Residual income, non-earnings information, and information content

Ruey S. Tsay, Yi-Mien Lin and Hsiao-Wen Wang
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Ruey S. Tsay: Graduate School of Business, University of Chicago, Chicago, Illinois, USA, Postal: Graduate School of Business, University of Chicago, Chicago, Illinois, USA
Yi-Mien Lin: Department of Accounting, National Chung Hsing University, Taichung, Taiwan, Postal: Department of Accounting, National Chung Hsing University, Taichung, Taiwan
Hsiao-Wen Wang: Department of Accounting, National Changhua University of Education, Changhua City, Taiwan, Postal: Department of Accounting, National Changhua University of Education, Changhua City, Taiwan

Journal of Forecasting, 2009, vol. 28, issue 6, 487-511

Abstract: We extend Ohlson's (1995) model and examine the relationship between returns and residual income that incorporate analysts' earnings forecasts and other non-earnings information variables in the balance sheet, namely default probability and agency cost of a debt covenant contract. We further divide the sample based on bankruptcy (agency) costs, earnings components and growth opportunities of a firm to explore how these factors affect the returns-residual income link. We find that the relative predictive ability for contemporaneous stock price by considering other earnings and non-earnings information is better than that of models without non-earnings information. If the bankruptcy (agency) cost of a firm is higher, its information role in the firm's equity valuation becomes more important and the accuracy of price prediction is therefore higher. As for non-earnings information, if bankruptcy (agency) cost is lower, the information role becomes more relevant, and the earnings response coefficient is hence higher. Moreover, the decomposition of unexpected residual income into permanent and transitory components induces more information than that of the unexpected residual income alone. The permanent component has a larger impact than the transitory component in explaining abnormal returns. The market and industry properties and growth opportunity also have incremental explanatory power in valuation. Copyright © 2008 John Wiley & Sons, Ltd.

Date: 2009
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Persistent link: https://EconPapers.repec.org/RePEc:jof:jforec:v:28:y:2009:i:6:p:487-511

DOI: 10.1002/for.1104

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