Portfolio performance and accounting measures of earnings: an alternative look at usefulness

Portfolio performance and accounting measures of earnings: an alternative look at usefulness Measures of economic performance, such as accounting earnings, working capital and cash flows, have been evaluated in tests of relative explanatory power of regressions of market returns on earnings, working capital and cash flows. We employ a different test. Using Basu’s (J Finance 663–682, 1977) investment trading strategy, we measure portfolio returns based on these three accounting measures of earnings. The objective is to ascertain whether investment performance also supports the findings of the explanatory power studies that accounting earnings is the premier measure of performance. The evidence does not support this conclusion. Our findings are at variance with prior conclusions that accounting earnings is more useful than cash flow. The Basu trading strategy is effective for all three measures. Excess market returns are observed for all three measures, even when controlled for risk and for low priced stocks. But accounting earnings portfolios do not dominate working capital or cash flow portfolios. In fact, the raw returns to cash flow portfolios are marginally (statistically) larger than accounting earnings portfolios. Economically, a dollar invested in a portfolio using accounting earnings to select the stock would have an accumulated value of $22.73 while the same dollar investment using cash flow instead of accounting earnings would accumulate a value of $33.94 over the same 16 years starting with the second quarter of 1988 and concluding at the end of the first quarter of 2004. Thus, our results have implications for the studies of explanatory power of different measures of earnings and their comparison in the US and other markets. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Review of Quantitative Finance and Accounting Springer Journals

Portfolio performance and accounting measures of earnings: an alternative look at usefulness

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Publisher
Springer US
Copyright
Copyright © 2010 by Springer Science+Business Media, LLC
Subject
Finance; Corporate Finance; Accounting/Auditing; Econometrics; Operation Research/Decision Theory
ISSN
0924-865X
eISSN
1573-7179
D.O.I.
10.1007/s11156-010-0220-1
Publisher site
See Article on Publisher Site

Abstract

Measures of economic performance, such as accounting earnings, working capital and cash flows, have been evaluated in tests of relative explanatory power of regressions of market returns on earnings, working capital and cash flows. We employ a different test. Using Basu’s (J Finance 663–682, 1977) investment trading strategy, we measure portfolio returns based on these three accounting measures of earnings. The objective is to ascertain whether investment performance also supports the findings of the explanatory power studies that accounting earnings is the premier measure of performance. The evidence does not support this conclusion. Our findings are at variance with prior conclusions that accounting earnings is more useful than cash flow. The Basu trading strategy is effective for all three measures. Excess market returns are observed for all three measures, even when controlled for risk and for low priced stocks. But accounting earnings portfolios do not dominate working capital or cash flow portfolios. In fact, the raw returns to cash flow portfolios are marginally (statistically) larger than accounting earnings portfolios. Economically, a dollar invested in a portfolio using accounting earnings to select the stock would have an accumulated value of $22.73 while the same dollar investment using cash flow instead of accounting earnings would accumulate a value of $33.94 over the same 16 years starting with the second quarter of 1988 and concluding at the end of the first quarter of 2004. Thus, our results have implications for the studies of explanatory power of different measures of earnings and their comparison in the US and other markets.

Journal

Review of Quantitative Finance and AccountingSpringer Journals

Published: Jan 4, 2011

References

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