Abstract
This study presents evidence that the marginal response of stock price to unexpected earnings declines as the absolute magnitude of unexpected earnings increases. Most previous studies assume a linear relation between unexpected returns (UR) and unexpected earnings (UE). The constant marginal response of prices to earnings in linear models is typically referred to as the earnings response coefficient (ERC) and estimated as the slope coefficient from simple linear regression of UR on UE. Relative to the linear model, a nonlinear approach provides both significantly higher explanatory power and a richer explanation for differences between ERCs and price-earnings ratios. The nonlinear relation described in this paper rests on the premise that the absolute value of unexpected earnings is negatively correlated with earnings persistence. Valuation theory suggests that analysts and investors should place greater emphasis on forecasting high-persistence earnings than low-persistence earnings, because a given amount of the former has a greater valuation impact than the same amount of the
Keywords
EarningsEconometricsEarnings response coefficientValuation (finance)EconomicsExplanatory powerStock (firearms)Linear modelFinancial economicsMathematicsStatisticsAccounting
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Publication Info
- Year
- 1992
- Type
- article
- Volume
- 30
- Issue
- 2
- Pages
- 185-185
- Citations
- 557
- Access
- Closed
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Cite This
Robert N. Freeman,
Senyo Y. Tse
(1992).
A Nonlinear Model of Security Price Responses to Unexpected Earnings.
Journal of Accounting Research
, 30
(2)
, 185-185.
https://doi.org/10.2307/2491123
Identifiers
- DOI
- 10.2307/2491123