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Earnings Quality and Stock Returns

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  • Konan Chan
  • Louis K. C. Chan
  • Narasimhan Jegadeesh
  • Josef Lakonishok
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    Abstract

    An exclusive focus on bottom-line income misses important information about the quality of earnings. Accruals (the difference between accounting earnings and cash flow) are reliably, negatively associated with future stock returns. Earnings increases that are accompanied by high accruals, suggesting low-quality earnings, are associated with poor future returns. We explore various hypotheses -- earnings manipulation, extrapolative biases about future growth, and under-reaction to business conditions -- to explain accruals' predictive power. Distinctions between the hypotheses are based on evidence from operating performance, the behavior of individual accrual items, and discretionary versus nondiscretionary components of accruals.

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    Bibliographic Info

    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 8308.

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    Date of creation: May 2001
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    Publication status: published as Chan, Konan, Louis K. C. Chan, Narsimhan Jegadeesh, and Josef Lakonishok. "Earnings Quality and Stock Returns." Journal of Business 79, 3 (May 2006): 1041-82.
    Handle: RePEc:nbr:nberwo:8308

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    1. Degeorge, Fran├žois & Patel, U & Zeckhauser, Richard, 1998. "Earnings Management to Exceed Thresholds," CEPR Discussion Papers, C.E.P.R. Discussion Papers 1790, C.E.P.R. Discussion Papers.
    2. Shleifer, Andrei, 2000. "Inefficient Markets: An Introduction to Behavioral Finance," OUP Catalogue, Oxford University Press, Oxford University Press, number 9780198292272, October.
    3. Teoh, Siew Hong & Welch, Ivo & Wong, T. J., 1998. "Earnings management and the underperformance of seasoned equity offerings," Journal of Financial Economics, Elsevier, Elsevier, vol. 50(1), pages 63-99, October.
    4. Jegadeesh, Narasimhan & Titman, Sheridan, 1993. " Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency," Journal of Finance, American Finance Association, American Finance Association, vol. 48(1), pages 65-91, March.
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    Cited by:
    1. Daniel Bergstresser & Mihir A. Desai & Joshua Rauh, 2004. "Earnings Manipulation and Managerial Investment Decisions: Evidence from Sponsored Pension Plans," NBER Working Papers, National Bureau of Economic Research, Inc 10543, National Bureau of Economic Research, Inc.
    2. Gene D'Avolio & Efi Gildor & Andrei Shleifer, 2001. "Technology, Information Production, and Market Efficiency," Harvard Institute of Economic Research Working Papers, Harvard - Institute of Economic Research 1929, Harvard - Institute of Economic Research.
    3. Hirofumi Uchida & Gregory F. Udell & Wako Watanabe, 2006. "Are Trade Creditors Relationship Lenders?," Discussion papers, Research Institute of Economy, Trade and Industry (RIETI) 06026, Research Institute of Economy, Trade and Industry (RIETI).
    4. Christopher Polk & Paola Sapienza, 2004. "The Real Effects of Investor Sentiment," NBER Working Papers, National Bureau of Economic Research, Inc 10563, National Bureau of Economic Research, Inc.
    5. Kenshi Taketa & Gregory F. Udell, 2007. "Lending Channels and Financial Shocks: The Case of Small and Medium-Sized Enterprise Trade Credit and the Japanese Banking Crisis," Monetary and Economic Studies, Institute for Monetary and Economic Studies, Bank of Japan, Institute for Monetary and Economic Studies, Bank of Japan, vol. 25(2), pages 1-44, November.

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