What Information in Financial Statements Could Be Used to Predict the Risk of Equity Investment?

Min (Shirley) Liu

doi:10.3390/jrfm14080365

Abstract

Theoretically, accounting earnings could be used to estimate the intrinsic value of equity. If accounting earnings could be predicted accurately, then, so could be the value of equity, thereby, creating much less risk in equity investment. However, earnings surprises are common, and therefore so is the risk in equity investment. To quantify the risk in the investment implied from accounting earnings, I propose to use financial statements to construct abnormal sales growth rates (ABG) and abnormal changes in profit margins (ABPM) to measure the uncertainty embedded in the accounting earnings. I measure ABG (ABPM) as the difference between the current value of sales growth rate (profit margin) and its benchmark, a weighted value of the three preceding years’ sales growth rate (profit margin). Then, I quantify whether and to what extent the news of ABG and ABPM are material enough to change the expected earnings (proxied by analysts’ forecasted earnings revisions [FREV] and predicted unexpected earnings [UE], and future stock returns [SAR]). Fama–MacBeth regression results show that, together, solely ABPM and ABG could explain 8.2% (2.3%) (5.4%) of the variation of FREV (UE) (SAR). The risk-predictability of ABPM and ABG is robust to the presence of abnormal growth in net operating assets and accruals quality, which, suggested by previous literature, might influence unexpected earnings. Further contingent analyses indicate that the capital market reacts more strongly to the bad news embedded in the ABPM/ABG (with negative signs) than the good news in ABPM/ABG (with positive signs).

Highlights

Sell-side security analysts primarily provide future earnings forecasts and stock recommendations
Unexpected earnings factors (ABG and abnormal changes in profit margins (ABPM)) determine the changes in expectations of future earnings; analysts regard the abnormal growth in net operating assets (NOA) as a positive sign for future earnings; and analysts revise downward forecasted earnings for firms with poor accruals quality
Results of the forecast revision regression show that the forecast revisions are positively associated with abnormal changes in profit margins (ABPM), abnormal sales growth (ABG), abnormal growth in net operating assets (ABNOAG), and earnings quality (AQ)

Summary

Introduction

Sell-side security analysts primarily provide future earnings forecasts and stock recommendations. This paper examines which unexpected future earnings indicators, obtained from financial statements, lead to forecast revisions. In earnings forecasting, analysts usually begin with sales growth and operating profit margins obtained from firms’ financial statements. When analysts forecast future earnings, they may compute the net operating assets growth, measured by how much capital retained from current period earnings to reinvest into the operating period. To figure out whether these financial indicators are reliable, analysts investigate the reported earnings quality to find out whether current earnings are good predictors for future earnings. I examine whether these three financial items contain any useful information to predict future earnings, and whether analysts factor in earnings quality in earnings forecasts

Results

Discussion

Conclusion