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Improving profitability forecasts with information on earnings quality

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  • Demmer, Matthias

Abstract

Prior literature documents the usefulness of the DuPont disaggregation for predicting firms future profitability, operating income, and stock market returns. In addition, research also emphasizes the importance of earnings quality information. However, there is a lack of research examining how earnings quality affects forecasts of profitability. This paper explores whether different earnings quality factors moderate the accuracy of profitability forecasts. This study contributes to the existing literature along three dimensions. First, contrary to financial statement analysis studies, I find that changes in profit margin provide incremental information for predicting changes in future return on assets. After controlling for earnings quality factors, the incremental usefulness of this accounting signal increases significantly. Second, this paper contributes to the earnings quality literature by providing an approach as how to include this information into forecasts of profitability. In doing so, I incorporate the main drivers of earnings quality (i.e. fundamental performance and the accounting system) into profitability forecasts. Last, the paper adds to the literature on how capital market participants perceive accounting information. I document that both analysts and investors appear to efficiently incorporate earnings quality information in their investment decisions.

Suggested Citation

  • Demmer, Matthias, 2015. "Improving profitability forecasts with information on earnings quality," Discussion Papers 2015/16, Free University Berlin, School of Business & Economics.
    • Handle: RePEc:zbw:fubsbe:201516
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    2. Dariusz Kusz & Iwona Bąk & Beata Szczecińska & Ludwik Wicki & Bożena Kusz, 2022. "Determinants of Return-on-Equity (ROE) of Biogas Plants Operating in Poland," Energies, MDPI, vol. 16(1), pages 1-22, December.

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    More about this item

    Keywords

    financial statement analysis; forecasting profitability; DuPont analysis; earnings quality; conservative accounting; persistence; growth; return on net; operating assets;
    All these keywords.

    JEL classification:

    • M41 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Accounting - - - Accounting

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