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Joint Effect of Earnings Components and Earnings Surprises on Future Performance and Stock Returns
Xavier Garza Gomez, University of Houston - Victoria
Michio Kunimura, Meijo University
Yong Lee, University of Houston - Victoria
ABSTRACT. We test the relative abilities of earnings, cash flows, accruals, and analysts’ expectations in the prediction of future cash flows and stock returns. Our analysis, which uses a cross-sectional approach on data from the Japanese stock market, yields two main conclusion. First, by disaggregating earnings into cash flows and accruals, we obtain better predictions of future cash flows than those obtained using only earnings. Second, using IBES data to measure earnings surprises, we find that surprises can predict future earnings better than they can predict future cash flows. Tests involving future stock returns show a strong relation between earnings and risk which renders the premium obtained from strategies based solely on earnings components statistically insignificant in the short term. On the contrary, investment strategies combining earnings components and analysts’ expectations obtain significant return premiums. Inferences are robust after controlling for common risk factors.
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