Earnings Quality and Stock Returns
Konan Chan, Louis K. C. Chan, Narasimhan Jegadeesh, Josef Lakonishok
NBER Working Paper No. 8308
An exclusive focus on bottom-line income misses important information about the quality of earnings. Accruals (the difference between accounting earnings and cash flow) are reliably, negatively associated with future stock returns. Earnings increases that are accompanied by high accruals, suggesting low-quality earnings, are associated with poor future returns. We explore various hypotheses -- earnings manipulation, extrapolative biases about future growth, and under-reaction to business conditions -- to explain accruals' predictive power. Distinctions between the hypotheses are based on evidence from operating performance, the behavior of individual accrual items, and discretionary versus nondiscretionary components of accruals.
Published: Chan, Konan, Louis K. C. Chan, Narsimhan Jegadeesh, and Josef Lakonishok. "Earnings Quality and Stock Returns." Journal of Business 79, 3 (May 2006): 1041-82.