The information content of permanent versus transitory earnings: UK evidence

Abstract

This study examines whether UK investors perceive permanent earnings to be different from transitory earnings. Specifically, the current study investigates the relative informativeness (measured by earnings response coefficient) of permanent earnings compared to transitory earnings. The study uses a contextual model (of the relation between stock returns and accounting earnings) with a dummy variable approach that allows parameter shifts for firm-years having transitory earnings. The results of the study indicate that the earnings response coefficient is significantly positive for permanent and transitory earnings. However, the earnings response coefficient is significantly higher for permanent earnings compared to transitory earnings. These results are consistent with US findings and suggest that permanent earnings have more information content than transitory earnings. The results of this study could reflect two different things if we think about a standard model in which price is the present value of future earnings: i) a given level of earnings will have greater implications for future earnings if the earnings are permanent, causing a larger stock price response; ii) firms with more volatile earnings could be riskier, and, therefore the discount rate would be higher.