Earnings Persistence, Losses and the Estimation of Earnings Response Coefficients

One of the major themes of capital markets accounting research concerns mapping the relation between accounting earnings and security returns. There is still not agreement on the functional form of this relation. The models analysed here are those where: the level of earnings alone, the change in earnings alone, or both, scaled by price, are used as explanatory variables for returns. This article demonstrates that if earnings are either completely permanent or entirely transitory, the earnings response coefficients (ERCs) estimated by levels and changes models should coincide. However, if earnings comprise a mixed process of permanent and transitory components, the ERC estimated by the levels will differ from that estimated by the changes model. Using losses to identify transitory components in earnings, empirical evidence consistent with these predictions is provided. A combined model using both the level of, and change in, earnings is justified as a weighted average of an earnings and a book value valuation model (e.g., Ohlson, 1989). An alternative rationalization concerns the mitigation of an errors‐in‐variables problem associated with the estimation of unexpected earnings (Ali and Zarowin, 1992). The results for the combined model are more consistent with the latter. In this context, some previous empirical studies perceive the levels variable as a useful addition to the changes variable when there are transitory components in earnings. However, the evidence reported here suggests that the level of earnings, scaled by price, appears to be the fundamental earnings explanatory variable for returns (Ohlson, 1991, p. 1). The changes variable can, when the errors‐in‐variables problem is not mitigated by other methods, be a useful addition to the levels variable.