Research paper review
The first link assumed that the current accounting earnings reflect the current wealth creation of the firm and help predict its future earnings. The second link assumed that the current accounting earnings together with predictions of future earnings provide insight into the firm’s dividend-paying ability, that is, shareholders’ expectations of future dividends. The third link uses the expectations of future dividends to determine the present value of the future dividends, which ultimately represents the stock returns.
So all in all, the three-links theory uses the current accounting earnings as a basis for prediction of future earnings, which then indicates the expectation of future dividends, which is believed to represent the present value of stock returns. The empirical evidence was developed using data from 1988 through 2002. The researchers replicated and extended the three classic studies related to the relationship between earnings and stock returns. All the findings served as empirical evidence for the three-links theory.
The first study, Ball and Brown (1968), aimed at showing the impact Of annual earnings changes (increase or decrease) on the annual stock returns changes. The study was further extended to also examine the impact of changes in operating cash flows of a firm on its stock returns. The results showed that the impact of annual earnings was more significant than that of cash flows from operations. The second study, Cordoned and Lips (1 987), aimed at studying the importance of earnings persistence, which is the likelihood of a firm’s earnings level to recur in subsequent periods.
The results showed that the stock returns react more strongly to earning-increases with firms that have higher earnings persistence. The study was further extended to examine he effect when earnings decreased and the result was irrelevant , the stock returns react less strongly to earning-decreases because earning-decreases are usually non persistent. The third study, Bernard and Thomas (1989), aimed at examining the response of the capital market to the new earnings information.
The results showed that the stock returns tend to predict the earnings information weeks before the actual earnings announcement, which indicates a good response. However, the results also showed that this response kept fluctuating up to 60 days after the quarterly earnings announcement, which indicates that the capital market is not yet efficient with respect to new accounts nag-earnings information. Summary of the findings: The sample used for the studies included the data from publicly listed firms on NYSE, AMES and NASDAQ during the period 1988-2002. . Ball and Brown (1968): The original study was performed over the sample period 1957-1965. At that time, the sign of annual earnings changes led to an average of 16. 8% difference in annual stock returns. For the purposes of replicating the study, the sample firms from period 1988-2002 were grouped into two portfolios: rims with positive and negative earnings changes. It was shown that firms with positive earnings changes had positive abnormal returns Of 19. 2%, meanwhile the firms with negative earnings changes has -16. % change in annual returns. So the sign of annual earnings changes led to a new average of 35. 6% (19. 2+ -16. 41 ) difference in annual stock returns. The extension of this study dealt with changes in operating cash flows, which also affected the abnormal annual returns, but less strongly than the annual earnings changes, that is leading to an average of 1 1. 3+3. =15% difference in annual stock returns. 2. Cordoned and Lips (1987): The study provided some insight into the effects of earnings persistence on the earnings-returns association.
Following the classic study of Cordoned and Lips, the research proved that the stock returns reaction is stronger with increase in earnings of firms with high earnings persistence, that is 25. 3% comparing to only 13. 6% in case of the low earnings persistent firms. However, unlike Cordoned and Lips, the research also extended to prove that there is very little difference, if not none, between low and high persistent rims when comparing the case of earnings decreases.
