journal of Accounting and Economics 20 (1995) 155-192
167
Table 2
Pooled time-series and cross-sectional estimation of the price, return, differenced-price, and deflated-price specifications of the price-earnings relation; sample of 38,890 firm-year observatiom
from 1952-1989
Earnings response coefficient
Standard error
Standard error
White
Model
Estimate OLS
White
Estimate OLS
White
Rz
star.
Price
Return
Diff. price
Deft. price
11.47
I. 11
1.51
4.69
0.100
0.011
0.043
0.087
6.55
0.45
Z09
9.03
0.049
0.112
0050
0.066
42.2%
2.3
6.7
37.2
1025
14.2
141.3
432.6
0.104
0.003
C.044
0.037
Price model:
Pr = + ffXt + ~,
Return model:
P,/Pt- ,. = ~ + [JX,/P,_ t + e,
Differenced-price model:
APt = + [JAXt + e,
Deflated-price model:
0.039
0.015
0.040
0.062
Sample: The sample includes any firm that has at least two consecutive annual earnings and return
observations. X, is annual earnings per share excluding the extraordinary items and earnings from
discontinued operations. Price relatives exclusive of dividends, PdPr- i, are measured over calendar
years. Only firms with a December fiscal year-end are included. The largest and smallest I% of
observations for each variable are excluded from the sample. Earnings, X , and prices, P , are
adjusted for stock splits and stock dividends when deflating by Pt-t and obtaining differenced
variables.
TOne interpretation of the relatively small coefficient estimate from the differenced-pri~ model
compared to that from the price model is that the price model is misspecified. If regressions using
first-differenced data yield different results, they frequently indicate misspecification of the undifferenced Ior levels) regression model tPiosser, Schwest, and White, 1982). However, since prices are
forward-looking, the independent variable, X,, is expected to be correlated with lagged errors.
Under these conditions. Plo~ser et aL point out that the slope coefficient from a differenced
regression model is inconsistent and, therefore, results from a differenced regression cannot unambiguously indicate misspecification. Ira suitable set of instrumental variables is used to eliminate the
correlation between X, and lagged errors, then the Plosscr et ai. (1982) differencing test can be
applied. However, suitable instrumental variables are not easily obtained and, therefore, we do not
perform the Plosser et al. differencing test of specification.
168 S.P. Kothari. J.L. Zimmerman / Journal of Acco,.mting and Economics 20 (1995) 155--192
differences and cross-sectional variation in the slope coefficient, which the model
assumes to be a constant. Easton (1985) and Christie (1987) recommend deflating the price model by a variable that is a function of the independent variable
(earnings) to reduce heteroscedasticity.8 Second, there is a danger of obtaining
a significant coefficient on an (economically or theoretically) irrelevant included
variable in a price regression (see Christie, 1987).9 The intuition is that the
significant coefficient on an irrelevant variable might merely be capturing scale
differences across the sample of firms. Use of a suitable deflator in estimating
price models is therefore recommended. We reestimate the price model using X,
as the deflator: ~
P,/X, =
~(I/X,) + )6 + ~,.
(7)
The last row of Table 2 reports results of estimating Eq. (7), the deflated-price
model. The i n t e r c e p t , ~, is an estimate of the earnings response coefficient.
The coefficient, 9.03 (White standard error 0.066), is greater than that from
the price model, reducing the concern that the price models yield spuriously
large coefficients. The White statistic, 432.6, remains significant, however.
The coefficient on 1 i X , , which is an estimate of ~ in the price model, is 4.69
(White standard error 0.087), which is more than 50% smaller than the estimated ~ from the price model, indicating a better-specified model. The 37%
adjusted R 2 of the deflated-price model is only marginally smaller than the
42.2% explanatory power of the price model. Since the regression errors of
individual firms in the sample are likely to be positively autocorrelated, the
explanatory power could be overstated (Maddala, 1990, p. 199) even with the
deflated-price model.
The smaller degree of bias in the coefficients from the price and deflated-price
models in Table 2 is consistent with the prices-lead-earnings phenomenon
contributing to biased coefficients from the return- and differenced-price specifications. Recall that velue-irrelevant noise in earnings biases the estimated
whereBVA,_ ~ is the book valueof assetsat the beginningof year t. The earningsresponsecoefficient
estimate from this model is 11.91 (standard error = 0.07) and the adjusted R2 is 44.6%.
S.P. Kothari, J.L. Zimmerman / Journal of Accounting and Economics 20 (199S) 155-192 169
price and deflated-price models are considerably greater than those from the
return or differenced-price specifications, they are somewhat smaller than the
price-earnings ratio of a typical stock in our sample. The ratio of average price
to average earnings per share for the pooled sample (Table 1, panel A) is 12.4
(24.41/1.97). 11 The ratio of medians is 11.3. The coefficients from the various
models range from 0.45 to 9.03 (see Table 2). One reason for the difference
between the estimated coefficients and the average price-earnings ratio of the
sample firms is the presence of transitory components of earnings, violating the
random walk assumption underlying the prediction about the earnings response
coefficient magnitude. Analysis described in Section 5 and previous research
indicate that the presence of transitory components in earnings explains a large
portion of the difl~rence between 1it and the estimated earnings response
coefficient from the price or deflated-price model. The considerably smaller
coefficients frcm the return model, however, are due largely to the effect of prices
leading earnings.
170 S.P. Kothari. J.L. Zimmerman / Journal of Accounting and Economics '0 (1995) 155-192
S.P. Kothari. J.L. Zimmerman / Journal o f Accounting and Economics 20 (1995) 155-192
171
Table 3
Annual cross-sectional estimation of the price, return, differenced-price,and deflated-price specifications of the price-earnings relation; 38 annual regressions using a sample of 38,890 firm-year
observations from 1952-1989
Coeff.
Mean
Std. err.
Min.
QI
Med.
Q3
Max.
7.5
5,9
47.0
15.4
10.0
7.3
51.1
22.2
12.6
9.7
59.8
33.3
19.1
14.2
67.5
1.01
1.45
12.5
3.7
1.20
2.90
17.4
5.2
1.46
4.17
33.9
2.14
2.98
12.7
8.0
3.8
4.6
18.4
11.7
15.2
7.8
27.6
4.9
8.6
40.0
10.8
6.2
12.7
49.1
15.9
10.4
16.7
60.5
10.2
7.9
53.1
23.1
0.58
0.41
3.9
3.9
40.2
35 significant at
0.05 p-value
On each panel, average value of the estimated coefficients, adjusted RZs, and White (1980) chi-square
statistics from 38 cross-sectional regressions are reported. Standard errors are for the time-series
sample mean coefficients. Qt and Q3 are 25th and 75th fractiles of the distribution of estimated
coefficients, adjusted RZs, or White statistics.
Sample. The sample includes any firm that has at least two consecutive annual earnings and return
ob~rvations. X, is annual earnings per share excluding the extraordinary items and earnings from
discontinued operations. Price relatives exclusive of dividends, P,/P,_ 1, are measured over calendar
years. Only firms with a December fiscal year-end are included. The largest and smallest 1% of
observations for each variable are excluded. Earnings, X,, and prices, P , are adjusted for stock splits
and stock dividends when deflating by Pt- 1 and obtaining differenced variables.
r e g r e s s i o n s (see p a n e l s B a n d C ) y i e l d s l o p e c o e f f i c i e n t s t h a t a r e s u b s t a n t i a l l y
s m a l l e r t h a n t h o s e f r o m t h e p r i c e m o d e l r e g r e s s i o n . T h i s r e s u l t is c o n s i s t e n t w i t h
t h e i n t u i t i v e a n a l y s i s in S e c t i o n 2 a s s u m i n g p r i c e s c o n t a i n i n f o r m a t i o n a b o u t
future earnings.
172 s.P. Kothari. J.L. Zimmerman / Journal of Accounting and Economics 20 (! 995) ! 55- ! 92
Deflated-price model. Panel D reports results of estimating the deflated-price
model. The estimated slope coefficient, 9.6, is greater than that from the price
model. I~ The implied expected rate of return is 10.4%. The 38.7% average
adjusted R 2 of the deflated-price model is considerably less than the 53.1%
average explanatory power of the price model in panel A. The explanatory
power of the return and differenced-price models is considerably lower, consistent with the earlier analysis indicating downward bias in the estimated slope
coefficient and explanatory power of these models,~3
Evaluation of the various models using the results in Table 3 has so far been
based on the closeness of the coefficient estimates to P I E ratios. A related
criterion of interest could be to assess an estimate relative to its standard error
(i.e., power). That is, is the return-model-based coefficient more likely to be
statistically significant, even though it is biased? Using the standard errors
reported in Table 3 as well as those adjusted for serial dependence in the
coefficient estimates, the price and deflated-price models yield coefficient estimates that are about twice as many standard errors away from zero as those
from the return model. The pooled regression analysis results also yield a similar
inference.
4.2.1. Estimated earnings response coefficients and interest rates
We next discuss correlating implied expected rates of return from the annual
estimated slope coefficients with long-term government bond yields as proxies
for the expected rates of return through time. Previous research (e.g., Collins and
Kothari, 1989) indicates that the return-model-based earnings response coefficient estimates through time exhibit variation that is correlated with the expected
rate of return proxies. Our focus here is on the extent to which the implied
expected rates of return from various models are correlated with long-term
government bond rates.
We estimate the following regression separately for each price-earnings
specification:
Rt = 70 + 7t It + errort,
(8)
where Rt is the implied expected rate of return for year t and equals 1/bt, bt is
the estimated earnings response coefficient from one of the four price-earnings
specifications, t covers 1952 to 1989 (38 years), and L is the long-term
government bond rate for year t, taken from Ibbotson and Sinquefield (1989).
ZZTheaverage coefficientestimate using the book value of assets as the deflator is 12.9.
13We also estimated all four models using the smaller time-seriesanalysis sample which includes
only those firmswith a minimumof 20 observationsper firm.The resultsare virtuallyindistinguishable from those reported here for the cross-sectionalsample.
S.P. Kothari, J.L. Zimmerman / Journal of Accounting and Economics 20 (I995) 155--I92 173
Assuming that the long-term government bond rates capture variation in the
expected rates of return over time, ?t will be 1 if the implied expected rates of
return from a particular price-earnings specification track the true expected
rates of return over the years. Under these assumptions, ~'o is an estimate of the
market risk premium. 14
OLS parameter estimates of model (8) are reported in columns 2-5 of Table 4.
The estimated 3'o and 71 using the implied expected rates of returns from the
price model are 0.06 (standard error = 0.01) and 1.10 (standard error = 0.16).
There is roughly a one-to-one correspondence between variation in the implied
expected rates of return and the bond yields, and the expected rates of return
estimates are about 6% greater than the bond yields. This fielding is consistent
with the economic intuition that the 6% intercept approximates the market risk
premium and the expected market return equals the sum of the bond yield and
the risk premium.
Since the expected rate of return estimates are autocorrelated, regression
errors of model (8) will be autocorrelated, as confirmed by the Durbin-Watson
statistic. Since under t h e ~ conditions the OLS estimates are unbiased but less
efficient than generalized least squares estimates (Maddala, 1990), we also report
results of estimating the regressions using the Cochrane-Orcutt (1949) procedure assuming that the OLS residuals follow a first-order autoregressive
process. The results are reported in the last two columns of Table 4. The
estimated 71, 0.98 (standard error = 0.23), is indistinguishable from the OLS
estimate of "/1. In addition, results for the deflated-price model in the last row
are similar to those for the price model. This finding is not surprising given the
similarity in earlier results on earnings response coefficient estimates.
The estimated 71s using the Cochrane-Orcutt procedure for the return and
differenced-price models are 5.73 (standard error = 1.94) and 4.18 (standard
error = 1.60). Is They indicate a positive association between the bond yields
and implied expected rates of return through time. However, since government
174 S.P. Kothari. J.L. Zimmerman / Journal o f Accounting and Economics 20 (1995) 155-192
Table 4
Regressions of expected rates of return thro,lgh time implied by the estimated slope coefficients from
the price, return, differenced-price, and deflated-price models on the long-term government bond
yields: Rt = 7o + ",'l i~ + errort
OLS estimation~
Cochrane-OrcutP
Standard error
Standard error
Model
7o
7~
Adj. R"
DurbinWatson
70
7~
Price
0.06
0.01
1.10
0.16
54.9%
0.99 b
0.07
0.02
0.98
0.23
Return
0.16
0.10
7.66
1.29
48.2
0.88 b
0.30
0.15
5.73
1.94
Diff. pr/ce
0.09
0.08
4.62
1.04
33.4
0.97 b
0.13
0.12
4.18
1.60
Deft. price
0.06
0.01
0.81
0.18
35.0
0.76 b
0.07
0.02
0.71
0.28
Rt = I/(bt) where Rt is the expected rate of return estimate for year t, b, is the estimated earnings
response coefficient from one of the four price-earnings specifications, and 1, is the long-term
government bond rate. If b, is less than 1. then the Rt is set equal to 1 to avoid extreme Rt
observations in a regression. R, is set equal to 1 seventeen times for the return specification, two
times for the differenced-pricespecification, and never for the price and deflated-price specifications.
There are 38 annual expected rate of return estimates from 1952 to 1989. The long-term government
b~,~d y/elds are taken from Ibbotson and Sinquefield (1989).
The price-earnings specifications are:
Price model:
Pt = + fiX, + er
Return model:
Pt/Pr- ~ = + f l X , / P t - ~ + e,
Differenced-price model:
3Pt = + flzJX, + e,
Deflated-price model:
P~/Xt = ~t(l/Xt) + fl + et
Results of ordinary least squares estimation and those from estimating the model after performing
the Cochrane-Orcutt AR~ 1) transformation of the data.
bThe Durbin-Watson statistic is significant at 5%.
bond yields over the sample period ranged from 3% to 14%, with an average of
6 . 8 % , t h e l a r g e c o e f f i c i e n t e s t i m a t e s in T a b l e 5 f o r t h e r e t u r n a n d d i f f e r e n c e d p r i c e m o d e ! s ....
~,-~nh,
,,~n~r~lh,
o f e x p e c t e d ,,,at.~,o
"~'"~ ~,J
,,r J~t.,.alai.
,,,,,,,,, ~:,,,.
r-.,. ~,
. . . . . . . . .., h i g h .l~',,p!s
...
,L.,i
e x a m p l e , if t h e b o n d y i e l d is 6 % , t h e n t h e r e t u r n - m o d e l - b a s e d e x p e c t e d r a t e o f
r e t u r n o n a t y p i c a l s t o c k in o u r s a m p l e will b e 3 4 % . T h e l a r g e 71 e s t i m a t e s a l s o
i m p l y tha~ t h e e x p e c t e d r a t e s o f r e t u r n b a s e d o n t h e p r i c e a n d d i f f e r e n c e d - p r i c e
m o d e l s e x h i b i t a v e r y h i g h d e g r e e o f s e n s i t i v i t y t o c h a n g e s in b o n d y i e l d s .
S.P. Kothari, J.L. Zimmerman / Journal of Accounting and Economics 20 (1995) 155-192 |75
Overall, the results from cross-sectional estimation of the various specifications of the price-earnings relation indicate that the price-model-based parameter estimates assume economically sensible values. The results are consistent
with the analysis in Section 2 under the assumption that prices contain information about future ,.., nings changes.
4.3. Time-series analysis
Results of 1,017 firm-specific time-series estimation of the various priceearnings specifications are reported in Table 5. In panel A, the average estimated
slope coefficient from the price model is 4.6, with a standard error of 0.13.
However, since we ignore cross-correlation among the coefficients' estimation
errors, the repo:~ed ~andard error undL,~.tates the true standard error. The
average explanatory power, 21.8%, is consia,., ably lower than that observed in
cross-sectional price model estimation. White's test is rejected at the 0.05 level
for 95 of the 1,017 firms.
The time-series estimation suffers from at least two problems. First, since
price and earnings levels are serially correlated through time, the regression
errors are autocorrelated. We therefore reestimate the regressions using
the Cochrane-Orcutt procedure (results are not reported). The average estimated slope coefficient increases marginally to 4.9 (standard error = 0.12).
Second, because prices contain information about future earnings, the earnings
variable for period t is likely to be positively correlated with the regression
disturbance terms for periods t - 1 and earlier. [Keim and Stambaugh (1986),
Stambaugh (1986), and Fama and French (1988) discuss this problem, which
is geNaane to many studies.] The positive correlation between the independent variable and lagged regression errors induces a finite-sample downward
bias in the estimated coefficient. The bias decreases in the number of timeseries observations and increases in the first-order autoregressive coefficient
on earnings, the independent variable (Stambaugh, 1986). Since the sample size
here is often 20-30 annual observations, and because time-series properties of
annual earnings are we!l-approximated by a random walk, the bias could be
serious.
The average estimated slope coefficient from time-series price-model regressions, 4.6, is considerably smaller than that from cross-sectional estimation, 7.9
(see Table 3). It is not obvious that the difference is due entirely to the downward
bias in the time-series estimate of the average slope coefficient. Differences in the
samples employed in the time-series and cross-sectional analyses are unlikely to
explain the smaller average slope coefficient estimate from the time-series
estimation (see Footnote 10L Moreover, since the time-series sample comprises
riatively large surviving filans, and because previous research indicates that
the expected rate of return on stocks is negatively related to firm size (Banz,
1981), the average slope coefficient for the time-series sample should be larger
176 S.P. Kothari, J.L. Zimmerman / Journal o f Accounting a n d Economics 20 (1995) 155-192
Table 5
Firm-specific time-series estimation of the price, return, differenced-price, and deflated-price specifications of the price-earnings relation; 1,017 firm-specific regressions using a sample of 27,127
firm-year observations from 1952-1989
Coeff.
Mean
Std. err.
Min.
QI
Med.
Q3
Max.
15.0
4.1
17.4
2.7
24.0
6.4
34.5
4. I
85.2
30.0
95.3
0.90
2.0
12.4
1.9
0.10
3.1
23.5
2.9
2.40
:3.8
91.0
1.0
2.5
4.9
1.9
2.1
4.7
14.7
2.8
10.9
34.4
82.3
12.3
4.7
48.6
2.6
21.8
7.2
72.4
4.0
78.2
39.0
98.6
Adj. R 2
White
star.
17.3
4.6
21.8
3.03
0.41
0.13
- 28.5
- 10.0
- 32.5
95 significant at
0.05 p-value
8.0
2.0
4.0
1.5
1.3
3.5
9.1
2.02
0.05
0.13
- 5.8
-- 10.6
- 11.1
6 significant at
0.05 p-value
0.4
1.1
- 1.0
1.1
Adj. R z
White
star.
15.6
0.43
- 75.5
5.0
0.14
- 11.6
47.3
3.07
- 29.5
93 significant at
0.05 p-value
6.1
2.3
23.5
1.6
In each panel, average value of the estimated coefficients, adjusted R2s, and White (1980) chi-square
statistics from 1,017 time~ries regressions are reported. Standard errors are for the cross-sectional
sample mean coefficients. Qt and Q3 are 25th and 75th fractiles of the distribution of estimated
coefficients, adjusted RZs, or White statistics.
Sample: The sample includes any firm that has at least 20 consecutive annual earnings and return
observations. X, is annual earnings per share excluding the extraordinary items and earnings from
diseontinucd operations. Price relatives exclusive of dividends, P,/P,_ ~, are measured over calendar
years. Only firms with a December fiscal year-end are included. The largest and smallest 1% of
observations for each variable are excluded. Earnings, X , and prices, P,, are adjusted for stock splits
and stock dividends when deflating by P,_ i and obtaining differenced variables.
t h a n t h a t for t h e c r o s s - s e c t i o n a l s a m p l e . T i m e - s e r i e s e s t i m a t i o n m a y t h u s yield
c o n s i d e r a b l y d o w n w a r d - b i a s e d s l o p e coefficient e s t i m a t e s a n d / o r c r o s s - s e c t i o n a l e s t i m a t i o n m a y r e s u l t i n u p w a r d - b i a s e d s l o p e coefficient e s t i m a t e s , b u t
a c o m p l e t e r e s o l u t i o n o f t h i s i s s u e is b e y o n d t h e s c o p e o f t h i s p a p e r .
S.P. Kothari, J.L. Zimmerman / Journal of Accounting and Economics 20 (1995) 155-192
[77
178 S.P. Kothari. J.L. Zimmerman / Journal of Accounting and Economics 20 (1995) 155-192
5.1. Transitory components in earnings and linear regression
5. !. 1. Transitory earnings components" effect on coefficient magnitudes
To assess the degree of bias in the estimated coefficients from the various
models, we use I/r as the benchmark, based on 'earnings following a random
walk" as one of the assumptions. However, earnings changes exhibit mild
negative serial correlation. If this violation of the underlying assumption affects
the various models differently, then we cannot unambiguously conclude that
earnings response coefficient estimates from the price model are less biased. We
briefly discuss the effect of transitory components in earnings on the coefficient
estimates from the various models.
If earnings are a mixture of a random walk and a zero-mean transitory
process, then the coefficient on earnings (i.e., the sum of these two components)
will be a weighted average of the coefficients on the random walk and transitory
components. Since the coefficient on the random walk component is fl = 1/r and
that on the transitory component is 1, the coefficient on earnings in a price
model will be smaller than fl (assuming r < 100%). Specifically, the coefficient
will be k(fl - 1) + 1, where k is the ratio of the variance of the random walk
component of earnings to the sum of variances of the random walk and
transitory components of earnings, i.e., 0 < k _< 1 (proof available on request). If
earnings are entirely permanent, then k = 1 and the coefficient will be ft.
Alternatively, if earnings are entirely transitory, then k = 0 and the coefficient is
1. Note, howe'-:er, that the average-price-to-average-earnings ratio for a sample
of firms will be close to fl precisely because earnings averaged over time and
across firms, by definition, are expected to have a zero transitory component.
Our results in Table 2 and from cross-sectional regressions in Section 4.2 are
consistent with the presence of transitory components: coefficients from the
deflated-price model are 9.0 to 9.6, compared to an average price-earnings ratio
of 12-13. The difference between the estimated slope coefficient and the average
price-earnings ratios indicates that transitory components account for about
25% of the variation in earnings. We also find (but do not report) that, as
expected, including special items and earnings without special items as two
distinct independent variables in the price and deflated-price models yields
a larger earnings response coefficient on earnings without special items.
Transitory earnings components affect the return-model analysis in much the
same way as the price-model analysis. Expectational error in the earnings
variable due to the forward-looking nature of price, however, complicates the
returr~Imodel analysis. In the absence of prices leading earnings, however,
transi,~ory components" effect on the return-model-based earnings response
coefficient estimate will be identical to that for the price model. When prices lead
earnings, to the extent that a portion of the transitory component is also
anticipated, the estimated earnings response coefficient from the return model
will be biased downward.
S.P. Kolhari. J.L. Zimmerman / Journal of Accounting and Economics 20 (1995) 155-192
179
180 S.P Kothari. JL. Zimmerman / Journal of Accounting and Economics 20 (1995) 155-192
earlier. For example, the average coefficient from annual cross-sectional pricemodel regressions ci~anges from 7.9 in Table 3 to 7.8. The corresponding
numbers for the r~turn model are 1.65 and 2.0.
5.2. Omitted-variables bias
S.P. Kothari, J.L. Zimmerman / Journal of Accounting and Economics 20 (1995) 155--192 18|
reliably negative, consis:e.nt with a negative relation between firm size and
expected rates of return (e.g., Banz, 1981; Reinganum, 1981),
While firm size is helpful in rendering the average estimated intercept insignificant in the price model, White's (1980) test continues to indicate heteroscedasticity and/or specification problems for the price, deflated-price, and differenced-price models. More importantly, the White test statistic for the return
model is significant in 33 of the 38 cross-sectional regressions. Without firm s/ze,
it was significant in only six years. Since firm size is negatively correlated with
the variance of returns, the residual variance is correlated with firm size as an
independent variable, causing heteroscedasticity. Consequently, the White test
statistic is frequently significant.
Correlated-omitted-variable bias. Since the earnings response coefficient in all
the models is assumed to be a cross-sectional constant, regression errors include
(fli - fl)Xi,, where fli is firm fs coefficient, (fl~ - r ) is the deviation of firm/'s
coeffic/ent from the cross-sectional average, r, and X~, is earnings per share. In
addition to contributing to heteroscedastic errors, constraining the coefficient to
be a constant creates an upward bias in the coefficient estimate in the price
model because of a positive correlation between (fl~ -- r ) and X~t. To see this,
first note that, ceteris paribus, low-risk stocks have higher eacnings respr, nse
coefficients, i.e., fl~ - ,6 > 0; conversely, fl~ - / / < 0 for high-risk stocks. Thus,
f l i - / / and risk are negatively correlated in the cross-section. Next, as an
empirical matter, earnings per share and stock price are both decreasing functions of risk, because both correlate positively with firm size, which is wellknown to be inversely related to the expected rate of return. 19 The net result is
that f l i - fl and earnings per share are positively correlated. The resulting
upward bias can be viewed as arising from a firm's risk being a positivelycorrelated-omitted variable from the regression. A similar analysis indicates that
the coefficient from the return model is likely to be downward-biased.
To assess the degree of bias, we reestimate the price and deflated-price
models with the capital asset pricing model (CAPM) beta included in the
regressions. The C A P M beta is estimated using 60 monthly returns prior to year
t. e The average coefficient on earnings from 38 cross-sectional price-model
ZgThe analysis is more compl/cated when one accounts for the positive relation betweenearnings
changes and risk changes (Ball, Kothafi, and Watts, 1992).
2Betas estimated using monthly returns might not adequately capture cross-sectional variation in
expected returns ~e.g., Handa, Kothari, and Wasley, I989: Kothari, Shanken, and Sloan, 1995),
which might inhibit finding the correlated-omitted-variable bias in the price-earnings regressions.
We use betas estimated using monthly returns because for individual firms the use of longer-thanmonthly return observations to estimate betas sacrifices statistical p~'ecision potentially due to
nonstationarity. Another reason is that the effectof inclnding betas estimated from monthly returns
in the price-earnings regressions[s so small that it seemsunlikelythat better estimatesof beta would
alter the tenor of the resu,ts h~ the paper.
182 S.P. Kothari, J.L. Zimmerman / Journal of Accounting and Economics 20 (1995) 155-192
Since the estimated slope coefficients from the price model are smaller than
the sample firms" average price-earnings ratio, the price-model estimated
slopes are potentially biased downward. Instrumental-variable estimation
is a common approach to obtain less biased slope coefficient estimates. We
use average earnings of all the sample firms belonging to a two-digit SIC
industry as the instrumental variable for earnings on all the firms in that
industry. We obtain an average estimated instrumental-variable earnings
response coefficient of 7.9, which is the same as that obtained from the
OLS estimation of the price model. Alternative interpretations of the results are
that two-digit SIC code membership is not a very good instrumental variable,
and/or the value-irrelevant noise is cross-correlated such that industry-level
regressions are not belpful in mitigating the bias they cause, or there are omitted
variables.
S.P. Kothari. J.L. Zimmerman / Journal of Accounting and Economics 20 ~!995) 155- i 92 | 83
The return model exhibits less serious heteroscedasticity and/or other spec/fication problems compared to the price and differenced-price models.
The tests indicate that transitory components in earnings explain the fact that
the price model yields coet~cieats that are smaller than average price-earnings
ratios. Transitory components, however, do not explain the observed differences
between the estimated coefficients from the price and return or differenced-price
models. Including size in the price and deflated-price models yields intercepts
that are indistinguishable from zero. Bias due to a correlation between earnings
per share and the expected rate of return appears small. The instrumentalvariable regressions do not yield earnings response coefficient estimates that are
any closer to the price-earnings ratios than those reported earlier. Researchers
should be aware of the econometric limitations of the various models in
designing their tests. Future research should address the issue of nonlinearit/es
in the price-earnings relation.
Our findings have implications for capital market research in accounting.
Currently, much of the research uses the return model as the functional form.
The findings in this paper do not suggest using either price or return models
exclusively, because both have serious econometric problems and both have
impo~_ant deviations from the underlying theoretical model. Future studies can
be enriched by testing for sensitivity to the functional form and by incorporating
the relative strengths and weaknesses of alternative specifications. Using the
price model, perhaps in addition to the return model, could permit more
definitive inferences.
For example, many studies hypothesize that the earnings response coeffcient
will change around or during an information event because of accrual manipulation (e.g., Collins and DeAngelo, ! 990, Collins and Salatka, 1991). Alternatively,
the coefficient also changes if the information content of prices or earnings
changes such that the unexpected earnings proxy used by ~ researcher becomes
more or less noisy over time, e.g., Skinner (1990) studies option-listing and
Rao (1989) studies firms after their initial public offerings. Use of price models,
in addition to return models, in the above research contexts could be useful
in drawing inferences about managemeat's accrual manipulation (via transitory
earnings) or the timeliness of earnings. If accrual manipulation introduces
random noise or transitory earnings, then both price and return regressions
should yield smaller earnings response coefficient estimates. If accrual manipulation biases the earnings per share of all finns by a constant fraction, then,
depending on the upward or downward bias, both price and return models
should yield lower or higher slope coefficient estimates in the event period
compared to coefficients in the nonevent period. Finally, if the earnings
response coefficient is expected to change because prices are forward-looking,
then, unlike the return model, the price model does not predict a change in the
earnings response coefficient (because the forward-looking nature of prices does
not bias the earnings response coefficient estimate from the price model). The
184 S.P. Kothari. J.L. Zimmerman / Journal of Accounting and Economics 20 (1995) 155-192
use of both return and price models has the potential to yield more convincing
evidence.
T --ts of information content of accounting earnings and its components are
also" .mmon in the accounting literature. These tests either assess the significah~ of estimated slope coefficients or test incremental explanatory power of
a set of variables (e.g., Beaver, Griffin, and Landsman, 1982; Beaver and
Landsman, 1983; Barth, Beaver, and Landsman, 1992). While we analyze only
a simple regression of prices on earnings, the advantage of price studies is that
even in a regression of prices on various revenue and expense items they yield
unbiased (or less biased) slope estimates compared to return studies. One must,
however, be careful in interpreting the coefficients on various revenue and
expense variables from a price regression. The coefficient magnitudes will
depend on the time-series properties of these items and the riskiness of the
various items. In addition, the empirical correlation among the variables can be
important. Therefore, coefficients on various revenue and expense items are not
expected to be equal (Jennings, 1990).
Finally, while price mcdels likely yield less biased slope estimates in information content studies, it is important to recognize that price models do
not measure information arrival over a period. The dependent variable, price,
is not a measure of the impact of information arriving in the current period.
In an efficient market, the impact of information over a period is measured
by stock returns (i.e., the deflated change in the price level). However, the
explanatory power of return models provides only a lower bound on the
information content of an accounting variable because of the errors-invariables problem discussed herein. Stated differently, unless the market's
earnings expectations are proxied accurately, the return model R2s understate
the extent to which current period's accounting numbers reflect the information
affecting security prices. While a significant association between returns
and accounting numbers indicates information content, the low R2s of
the return studies might potentially lead researchers to draw incorrect
inferences, e.g., Lev's (1989) inference that earnings contain "noise' or Shiller's
(1989) conclusion that much of the stock market's volatility reflects investor
irrationality.
Appendix
This appendix describes a stylized valuation model that assumes that prices
are set in the market using only the information in the current and past time
series of earnings. Under such a valuation model, and when earnings follow
a random walk, the price, return, and differenced-price specifications of the
price-earnings relation are equivalent. We then examine alternative models by
allowing prices to reflect a richer information set than the current and past time
S.P. Kothari, J.L. Zimmerman / Journal of Accounting and Economics 20 (1995) 155-192 185
(A.I)
where a and/3 are the intercept and slope coefficients, and the error term, e,, is
included because empirically the assumptions underlying the valuation model
may be violated. The estimate of/3 is 21
b = cov(Pt, X , ) / v a r ( X , ) .
(A.2)
(A.3)
Using (1), {A.2), and (A.3), the estimated intercept can be shown to be zero.
Return specification. T o derive the return specification, we divide Eq. (1) by
price at the beginning of period t:
Pt/Pt- l = (1/r}Et(X,+ l ) / P , - I.
(A.4)
zt Since price and earnings follow a random walk, their (time-series) variances are undefined. [We
define b in Eq. (A.2) merely for notational comparability with the expressions for b using other
price-earnings specifications.] However, b is well-defined in the sen~ that it can he estimated as
a projection of P, on X, using the sample observations. If the price and earnings vectors are
cointegrated {i.e..even though the two variables follow a random walk, the errors have a zero mean
and constant variance because movements in the two variables are governed by common factors; see
Engle and Granger, 1987; Maddala. 1990).then there is no econometric difficulty in estimating the
price model (1). To mitigate potential econometric problems in estimating the valuation models, we
also estimate model (I) using a suitable deflator (see estimation of deflated valuation models in
Section 4).
186 S.P. Kothari, J.L. Zimmerman / Journal of Accounting and Economics 20 (1995) 155-192
The empirical analog of (A.4), using X, as the time-series expectation proxy for
E , ( X , + l), is
P,/P,_ ~ = + X,/P,_
t + e.,.
(A.5)
Analogous to Eq. (A.3), E(b) =/~ = 1/r, and is expected to be zero. Therefore,
the price and return models give equivalent estimation of the slope coefficient.
F i r s t - d i f f e r e n c e d - p r i c e s p e c i f i c a t i o n is
P, -
- E,_ ~(X,)] = ( 1 / r ) A X t .
(A.6)
By substituting the pricing model (1), the earnings response coefficient estimate from an empirical analog of (A.6) can be shown to have Elb) =/~ = l / r .
A l t e r n a t i v e s p e c i f i c a t i o n s w h e n p r i c e s l e a d e a r n i n g s . Section 2.2 in the text
describes the 'prices-lead-earnings' assumption. The analysis below examines
the effect of prices containing information about two future periods' earnings
changes on the alternative price-earnings specifications. Using Eq. (5) from the
text, the market's expectation of future earnings is
E~(X,+ l) = X , + at+ ,., + at+ l.t- I
(A.7)
and
E~{X,+k) = X , + a , + l . t + a , ~ l . , - t
t- at+2.t
for
k >_ 2.
(A.8)
+ a,+2.,)/r] -
[a,+2.,/{1 + r)]
(A.9)
where the approximation is obtained because a,+ 2 . t / ( l + r) represents a discounted one-period cash flow from the anticipated earnings a,+2.t and thus
makes only a small contribution to P,.
P r i c e s p e c i f i c a t i o n . The earnings response coefficient estimate from a price
regression is
b = cov{P,, X,)/var(X,)
cov[{P,-2 + A P , - I + 3 P t ) , X z - 2 + St--I + a t - t . , - 2 + a t - l . t - 3 + st + at.t- l + ar.t-2]
var[X,-2 + s,-t + a , - t . , - z + a t - t . t - 3 + st + ar,t-t + at.t-2]
coy[P,_ z.{X,-- z + a,_ t.,- 2 + a,_ l.,- 3 + a,.,_ 2 )] + coy[APt ._1.{s,_t + a.... t )] + cov[ AP,, s,]
var[X,_z + a,_ l.,-z + a,_ 1.,-3 + a t . t - 2 ] + var[s, t + a,.~ i] + var[s,]
=.
var[X,_ 2 + a,_ t., - z + a,_ i.,- 3 + a,.,_ z] + var [s,_ t + a,.,_ t] + vat[s,]
= l/r.
{A.10)
S.P. Kothari, J.L. Zimmerman / Journal of Accounting and Economics 20 (1995) 155-192 187
The price specification thus yields an unbiased estimate of the earnings response
coefficiet,,. The intuition, once again, is that the econometric consequence of
prices containing information about future periods' earnings changes is that
there is an uncorrelated-omitted-variables problem that leaves the estimated
slope coefficient unbiased.
Return specb'ication. The earnings response coefficient estimate from a return
model is
b=
(A.11)
To simplify the expression for b, first focus on the var[(X,_ ~ + at.t- 1 + at.,-2)~
Pt-1] term in the denominator of Eq. (A.I 1). Since (X,-l + a:.,_ i + at.t-,_ +
at+ l . t - l ) / P t - i] ~ r is a constant [see Eq. (A.9)], ( X t - 1 + at.t- l + a t . , - 2 ) / P t - 1
and a,+ L , - ~ / P t - ~ are (almost) perfectly negatively correlated and, therefore,
var[(Xt_ 1 + at.t- 1 + a t . , - 2 ) / P t - 1] = var(at+ Lt- 1 / P t - 1). To derive the degree
of bias in the earnings response coefficient estimate, we must make assumptions
with respect to the relative magnitudes of the variances of st, a,.t- ~ and a,.t-2- If
the variances of s,, at.t-~, and a,.t-2 are assumed equal, v a r l a t + L , - t / P t - l )
= v a r l s , / P t _ t). Substituting this result in Eq. (A.11),
b = c o v ( s t / P , - l, P t / P t - 1 )/2 * v a r ( s t / P t - l ),
(A.12)
which implies E(b) = 0.5 ,(I/r). The return model yields biased slope coefficient
estimates because earnings changes are anticipated. The greater the degree of
earnings anticipation (i.e., larger variances of a,.,_ ~ and at.,-2) relative to the
variance of the surprise component of X,, i.e., s,, the greater the degree of bias in
the earnings response coefficient estimate. Also, the bias will be greater if prices
anticipate earnings changes more than two periods ahead (e.g., Kothari and
Sloan, 1992) because st will then be a relatively smaller component o f A X t . Note,
however, that our objective is not to determine the exact degree of bias, but
merely to demonstrate that the return specification produces a biased coefficient
when prices lead earnings.
Differenced-price specification. We derive the bias in the estimated earnings
response coefficient from the differenced-price specification when prices lead
earnings by one period. We do not explore the bias under the assumption that
prices lead earnings by two periods because the estimated coefficient is biased
even when pi~ce.~ anticipate one-period-ahead earnings changes. Barth, Beaver,
and Landsman (1992), among others, provide an intuitive discussion of bias in the
estimated slope coefficients from a differenced-price model that could arise if
changes in earnings do not accurately proxy the surprise in earnings to the market.
188 S.P. Kothari. J.L. Zimmerman / Journal of Accounting .nd Economics 20 (1995) 155-192
The slope coefficient estimate from the differenced-price regression model is
given by
b = coy [AP t, AXt]/var(Xz)
= coy [(l/r) (st + at + 1.t), (st + at.t - t )]/var [st + at.t - t ]
= (1/r)var{st){var(st) + var(at.t-1)}.
(A.13)
Eq. (A.13) indicates that the earnings response coefficient estimate will be biased
because of the vat(at.t- 1) term in the denominator. Once again, the degree of
bias will be an increasing function of the extent to which earnings changes are
anticipated by the market versus they are a surprise.
Alternative specifications when earnings contain value-irrelevant noise. The
notion of a value-irrelevant component in earnings is as formalized in Eq. (6) of
the text. The earnings component without noise, xt, is assumed to follow
a random walk:
xt = xt-1 + ~h,
(A14)
where rh has a zero mean and variance of tr2 , and it is serially uncorrelated, u,
is also a zero mean, serially uncorrelated, white noise term with variance a,z.
x, is perfectly correlated with price and u, is uncorrelated with xt as well as price.
The pricing equation is
~A.15)
= (1/r)[1/{ 1 + var(ut)/var(xt)}],
(A.16)
where, given the price equation (A.15), we substitute 1/r for cov(xt, Pt)var(xt).
Eq. (A.16) indicates that, unless var(ut) = 0, b is biased toward zero. The bias
increases in the ratio of the variances of ut and x,.
Return spec!t~cation. The slope coefficient from estimating the return regression model is
b = coy ( X J P t - a, Pt/Pt- t ) / v a r ( X t / P t - 1)
= coy [-(xt + ut)/Pt-1, PdPt-1]/var['(xt + ut)/P~-t]
(A.17)
S.P. Kothari, 3.L. Zimmerman / Journal 6f ,~.ccounting and Economics 20 (1995) 155-192
189
where we substitute 1/r for cov(xJP,_ 1, Pt/Pt- t)/var(x,/P,- 1). As in case of the
price specification, the return specification also yields a biased slope c ~ t
estimate because earnings contain valuation-irrelevant noise. The degree of bias
is determined by the ratio var(u~/P,_ ~)/var(x,/P,_ ~).
Differenced-price specification. The analysis here is similar to that for the price
specification. Specifically, the estimated slope coefficient is given by
b = (/r)[l/{1 + var(Aur)/var(Axt)}].
(A.18)
The degree of bias in Eq. (A.18) depends on the ratio of var(Au,) to var(Axr).
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