Determinants of the Returns-Earnings Correlation

Pervin K. Shroff

Corporate Finance & Organizations from Ohio State University

Abstract: The weak correlation between accounting earnings and security returns documented by numerous empirical studies is an issue of concern in current accounting research. Given that price is determined not solely by accounting earnings but also by other sources of information about future earnings, this paper focuses on the relation between earnings and other information to understand the returns-earnings association. The analysis indicates that current earnings exhibit high explanatory power for returns if they correlate with expected future earnings (or with other information which reflects expected future earnings). A high price-earnings (P/E) ratio coupled with a high return on equity (ROE) can ex ante indicate earnings growth, and the earnings of firms with these attributes are positively correlated with future earnings. The high growth subset obtains an impressive returns-earnings R2 of 31 percent and an earnings coefficient of 6.17, demonstrating that it is possible to identify firms whose earnings are strongly correlated with returns using a parsimonious set of firm characteristics.

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