Predictability of Earnings and Reversion of Profitability

Predictability of Earnings and Reversion of favourableness1. INTRODUCTION, RESEARCH QUESTION AND plowsh areIn a competitive environment, economists say on that point is a smashed reversion of profitableness. Mean reversion of favorableness infers that variation in profitability and net income can be predicted. Although at that place are some literatures reservation an effort to find prediction in profitability and earnings, the findings somewhat cannot richly explain those variations. Early researches (Beaver 1970 Brooks and Buckmaster 1976 and Lookabill 1976) did not test the prediction formally. When in that respect were formal tests, models were mostly time-series and identified only companies with long-earning histories (20 classs). This approach causes the issue that long-term survivors might not represent all the firms. Further more than, 20 course of studys of information on earnings is an inaccurate estimation of the time-series model. Thus, the results found are statistically weak (Lev 1969 freewoman, Ohlson, and Penman 1982). There are some later researches attempting to list those variations as well. Freeman et al (1982), Collins and Kothari (1989), Easton and Zmijewski (1989), Ou and Penman (1989), Elgers and Lo (1994) and Basu (1997) found that cross-sectional tests constructed more consistent evidence of predictability. However, Elgers and Lo (1994) found the unrealistic assumption that there is no correlation among companies due to changes in earnings and profitability. Moreover, most lively literatures do not investigate connection of the predictability of profitability and that of earnings. Contrastingly, like Freeman et al. (1982) and Lev (1983), this research report is to settlement the question Is much of what is predictable about(predicate) earnings due to the mean reversion of profitability? The result confirms the answer to question is yes. Those results are applicable to the real world. Therefore, the main contribut ion is the verification of economists presumption that there is a mean reversion of profitability in a competitive environment.2. Data and methodology2.1 A First-Pass Partial change Model for ProfitabilityThis test uses a simple cross-section fond(p) adjustment infantile fixation in profitability changing for each form t from 1964 to 1995. This regression from t to t+1 is as followed (1a) (1b)where is issue forth volume assets of firm at the end of year t,is earnings onward interest,is profitability measure, is expect value of profitability measure, is profitability change from year t to t+1 and is the profitability deviation from the expected value. The motif uses a two-step method to identify equation (1). After doing regression to investigate differences in expected profitability among companies, the fitted values from the first-step regression are used as the proxy for in the cross-section regression. In the first-stage regression, (dividends to book value of e quity at the end of year t) is used as proxy for expected profitability, (dummy variable to capture nonlinear relationship of dividends and expected profitability) and (market-to-book ratio to find variation of expected profitability which cannot find by dividend determinants. In the cross-section regression, in (1) is the fitted value from the first-stage regression. (2) Due to the high command during the sample period (1964-1995), financial companies and utilities are omitted. This opus considers only the firms with more than $10 million assets and more than $5 million book equity. With these exclusions, 2,343 companies per year are taken into account.The interpretation is based on the average slopes and the time-series touchstone errors of the average slopes. However, with only 33 slope observation from 1964 to 1995, the estimation of autocorrelation is inaccurate. Therefore, this paper uses a less strict approach with t-statistics requirement of about 2.8 alternatively th an the common 2.0.2.2 A Nonlinear Partial Adjustment Model for ProfitabilityThis test is developed to investigate whether there is comparable nonlinearity in profitability characteristics with the system that the mean reversion of profitability results in the predictability of earnings. The nonlinear partial adjustment model equation is expanded from equation (1). (3) where is the negative deviations of profitability from expected values, is the squared negative deviations, is the squared positive deviations, is negative changes in profitability, is squared negative changes and is squared positive changes. , and are to capture the nonlinearity in the mean reversion of profitability and , and are to capture the nonlinearity in the profitability changes autocorrelation.2.3 Predicting EarningsFreeman et al. (1982) and Lev (1983) argue that the competition causes mean reversion of profitability. This paper inspects the predictable changes in earnings and how much of the predicta bility brings the nonlinearity of mean reversion in profitability. The dependent variable is change in earnings, . The regression of change in earnings is (4) where is negative changes in earnings, is squared negative changes in earnings and is squared positive changes in earnings. , and are to capture the nonlinearity in the earning changes autocorrelation.3. results3.1 A First-Pass Partial Adjustment Model for ProfitabilityThe negative slope of implies that there is a nonlinear relationship of dividends and profitability. The significant positive slope of confirms the hypothesis that market-to-book ratio investigates variation of expected profitability which cannot find by dividend determinants.