Using residual income to refine the relationship between earnings growth and stock returns

Sudhakar Balachandran () and Partha Mohanram ()
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Sudhakar Balachandran: Columbia Business School
Partha Mohanram: Rotman School of Business

Review of Accounting Studies, 2012, vol. 17, issue 1, No 6, 134-165

Abstract: Abstract We use residual income (RI) to decompose earnings growth into growth in RI, growth in invested capital and other components and use this decomposition to explain stock returns. Our approach provides a significant increase in explanatory power vis-à-vis a regression of returns on levels and changes in earnings. While the market values growth in RI more than growth in invested capital, it still undervalues growth in RI and overvalues growth in invested capital. Earnings growth from growth in RI is more persistent, while earnings growth from growth in invested capital is more likely to reverse. Future returns are positively associated with growth in RI and negatively associated with growth in invested capital. A trading rule based on these findings generates significant hedge returns that persist after controlling for known risk factors. Hence, RI, a measure long recommended by accountants, allows investors to differentiate and evaluate different sources of earnings growth.

Keywords: Earnings growth; Residual income; Growth in residual income; Growth in invested capital (search for similar items in EconPapers)
JEL-codes: M40 M41 (search for similar items in EconPapers)
Date: 2012
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DOI: 10.1007/s11142-011-9168-1

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