How Do Accounting Variables Explain Stock Price Movements? Theory and Evidence

Abstract

This paper provides theory and evidence showing how accounting variables explain cross-sectional stock returns. Based on Zhang (2000), who relates equity value to accounting measures of underlying operations, we derive returns as a function of earnings yield, equity capital investment, and changes in profitability, growth opportunities and discount rates. Empirical results confirm the predicted roles of all identified factors. The model explains about 20% of the cross-sectional return variation, with cash-flow-related factors (as opposed to changes in discount rates) accounting for most of the explanatory power. The properties of the model are robust across various subsamples and periods.JEL Classification: M41, G12, G14

Capturing the Impact of Unobserved Sector‐Wide Shocks on Stock Returns with Panel Data Model

“…In fact, results from previous studies show that the capability of accounting variables, together with market-wide impact, such as S&P500, is limited in explaining stock price movements (cf. Chen & Zhang, 2007;Bettman et al, 2009). This, to some extent, demonstrates the existence of other factors, such as sector-wide common shocks, that influence stock price movements.…”

“…In order to capture the company-specific factors that influence stock returns, we employ the equity valuation model of Zhang (2000). Chen and Zhang (2007) extended the model to establish the theoretical relationship between stock returns and accounting fundamentals. The model measures the characteristics of underlying operations of a company using the links between the future cash flows and observed accounting data in valuing equity.…”

“…To simplify the analysis, assume that profitability follows a random walk,q tþ1 ¼ q t þê tþ1 . Chen and Zhang (2007) derived the valuation function of equity as…”

Portfolio Quality and Mutual Fund Performance

“…We selected 14 accounting measures (see Table 2) which the previous studies emphasize as indicators of profitability, variability, operating efficiency, and financial health. Chen and Zhang (2007) determine that profitability (ROE) is an important factor in explaining future stock price movements, more so than scale-related factors (i.e., capital investment and change in growth opportunities). In addition, ΔROE (Bird and Casavecchia 2007), return on assets (ROA) 5 and ΔROA (Fairfield and Whisenant 2000;Piotroski 2000) are included as indicators of profitability.…”

“…AlthoughPiotroski (2000),Mohanram (2005), andBird and Casavecchia (2007) examine quality aspects associated with value and growth stocks, the analysis is conducted on a relevant universe of stocks and not applied to the stock holdings of mutual funds. 5Fairfield and Whisenant (2000);Piotroski (2000); Mohanram (2005);Bird and Casavecchia (2007);Chen and Zhang (2007).…”