Earnings Quality and Price Quality

Abstract

Several papers have considered the relevance or quality of earnings by examining its relationship to prices, implicitly assuming that the quality of prices (or the market in which prices are set) remains constant. However, the quality of or noise in prices can vary across firms and over time, and trading pressure beyond what can be justified by correlated information about fundamentals can contribute to such variation. So we relax the assumption that the quality of prices is constant and reconsider the relevance of earnings. We construct a firm-specific measure of speculative intensity based on autocorrelation in daily trading volume adjusted for the amount of information available, and find that speculative intensity has a significant positive impact on returns. However, after controlling for speculative intensity, our results confirm a key result of previous research that earnings numbers still matter but departs from other work that suggests that earnings relevance has declined. We find that the explanatory power of earnings surprises has not declined, the influence of speculative intensity has increased, and so the omission of speculative intensity explains the previously documented decline in earnings relevance. This result is robust to excluding loss observations, which is another potential explanation for previous results.