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.
Review of Accounting Studies – Springer Journals
Published: Aug 19, 2011
It’s your single place to instantly
discover and read the research
that matters to you.
Enjoy affordable access to
over 18 million articles from more than
15,000 peer-reviewed journals.
All for just $49/month
Query the DeepDyve database, plus search all of PubMed and Google Scholar seamlessly
Save any article or search result from DeepDyve, PubMed, and Google Scholar... all in one place.
All the latest content is available, no embargo periods.
“Whoa! It’s like Spotify but for academic articles.”@Phil_Robichaud