Improving Profitability Forecasts with Information on Earnings Quality

Abstract

Standard-Nutzungsbedingungen:Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden.Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen.Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. Terms of use: Documents in AbstractPrior literature documents the usefulness of the DuPont disaggregation for predicting firms' future profitability, operating income, and stock market returns. In addition, research also emphasizes the importance of earnings quality information. However, there is a lack of research examining how earnings quality affects forecasts of profitability. This paper explores whether different earnings quality factors moderate the accuracy of profitability forecasts. This study contributes to the existing literature along three dimensions. First, contrary to financial statement analysis studies, I find that changes in profit margin provide incremental information for predicting changes in future return on assets. After controlling for earnings quality factors, the incremental usefulness of this accounting signal increases significantly. Second, this paper contributes to the earnings quality literature by providing an approach as how to include this information into forecasts of profitability. In doing so, I incorporate the main drivers of earnings quality (i.e. fundamental performance and the accounting system) into profitability forecasts. Last, the paper adds to the literature on how capital market participants perceive accounting information. I document that both analysts and investors appear to efficiently incorporate earnings quality information in their investment decisions. JEL classification: M41

Using DuPont analysis to assess the financial performance of the top 3 JSE listed companies in the food industry

“…Dechow et al (2010), the quality of earnings is recognized as higher when they provide more information about the features of a firm's financial performance for decision making, which, in turn, depends on the specific situation. It has also been stated in prior literature that the accounting system influences both future profitability and market reactions of a firm (Demmer, 2015).…”

“…DuPont analysis is a preferred method to estimate the market value of a firm, indicating the leverage of a company to improve future profitability through more efficient utilization of its assets which will, in turn, improve the return to shareholders -higher leverage being preferable for potential investors. Demmer (2015) reports documentation in prior literature on the usefulness of DuPont disaggregation for predicting a firm's future profitability, operating income, and stock market returns and concludes that changes in profit margin provide important and relevant information on future return on assets. His findings also imply that DuPont components are partially influenced by the quality of the firms' expected earnings.…”

“…His findings also imply that DuPont components are partially influenced by the quality of the firms' expected earnings. He points to recent financial statement analysis (FSA) research which has shown the usefulness of change in profit margin for predicting year-ahead changes in RNOA (Demmer, 2015). Dechow et al (2010), the quality of earnings is recognized as higher when they provide more information about the features of a firm's financial performance for decision making, which, in turn, depends on the specific situation.…”

“…Of these possible indicators, literature indicates that the most important measure of profitability and performance is the one which is calculated using DuPont analysis. Demmer (2015) notes that changes in profit margin provide incremental information for Mishelle Doorasamy, 2016. Mishelle Doorasamy, Lecturer, Department of Accounting, University of KwaZulu-Natal, Westville, Durban, South Africa.…”

“…Ratios are tools used to quantify the risk element before making any strategic decisions, more especially, investment decisions. It has been reported to be one of the most important financial ratios, because it provides investors with a more comprehensive measure of performance (Demmer, 2015). A detailed financial analysis of all three companies using the DuPont system shows that investing in Tiger Brands would generate a higher return to shareholders than Pioneer Foods or RCI.…”