Financial statement analysis and the prediction of stock returns

Abstract

This paper performs a financial statement analysis that combines a large set of financial statement items into one summary measure which indicates the direction of one-year-ahead earnings changes. Positions are taken in stocks on the basis of this measure during the period 1973–1983, which involve canceling long and short positions with zero net investment. The two-year holding-period return to the long and short positions is in the order of 12.5%. After adjustment for ‘size effects’ the return is about 7.0%. These returns cannot be explained by nominated firm risk characteristics.