The value relevance of earnings levels in the return-earnings relation

Abstract

Purpose – Prior studies provide mixed propositions on whether earnings levels or earnings changes provide the better explanatory power for variations of stock returns and whether the time-series behavior of earnings affects the value relevance of both earnings variables. This paper aims to compare the value relevance of earnings levels with that of earnings changes in the return-earnings relations. Design/methodology/approach – The unobservable components model is used to estimate permanent and transitory components of earnings. Findings – The finding shows that the proxy ability of earnings changes for unexpected earnings is sensitive to a firm's time-series earnings permanence property and is unstable and noisy when earnings contain predominantly transitory components, but that of earnings levels is not. The results support earnings levels are a stable and better value relevant proxy in the return-earnings relations. Research limitations/implications – The findings imply that the valuation role of earnings levels is important in the research relating to earnings components, earnings innovations, and equity valuation, especially when earnings permanence is of interest. Practical implications – The results provide a new understanding on the role of earnings levels in many business decisions such as executive compensations, institutional investment and conservative accounting where they often involve the choice of using levels and/or changes of earnings variables in making decisions. Originality/value – The paper contributes to the accounting literature by providing a new insight into the valuation role of earnings levels in the return-earnings relations. The stable value relevance of earnings levels also has important implications, especially for studies that use only earnings levels to assess earnings quality and earnings attributes.