The Relation Between Incremental Subsidiary Earnings and Future Stock Returns in Japan

Abstract

Japanese firms report both parent‐only and consolidated financial statements. Because of the unique business environment in Japan, there is a widely held view that parent‐only data provides a better means for assessing the value of the entire firm. We find that both parent‐only and subsidiary earnings are important in predicting future consolidated earnings. However, while stock prices accurately reflect the persistence of parent‐only earnings, the Japanese stock market appears to underestimate the persistence of subsidiary earnings, causing a significant positive relation between changes in subsidiary earnings in year t and stock returns in year t+1. This relation between subsidiary earnings and future stock returns does not persist beyond year t7plus;1. Taking a long (short) position in firms with large, positive (negative) changes in subsidiary earnings results in an average annual abnormal return of 7.06% with positive returns in 12 of the 13 years in the test period.