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Is Residual Income Really Uninformative About Stock Returns?
Sudhakar V Balachandran, Columbia Business School
Partha S Mohanram, Columbia Business School
ABSTRACT. Prior research finds that Residual Income (RI) is minimally informative about stock returns relative to Earnings, despite strong support for RI in theory and among practitioners. We examine three possible explanations for this puzzle. First, the empirical literature ignores salient features of practice or theory. Second, markets do not fully impound all information in RI income into current returns. Third, theory abstracts away some real world feature captured in prior empirical results. We find that while the incremental contribution of RI to earnings is modest in explaining current returns, conditioning on whether RI increased or decreased affects the relationship between earnings and returns. Further, markets only partially impound the information in RI into current returns. A strategy of going long on firms with the greatest increase in RI and short on firms with the greatest decrease in RI generates significant excess returns that persist after controlling for risk factors.
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