An Examination

An Examination of the Incremental Usefulness of Balance-Sheet Information Beyond Earnings in Explaining Stock Returns
Yuan Huang1 and Guochang Zhang2
Journal of Accounting, Auditing & Finance 27(2) 267293 The Author(s) 2012 Reprints and permission: sagepub.com/journalsPermissions.nav DOI: 10.1177/0148558X11409153 http://jaaf.sagepub.com
Abstract Until recently, studies in accounting research have predominantly focused on using earnings information to explain stock returns. This article examines how information provided by the other primary financial statementthe balance sheetis incrementally useful for determining returns. Based on existing models of equity value, the author shows theoretically that returns should be related to three balance sheetrelated variablesthe previous periods (equity) capital investment, contemporaneous capital investment, and the profitability changein addition to the earnings variables used in previous studies. Our empirical analysis yields the following results. First, the three balance sheetrelated variables each have a statistically and economically significant effect that is incremental to those of the earnings variables on equity returns, and together they improve the explanatory power of an earnings-only-based model from 11.5% to 13.9% in annual cross-sectional samples. Second, over time, the incremental explanatory power (IEP) of the balance-sheet variables is negatively correlated with the explanatory power of earnings. Third, in cross sections, the balance sheetrelated variables have a greater IEP for firms whose earnings are less informative (negative vs. positive earnings firms and young vs. mature firms) and for firms whose future earnings are more uncertain (firms with high vs. low analyst forecast errors, and firms with high vs. low analyst forecast dispersions). These results suggest that information from the balance sheet complements that contained in the income statement about equity returns. Keywords stock returns, balance sheet, incremental usefulness, earnings The relationship between stock returns and accounting data has been one of the most intensively studied topics in accounting research. Until recently, the focus in this line of research was predominantly on using income-statement data (such as earnings and earnings changes/ growth) to explain returns, with the other primary financial statementthe balance sheetleft
1 2
The Hong Kong Polytechnic University, Hung Hom, Kowloon Hong Kong University of Science and Technology, Clear Water Bay, Kowloon
Corresponding Author: Yuan Huang, The Hong Kong Polytechnic University, Hung Hom, Kowloon, Hong Kong Email: afyhuang@inet.polyu.edu.hk
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largely neglected, as is evident from the reviews of Lev (1989) and Kothari (2001). This is unsatisfactory because the balance sheet constitutes a vital part of a financial report, which informs investors of the sources and uses of the economic resources for a firms operations and thus provides essential information for assessing firm value and changes in firm value (returns).1 The lack of attention to the balance sheet in return studies is in contrast to research in related areas that has already demonstrated the importance of balance-sheet information in, for example, explaining stock prices (as opposed to returns; e.g., Barth, Beaver, & Landsman, 1998; Burgstahler & Dichev, 1997), evaluating the quality of earnings (e.g., Baber, Chen, & Kang, 2006), forecasting future earnings (e.g., Lev & Thiagarajan, 1993; Ou & Penman, 1989), and using residual income or EVA (which recognizes a charge on equity capital) to explain market prices and returns (Biddle, Bowen, & Wallace, 1997; Stewart, 1994) and to determine executive compensation (Balachandran & Mohanram, 2010). Our study is thus motivated to better understand the role of balance-sheet information in explaining returns beyond earnings. We address three specific questions. First, how should balance-sheet information be integrated along with earnings in return models in ways that are consistent with theoretical valuation models? Second, how much improvement can balance-sheet information bring to return models that already use earnings variables? Third, and more intriguingly, under what circumstances is balance-sheet information incrementally more useful in the diverse and changing business environment? These questions are of interest to standard-setting bodies, which need to decide whether to adopt a more balance sheetbased or a more income statementbased model of financial reporting,2 and to capital market investors, who rely on reported financial information to allocate capitals among different firms. We use two existing models of equity value developed in Ohlson (1995) and Zhang (2000) to identify the relevant data from the balance sheet. Both models follow the discounted cash flow framework, but they take different approaches to financial forecasting (explained in more detail below). Starting from Ohlsons (1995) model, where equity value is a linear function of earnings, current book value, and the previous years book value, we show that returns can be expressed as a function of earnings, the earnings change (relative to the previous year), and the change in equity book value over the prior period (lagged capital investment). However, based on Zhangs (2000) model, wherein equity value equals the earnings capitalization (representing the value of assets in place) plus real options to expand or contract the scale of operations, we show that returns are a function of earnings, the change in profitability (return on equity [ROE]) relative to the previous year, and the change in equity book value (contemporaneous capital investment). Based on the predictions of these two models, we set up a parsimonious return equation that incorporates three balance sheetrelated variables (the profitability change, contemporaneous capital investment, and lagged capital investment) and two earnings variables (the earnings level and the earnings change). This equation includes the factors arising from both Ohlson (1995) and Zhang (2000). As the economic settings examined in Ohlson (1995) and Zhang (2000) are complementary to each other in certain aspects, it is both informationally and economically meaningful to combine the factors identified from the two settings for empirical analysis. Our empirical return model incorporates earnings and the earnings change as explanatory variables, which are the factors used in previous earnings-based studies. The incremental effect of balance-sheet information is captured by the other three factors: contemporaneous capital investment, the profitability change, and lagged capital investment. The first two of these factors arise from the real-option terms in Zhang (2000). A
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distinguishing feature of Zhangs model is that firms make capital investment decisions contingently on profitability. Profitability being normalized earnings indicates a firms ability to generate value from invested capital, and thus, it serves as a guiding signal for investment activities. This suggests that when performing firm valuations, investors first need to determine a firms profitability, using both balance-sheet and income-statement data,3 and then based on profitability they need to assess the firms course of operations going forward (which incorporates the possibility of exercising real options) and the resulting cash flows. Intuitively, because value generation hinges on the amount of capital invested and the efficiency in utilizing invested capital, returns as changes in value should depend on changes in invested capital (equity book value) and changes in efficiency (profitability), both of which require balance-sheet data. Although profitability derives jointly from earnings and equity book value, given that our benchmark model already incorporates the earnings variables, any incremental explanatory power (IEP) of profitability (ROE) is attributable to balance-sheet information. For this reason, we classify ROE changes as a balance-sheet item in this study. In our empirical analysis, we further exploit the nonlinearity of Zhangs (2000) model caused by real options to examine how the coefficient on profitability changes with the level of profitability.4 Lagged capital investment is also included in our return model as another balance-sheet item. This factor arises from Ohlsons (1995) model to recognize the charge for the additional capital used to generate the incremental earnings in the current period relative to the prior period (the earnings change). Lagged capital investment does not arise from Zhang (2000), wherein a firms net investment is assumed to be zero for the period preceding the date of valuation. In our empirical analysis, we examine the incremental usefulness of balance-sheet information in a comprehensive data set from Compustat and Center for Research in Security Prices (CRSP) for the period of 1968 to 2007. Our results show that controlling for the earnings variables, the three balance sheetrelated variables (the profitability change, current capital investment, and lagged capital investment) each have a significant incremental effect, statistically and economically, on returns (although the effect of lagged investment is insignificant in some of the subsamples) and that the directions of the effects are consistent with the predictions of the underlying valuation models. Vuongs tests performed on pooled sample and annual samples consistently indicate that our return model performs significantly better than a benchmark that relies solely on earnings variables. In annual regressions, the average explanatory power of our comprehensive model that combines balance-sheet and income-statement information is 13.9%, compared with that of 11.5% for the earnings-only-based model. To gain insights into when, and under what circumstances, balance-sheet information is more useful, we conduct year-by-year analysis and analysis on various subsamples. We find that the usefulness of balance-sheet information in supplementing earnings variables is not uniform over time. Rather, the two tend to move in opposite directions. The Pearson correlation between the explanatory power of earnings variables and the incremental power of balance-sheet information in annual samples is 20.29 (t = 1.90), suggesting that balance-sheet information supplements earnings information to a greater extent in years in which the latter is less useful for explaining returns. We find a similar complementarity in cross sections. Prior studies have shown that earnings are less value relevant for firms with negative earnings (Collins, Maydew, & Weiss, 1997; Hayn, 1995) and for young firms (e.g., Chen, DeFond, & Park, 2002). In our context, we show that balance-sheet information has a greater incremental power to explain returns
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for firms with negative (vs. positive) earnings and for young (vs. mature) firms. In addition, we find that balance-sheet information is incrementally more useful for firms with low analyst forecast accuracies or large forecast dispersions, suggesting that investors rely on the balance sheet more when they face greater uncertainty about future earnings. Our study contributes to the literature in several ways. First, it corroborates recent studies that aim to refine the returnearnings relationship by distinguishing between different sources of earnings growth. Balachandran and Mohanram (in press) decompose earnings growth into a change in residual income component and a growth from investment component, and find significant improvement in explanatory power. Similarly, Harris and Nissim (2006) distinguish between earnings growth from profitability increases and earnings growth from investment. Consistent with these studies, we show that the different factors causing earnings growth (such as the profitability change and prior-period investment) each play a distinct role in the return model. But beyond those variables causing the contemporaneous earnings change, our study further incorporates factors that affect future earnings growth (such as current-period capital investment).5 Second, our study provides insights into when balance-sheet information is more useful in improving the performance of return models. Our annual regressions show that balancesheet variables are more useful in supplementing earnings information in the years when earnings have low power in explaining stock returns. Our analyses of subsamples in the cross section further show that balance-sheet information is more useful when firms are in an operational state in which earnings are less informative as a value indicator (e.g., when earnings are negative) and when investors face more uncertainty in predicting future earnings. The study thus highlights the complementary nature of the two primary financial statements. Third, compared with the simpler linear models adopted in previous studies that use earnings and equity book value in equity valuation (Barth et al., 1998; Collins et al., 1997), our return model embodies a more comprehensive set of information. When equity value is expressed as a linear function of earnings and equity book value, the return model derived from it is a linear function of earnings, the earnings change, and contemporaneous capital investment.6 As we show, these factors constitute only a subset of the information used in our model. More importantly, we introduce balance sheetrelated variables from formal models of equity value (Ohlson, 1995; Zhang, 2000), and in so doing, we explain the economic rationale for why these particular variables are relevant and predict the properties of their coefficients. Fourth, based on an extensive survey of return studies, Lev (1989) observes that earnings variables alone convey limited information for returns. Subsequently, several studies have attempted to augment the information set by bringing in future earnings numbers as additional explanatory factors (e.g., Collins, Kothari, Shanken, & Sloan, 1994; Kothari, 1992; Kothari & Sloan, 1992) on the ground that prices (and returns) anticipate future performance. However, future earnings are not observable, and in practice, investors must rely on observable information to set prices. In our study, we take an alternative approach to address the issue by making use of a broader set of reported financial data, thus avoiding the hindsight problem.7 The remainder of the article is organized as follows: Section titled Incorporating Balance-Sheet Information Into Return Models shows how in theory, balance-sheet data can be introduced into return models. Section titled Empirical Research Design and Sample describes our empirical research design and the sample. Section titled Results From Broad-Based Samples examines the incremental usefulness of balance-sheet
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information with broad-based samples and is followed by section titled Complementarity Between Balance-Sheet and Income-Statement Information, which reports the subsample analyses to explore how the usefulness of balance-sheet information varies over time and in the cross section. We conclude the article in the section titled Summary and Concluding Remarks.
Incorporating Balance-Sheet Information Into Return Models

In this section, we conduct a theoretical analysis to show how balance-sheet information can be incorporated into return models. We start with two existing valuation models that relate equity value to accounting data, namely, those of Ohlson (1995) and Zhang (2000). Both models arise from the residual income framework, which is based on discounted cash flow valuation and clean surplus accounting, but they adopt different approaches to forecasting future cash flows (or residual income). Whereas Ohlson assumes that residual income follows a linear (AR1) process over time, Zhang incorporates capital investment decisions that are contingent on profitability signals (which give rise to real options). As the two models capture different aspects of the accounting-value linkage, we will draw insights from both in designing our empirical research.8
Fundamental Factors for Explaining Returns According to Ohlsons Model

Starting with the discounted dividend model and assuming the clean surplus relation and a linear process for residual income, Ohlson (1995) shows that equity value at date t (Vt) is a linear function of contemporaneous earnings (Xt), book value (Bt), and dividends (net of capital contribution: Dt), as follows: Vt 5k (jXt Dt )1(1 k )Bt ; 1
where k = r w / (1 1 r 2 w) is a coefficient related to discount rate r and residual income persistence w (0 \ w \ 1), and j = (11r) / r is the earnings capitalization factor. Using the clean surplus relation, we replace the dividend term in (1) with earnings and equity book value Dt 5Bt 1 Bt 1Xt , which enables us to express equity value in terms of accounting variables as:9 Vt 5k(j 1)Xt 1Bt kBt 1 : To obtain the expression for returns, we apply Equation (2) to date t 1 1 to get Vt 11 5k (j 1)Xt 11 1Bt 11 kBt : Over the period from date t to date t 1 1, the equity return is defined as Rt 11 5 Vt 11 1Dt 11 Vt : Vt 4 3 2
Again, using the clean surplus relation to replace Dt11 in (4), we obtain
272 Rt 11 5
Journal of Accounting, Auditing & Finance Vt 11 1(Xt 11 Bt 11 1Bt ) Vt Vt (k (j 1)Xt 11 1Bt 11 kBt 1(Xt 11 Bt 11 1Bt ) k(j 1)Xt 1Bt kBt 1 5 5 Vt Xt 11 DXt 11 DBt 5 1k (j 1 ) k ; Vt Vt Vt
where DXt11 = Xt11 2 Xt is the change in earnings in period t 1 1 relative to period t, and DBt = Bt 2 Bt21 is the change in equity capital at date t relative to date t 2 1, which is the previous periods capital investment. This derivation identifies the same two earnings variables as in Easton and Harris (1991), but it shows that a complete return function from Ohlson (1995) also requires lagged capital investment. In Ohlsons (1995) model, capital investment activities are value-neutral in that they have zero net percent value (NPV) because, by assumption, expected future residual income is tied only to realized residual income and not to ongoing capital investments.10 Consequently, contemporaneous capital investment plays no role for explaining equity returns. However, lagged capital investment enters into Equation (5), along with earnings and the earnings change, because for the additional earnings generated in the current period relative to the prior period (i.e., the earnings change), one needs to recognize the capital charge on the incremental capital used. This explains why the coefficient on lagged capital investment is negative in Equation (5). Besides, the model also predicts the coefficient on earnings level is one and that on earnings change is positive.
Fundamental Factors for Explaining Returns According to Zhangs Model

Zhang (2000) develops a valuation model incorporating capital investment decisions that are contingent on profitability signals. A firm may expand its operation as profitability rises and contract (or abandon) it as profitability declines. Equity value is shown to consist of the value of the assets in place (earnings capitalization) and the real options to expand or contract, as follows: Vt 5Bt P (qt )1 qt =r 1gC (qt ); 6
where qt = Xt / Bt21 is the period t profitability (return on equity); g is the firms growth opportunity, which is defined as the percentage by which the scale of operations (capital invested) may grow; and P(qt) and C(qt) are the put option to abandon operations and the call option to expand operations, respectively, both normalized by Bt. The values of the options derive from the benefits from exercising the options and the likelihood of exercising the options, both of which are dependent on profitability q.11 To derive a model of equity return, we take the change in Equation (6) with respect to accounting variables Bt and qt from date t to t 1 1:12 DVt 11 v(qt ; gt ; r ) DBt 11 1Bt v0 Dqt 11 ; 7
where v(qt ; gt ; r )5P (qt )1qt =r 1gC (qt ); DVt11 = Vt11 2 Vt is the change in equity value from date t to date t 1 1; DBt11 and Dqt11 are similarly defined changes in equity book value and profitability, respectively, and v = dv / dqt, which is an increasing and convex function in qt. The period t 1 1 stock return is
Huang DVt 11 1Dt 11 DBt 11 Bt D 5v 1v0 Dqt 11 1 t 11 : Vt Vt Vt Vt DBt 11 B D t t 1 1 5 1v0 Dqt 11 1 : Bt Vt Vt
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Rt 11 5
Using the clean surplus relation, we replace Dt11 in Equation (8) with Xt11 and DBt11 and rearrange to obtain the following expression for the period t 1 1 return: Rt 11 5 Xt 11 Bt Vt DBt 11 1v0 Dqt 11 1( 1) : Vt Vt Bt Vt 9
Equation (9) shows that the return in period t 1 1 is a function of the profitability change, Dqt11, and contemporaneous capital investment, DBt11, in addition to earnings, Xt11. Changes in profitability affect returns because they revise expectations about a firms ability to generate value from invested capital. Investment results in a change in the capital base used to generate value, and so it also affects returns. Both variables revise expectations about future cash flows. In this model, value generation hinges on two basic attributes of operations as viewed from equity holders standpoint: the amount of capital invested (equity book value) and the efficiency in utilizing capital to generate profit (profitability). Furthermore, as a firms operations move forward, the scale of operation is adjusted in accordance with changes in profitability, thus, giving rise to real options. With equity value depending on equity book value and profitability, returns as changes in equity value naturally depend on contemporaneous equity investment, DBt11, and changes in profitability, Dqt11, both of which require balance-sheet data. Although the profitability variable is constructed jointly with balancesheet and income-statement data, we classify it as a balance-sheet variable because when we have already controlled for earnings and the earnings change, any IEP of profitability changes in explaining return comes from balance-sheet information. The two balance sheetrelated factors, DBt11 and Dqt11, are linked to real options through their coefficients as in Equation (9). The coefficient on Dqt11 contains v0 5dv=dqt 5 P 0 (qt )11=r 1gC 0 (qt ), which is positive and increasing in qt, given that v itself is increasing and convex in qt. In our empirical analysis below, we exploit this nonlinearity feature caused by real options to allow the coefficient on Dqt11 to vary with the level of profitability. The coefficient on DBt11 is (Vt / Bt 2 1) = P (qt )1qt =r 1gC (qt )21, representing the net present value per unit of incremental investment, which incorporates the effect of real options. Empirically, this coefficient can be either positive or negative, depending on whether the additional investment is profitable, that is, whether P (qt )1qt =r 1gC (qt )21 . 0.13 To the extent that firms on average make profitable (positive NPV) investments, we expect contemporaneous capital investment (DBt11) to have a positive coefficient in the return model. Thus, the real optionsbased model of Zhang (2000) provides an economically meaningful interpretation of the coefficient of DBt11. Finally, consistent with Equation (5), the coefficient on Xt11 is predicted to be one.
Empirical Research Design and Sample Research Design

From Ohlsons (1995) model, we show that the previous periods capital investment, along with the earnings level and the earnings change, explains returns. Moreover, from Zhangs
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(2000) model, we derive two additional balance sheetrelated variables, contemporaneous capital investment and the profitability change, together with earnings. The two models are developed from two distinct economic settings, which are complementary in certain aspects. Although Zhang considers contingent capital investment decisions, which give rise to real options, his model is embedded with an assumption that a firms scale of operations is kept constant in the period preceding the date of valuation (so that lagged capital investment is zero; Zhang, 2000); however, this condition is not imposed in Ohlsons linear model. Due to the complementarity between the two models, the factors from one model will not completely subsume those from the other in explaining returns. Thus, in our empirical analysis, we combine the factors from Ohlson and Zhang, and use them to jointly explain returns. The main return model for our empirical analysis is the following linear specification: Rit 5a1b xit 1g Dxit 1h Dqit 1u Dbit 1d Dbit 1 1eit : 10
In Equation (10), Dxit and Dbit21 arise from Ohlson (1995), Dqit and Dbit from Zhang (2000), and xit from both settings. Although it is true that Dqit already contains the information in Dxit and Dbit21 (which is combined in a particular fashion), the three factors originate from two distinct economic settings (explained above), and empirically, whether Dqit is sufficient for summarizing the information in Dxit and Dbit-1 to explain returns is unclear. For this reason, we keep all three factors (Dqit, Dxit, and Dbit21) in return Model (10). Model (10) also enables us to conveniently evaluate the incremental usefulness of balancesheet information beyond an earnings onlybased model (that uses only earnings and the earnings change). The dependent variable in (10), Rit, is the annual stock return, which is calculated from the 4th month after the prior fiscal year end to the 3rd month after the current fiscal year end. The independent variables are specified as follows: xit = Xit / Vit21 is the earnings in year t (Xit) scaled by the market value of equity at the beginning of year t (Vit21); Dxit = (Xit 2 Xit21) / Vit21 is the earnings change in year t relative to year t 2 1 scaled by Vit21; Dqit = qit 2 qit21 is the profitability change in year t relative to year t 2 1, with qit = Xit / Bit21; Dbit = (Bit 2 Bit21) / Vit21 is capital investment (the change in equity book value) in year t scaled by Vit21; and Dbit21 = (Bit21 2 Bit22) / Vit21 is the lagged capital investment (change in equity book value in year t 2 1) scaled by Vit21. According to Model (9), the coefficient on Dqit involves the first-order derivative of the growth option (included in v). Due to the convex behavior of real options, this coefficient is an increasing function of profitability. To capture this property, we distinguish the coefficient on Dqit between high- and low-profitability firms in the extended specification below, Rit 5a1b xit 1g Dxit 1h Dqit 1hH H Dqit 1u Dbit 1d Dbit 1 1eit ; 10a
where H is a dummy variable equal to 1 for firms with profitability above the median in a year and 0 otherwise. Based on the above theoretical analysis, we expect b = 1, g . 0, h . 0, u . 0, and d \ 0 in Model (10a). In addition, following the prediction that the return impact associated with one unit of profitability change is greater for more profitable firms, we expect hH . 0. To evaluate the incremental usefulness of the balance-sheet information as incorporated in (10a), we compare the performance of (10a) with that of the following benchmark Model (11) (Easton & Harris, 1991), which relies only on earnings variables:
Huang Rit 5a1b xit 1g Dxit 1eit :
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The factors in Model (11) are a subset of those in Model (10a). Observe that (11) can be viewed as a cut-down version of the return Model (5), which is derived from Ohlson (1995), without the lagged capital investment term. We assess the incremental usefulness of balance-sheet information in two aspects. First, for individual balance sheetrelated variables, we test whether the coefficients are consistent with the theoretical predictions. We examine the significance of these variables within our (more comprehensive) return Models (10) and (10a), controlling for the earnings variables. Second, we examine whether there is a significant improvement in model performance after introducing our balance sheetrelated variables, as measured by the IEP, which is calculated as the R2 of Model (10a) minus that of Model (11) (Biddle, Seow, & Siegel, 1995; Brown, Lo, & Lys, 1999).14 That is, we attribute the IEP of Dbit21, Dbit, and Dqit, beyond Dxit and xit, to balance-sheet information. As already explained above, although Dqit combines both earnings and book value, its IEP over and above that of the earnings variables is attributable to balance-sheet information. The difference in the explanatory power between (10a) and (11) represents the IEP of the three balance-sheet variables as a group. In addition, we also estimate the IEPs of the balance-sheet variables individually. This is computed as the R2 of Model (10a) minus that of Model (10a), excluding the concerned balance-sheet variable. Beyond examining the IEP on broad cross-sectional samples, we evaluate whether the IEP varies over time and across subsets of firms. We describe how the IEP of balancesheet information fluctuates from year to year in relation to the explanatory power of earnings numbers. We also compare the IEPs of firms that differ in earnings informativeness (negative vs. positive earnings firms and young vs. mature firms) or in the predictability of future earnings (firms with low vs. high analyst forecast accuracies and firms with large vs. small forecast dispersions).
The Sample and Descriptive Statistics

We extract the data on earnings before extraordinary items and discontinued operations (Xit, No. 18) and equity book value (Bit, No. 60) from the Compustat annual file. We extract the stock returns and beginning market values of common equity from the CRSP monthly files. Annual returns with dividends (Rit) are compounded from monthly returns starting from the 4th month after the prior fiscal year end to the 3rd month after the current fiscal year end. We exclude observations with an equity book value less than US$0.5 millions or total assets less than US$1.5 millions. To reduce the impact of outliers and extremely illiquid stocks, we require the stock price at the beginning of a fiscal year to be higher than US$3. We exclude firms in financial industries (whose balance sheets have distinctively different features) and utility firms (whose profitability is subject to regulations). The resulting sample consists of 87,439 firm-year observations for the period 1968 to 2007. In some parts of the analysis, the sample size varies where we also use analyst earnings forecasts from the Institutional Brokers Estimate System (I/B/E/S) detailed file.15 We winsorize the continuous variables at the top and bottom 1% of the distribution. Panel A of Table 1 presents the descriptive statistics of the main variables for the pooled sample. The annual stock return (Rit) has a mean (median) of 0.17 (0.09). The scaled earnings (xit) have a mean (median) of 0.07 (0.07), and the scaled earnings change (Dxit) has a mean and median of 0.01. The profitability change (Dqit) has a mean of 20.01
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Table 1. Summary Statistics Panel A: Descriptive Statistics M Rit xit Dxit Dbit Dqit Dbit21 0.17 0.07 0.01 0.06 20.01 0.06 SD 0.46 0.07 0.09 0.13 0.15 0.12 1% 20.57 20.10 20.33 20.41 20.49 20.41
25% 20.13 0.04 20.02 0.02 20.06 0.02
50% 0.09 0.07 0.01 0.06 0.00 0.05
75% 0.36 0.11 0.03 0.10 0.04 0.10
99% 1.82 0.21 0.33 0.53 0.43 0.44
Panel B: Correlation Matrix Rit Rit xit Dxit Dbit Dqit Dbit21 0.28 0.27 0.21 0.27 20.05 xit 0.34 0.52 0.56 0.39 0.20 Dxit 0.35 0.50 0.46 0.72 20.30 Dbit 0.25 0.60 0.48 0.30 0.17 Dqit 0.32 0.37 0.84 0.32 20.37 Dbit-1 20.04 0.27 20.18 0.27 20.38
Note: This table reports the summary statistics for our sample for the period 1968 to 2007. There are 87,439 firm-year observations. The variables are defined as follow: Rit is the annual stock return from the 4th month after the prior fiscal year end to the 3rd month after the current fiscal year end; xit = Xit / Vit21 is the earnings in year t (Xit) scaled by the beginning market value of equity (Vit21); Dxit = (Xit 2 Xit21) / Vit21 is the earnings change in year t relative to year t 2 1 scaled by Vit21; Dqit = (qit 2 qit21) is the profitability change of year t relative to year t 2 1, with qit = Xit / Bit21; Dbit21 = (Bit21 2Bit22) / Vit21 is the capital investment in year t 2 1 scaled by Vit21; and Dbit = (Bit 2 Bit21) / Vit-1 is the current years capital investment scaled by Vit21.In Panel B, the Spearman correlation coefficients are above the diagonal, and Pearson correlation coefficients are below the diagonal. All of the coefficients are significant at the .01 level
and median around 0, suggesting that the profitability tends to decline over time. Scaled contemporaneous capital investment (Dbit) has a mean (median) of 0.06 (0.06), and scaled lagged capital investment (Dbit21) has a mean (median) of 0.06 (0.05). Panel B reports the pairwise correlations among the variables. We find that all of the correlations in the panel are significant at the .01 level. The annual stock return is positively correlated with earnings (with a Pearson correlation equal to .28 and a Spearman correlation equal to .34) and with the earnings change (.27 and .35). More importantly, the return is also positively correlated with the profitability change (.27 and .32), contemporaneous capital investment (.21 and .25), and is negatively correlated with lagged capital investment (2.05 and 2.04), all having the predicted signs. We find strong correlations among the accounting variables. The earnings level is positively correlated with the earnings change, which is expected (shocks causing earnings to increase in year t tend to cause earnings to be higher than in year t 2 1). Current capital investment is positively correlated with earnings, earnings change, and profitability change, and is grossly consistent with the notion of capital following profitability (Biddle, Chen, & Zhang, 2001). Current capital investment is also positively correlated with lagged capital investment, suggesting that in general firms do not alter their investment activities drastically from one year to the next. The correlation between the earnings change and the profitability change is particularly high (.72 and .84). Earnings are a product of equity book value and profitability. In
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principle, the earnings change in a year relative to the prior year can arise from two sources: a change in book value (due to incremental investment or divestment) and a change in profitability (due to improvement or deterioration in operational efficiency). The high correlation between the earnings change and the profitability change suggests that, empirically, the earnings change between two consecutive years is mostly driven by the profitability change, rather than capital investment.
Results From Broad-Based Samples

This section examines the empirical importance of balance-sheet information in broad cross-sectional samples. The objective here is to gain an overall view of how useful the balance-sheet variables are beyond earnings variables in explaining stock return.
Results From the Pooled Sample

Using pooled samples, Table 2 reports the performance of our return Models (10) and (10a), relative to the performance of several variants of these two models and earningsonly Model (11). In running these pooled regressions, we adjust for cross and serial correlations with two-way (firm and year) clustering. Panel A shows the regression results of Models (10), (10a), and (11). Controlling for earnings and the earnings change, the three balance sheetrelated variables, Dqit, Dbit, and Dbit-1, all have a significant effect on returns and the directions of the effects are as predicted. The profitability change (Dqit) has a consistently positive coefficient in all the specifications in the table. In row (ii), without introducing the piecewise linear structure, the coefficient on Dqit is 0.37 (t = 13.31), significant at the .01 level. For the piecewise linear model (row i), the coefficient on Dqit is 0.15 (t = 4.02) for the low-profitability range, significant at the .01 level, and increases to 0.53 (=0.15 1 0.38) for the high-profitability range. The coefficient increase from the low-profitability to the high-profitability range is significant at the .01 level (t = 7.19). These results indicate that the effect of a change in profitability on returns is positive and is greater for firms with higher profitability. The magnitude of the coefficient demonstrates that the effect of the profitability change is economically important. Ceteris paribus, an increase in profitability by one standard deviation within the pooled sample (=0.15) is, on average, associated with a return increase of 0.02 for low-profitability firms and 0.08 for high-profitability firms, which amounts to 13.2% and 46.8% of the average annual return (0.17), respectively. In row (i), lagged capital investment (Dbit21) has a negative coefficient of 20.13 (t = 2.56), significant at the .05 level, consistent with the prediction. This suggests that a change of lagged capital investment by one standard deviation (0.12) is associated with an average return change of 20.02. Contemporaneous capital investment (Dbit) has a coefficient of 0.28 (row i), significant at the .01 level (t = 4.89). In absolute terms, the coefficient on Dbit is almost twice of that on Dbit21 and has a much higher t value. An increase in capital investment by one standard deviation (0.13) is associated with an average return increase of 0.04, which is economically significant. The coefficient on xit is highly significant; the coefficient is 1.02 (t = 3.56) in Model (10a), row (i), and is 0.97 (t = 3.40) in Model (10), row (ii). These values are not significantly different from the theoretical value of one at the .1 level. The coefficient on Dxit is sensitive to whether balance-sheet information is present. In the benchmark Model (11), row (iii), where only the two earnings variables are used, this
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Table 2. Pooled Sample Regressions Intercept xit Dxit Dqit
Dbit
Dbit21
H 3 Dqit
R2
Panel A: Comparison of our return models with earnings-only-based return models (i) Model (10a) (ii) Model (10) (iii) Model (11) 0.09a (3.23) 0.10a (3.55) 0.10a (3.27) 1.02a,d (3.56) 0.97a,d (3.40) 1.11a,d (4.27) 0.30b (2.56) 0.19c (1.73) 0.84a (7.08) 0.15a (4.02) 0.37a (13.31) 0.28a (4.89) 0.30a (5.15) 20.13b (22.56) 20.14a (22.69) 0.38a (7.19) .090*** .087*** .076***
Panel B: The effect of individual balance-sheet variables (iv) (v) (vi) 0.09a (3.22) 0.10a (3.26) 0.10a (3.30) 1.14a,d (4.42) 0.91a,d (3.19) 1.25a,d (4.65) 0.50a (4.02) 0.75a (6.95) 0.72a (5.35) 0.14a (3.41) 0.25a (4.08) 20.17a (23.04) 0.42a (7.51) .087*** .079*** .077***
Panel C: IEP of individual balance-sheet variables (vii) (viii) (ix) 0.10a (3.30) 0.09a (3.21) 0.09a (3.23) 1.06a,d (3.69) 1.20a,d (4.48) 0.93a,d (3.30) 0.56a (4.71) 0.46a (3.46) 0.38a (3.43) 0.30a (5.09) 0.13a (3.40) 0.17a (4.39) 0.26a (4.32) 20.24a (24.59) 20.07 (21.26) .081*** 0.41a (7.44) 0.39a (7.36) .087*** .090***
Note: IEP = incremental explanatory power. This table reports the pooled regression results for Models (10), (10a), and (11): Rit 5a1b xit 1g Dxit 1h Dqit 1u Dbit 1d Dbit1 1eit ; Rit 5a1b xit 1g Dxit 1h Dqit 1hH HDqit 1u Dbit 1d Dbit1 1eit ; Rit 5a1b xit 1g Dxit 1eit : 10 10a 11
Rit is the annual stock return from the 4th month after the prior fiscal year end to the 3rd month after the current fiscal year end; xit = Xit / Vit21 is the earnings in year t (Xit) scaled by the beginning market value of equity (Vit21); Dxit = (Xit 2 Xit21) / Vit21 is the earnings change in year t relative to year t 2 1 scaled by Vit21; Dqit = (qit 2 qit-1) is the profitability change of year t relative to year t 2 1, with qit = Xit / Bit21; Dbit21 = (Bit-1 2 Bit22) / Vit-1 is the capital investment in year t 2 1 scaled by Vit21; and Dbit = (Bit 2 Bit-1) / Vit21 is the current years capital investment scaled by Vit21. H is a dummy variable equal to 1 for firms whose profitability is larger than the annual median level. The t statistics in the parentheses are adjusted for firm-year two-way clustering. a,b , and c indicate the coefficient being significantly different from 0 at the .01, .05, and .1 levels, respectively. d indicates the coefficient is not significantly different from the predicted value of one at the .1 level. ***indicates the Vuongs Z statistics for comparing balance-sheet-information-integrated model (Model [10a] and its variants) with earnings-only model (Model [11]) being significant at the .01 level. The Z statistics are 26.36 (row [i]), 23.35 (row [(ii]), 26.77 (row [iv]), 11.47 (row [v]), 7.70 (row [vi]), 15.60 (row [vii]), 22.98 (row [viii]), and 25.70 (row [ix]), respectively, in favor of balance-sheet-information-integrated models.
coefficient is 0.84 (t = 7.08), but it decreases by more than half to 0.30 (t = 2.56) in the comprehensive Model (10a), row (i), which incorporates the balance sheetrelated variables. The explanatory power of Model (10a) is 9%, compared with that of 7.6% for benchmark Model (11) (row [i] vs. row [iii]). Thus, collectively, the balance-sheet variables have
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an IEP of 1.4%. Vuongs Z statistics for comparing Models (10a) and (11) is 26.36, significant at the .01 level, in favor of Model (10a). Similarly, Vuongs Z statistics for comparing Models (10) and (11) is 23.35, also significant at the .01 level, in favor of 10 over 11. Panel B details how the individual balance-sheet variables impact the role of Dxit in the return model. Inclusion of Dqit has the greatest impact, which reduces the coefficient on Dxit from 0.84 in row (iii) to 0.50 in row (iv), whereas the inclusion of Dbit and Dbit21, row (v) and (vi), has a smaller impact. The results demonstrate that Dqit has a more robust relationship with stock returns than does Dxit, reaffirming the usefulness of balance-sheet information for enhancing the performance of return models. The IEP of individual balance-sheet variables is provided in Panel C. Among the individual factors, the profitability change has the largest IEP of .9%. The IEP of contemporaneous capital investment is .3%. The IEP of lagged capital investment is the smallest at .01%. In Panels B and C, we conduct Vuongs tests to examine the performance of various balance-sheet-information-integrated models relative to the earnings-only model. The results show that the models incorporating various subsets of our balance-sheet variables all perform significantly better at the .01 level than the earnings-only model. Although the results in Table 2 are from regressions using raw returns as the dependent variable (which is originally derived from the underlying valuation models), we also perform regressions using market-adjusted returns as the dependent variable, which aim to mitigate potential concerns caused by the differences in the general level of returns across years. The results, presented in Table 3, are similar to those reported in Table 2. Therefore, our conclusion about the usefulness of the balance-sheet variables that we have identified (Dqit, Dbit, and Dbit21), both individually and as a whole, remains unchanged.16
Results From the Annual Samples

Panel A of Table 4 presents the results of Model (10a) from the annual samples. The top part of the panel shows the mean coefficients from the annual regressions across the sample years and the FamaMacBeth t values adjusted with NeweyWest approach. The average coefficient on xit is 1.26 (t = 7.76), which is not significantly different from the theoretical value of one at the .1 level. In annual regressions, the coefficient on xit is significantly different from 1 for 27 years at the 0.1 level or better and is not significantly different from 1 for 13 years. The average coefficient on Dqit is 0.21 (t = 4.61) for low-profitability firms, and the incremental coefficient on Dqit for high-profitability firms is 0.43 (t = 7.68), showing a relationship between returns and Dqit that is dependent on the level of profitability. The coefficient on Dqit is significantly positive for low-profitability firms in 21 of the 40 sample years and the incremental coefficient for high-profitability firms is significantly positive in 30 years at the .1 level or better, and generally insignificant for the remaining years, conditional on the earnings variables. The average coefficient on Dbit is 0.16 (t = 3.78) and that on Dbit21 is 20.09 (t = 22.54). The coefficient on contemporaneous capital investment is significantly positive in 17 years (at the 0.1 level or better), insignificant in 21 years, and significantly negative in 2 years. The coefficient on Dbit21 is significantly negative (at the .1 level or better) in 17 years, insignificant in 16 years, and significantly positive in 7 years. In Panel B of Table 4, we compare the annual R2s of Model (10a) with those of Model (11). In all the 40 years in our tests, introducing the balance-sheet information significantly improves the explanatory power of the return model (at the .1 level or better), as indicated
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Table 3. Pooled Sample Regressions With Market-Adjusted Returns Intercept xit Dxit Dqit Dbit Dbit21 H 3 Dqit R2
Panel A: Comparison of our return models with earnings-only-based return models (i) Model (10a) (ii) Model (10) (iii) Model (11) 20.04 (21.57) 20.02 (21.09) 20.032 (21.42) 1.06a,d (5.40) 1.02a,d (5.16) 1.10a,d (6.40) 0.39a (4.33) 0.28a (3.27) 0.93a (11.41) 0.15a (5.08) 0.37a (15.08) 0.25a (5.00) 0.27a (5.33) 20.16a (23.56) 20.16a (23.65) 0.37a (8.04) .109*** .106*** .094***
Panel B: The effect of individual balance-sheet variables (iv) (v) (vi) 20.03 (21.57) 20.03 (21.46) 20.03 (21.39) 1.13a,d (6.63) 0.93a,d (4.71) 1.27a,d (7.13) 0.58a (6.49) 0.86a (11.88) 0.79a (8.01) 0.16a (4.88) 0.21a (4.11) 20.20a (24.48) 0.40a (8.44) .106*** .096*** .096***
Panel C: IEP of individual balance-sheet variables (vii) (viii) (ix) 20.03 (21.43) 20.04 (21.57) 20.04 (21.56) 1.10a,d (5.57) 1.22a,d (6.90) 0.95a,d (4.87) 0.65a (7.52) 0.53a (5.32) 0.48a (5.99) 0.26a (5.28) 0.13a (4.45) 0.18a (5.87) 0.22a (4.32) 20.26a (26.10) 20.10b (22.20) .099*** 0.40a (8.31) 0.38a (8.29) .106*** .108***
Note: IEP = Incremental explanatory power. This table reports the pooled regression results for models (10), (10a), and (11): ExRit 5a1b xit 1g Dxit 1h Dqit 1u Dbit 1d Dbit1 1eit ; ExRit 5a1b xit 1g Dxit 1h Dqit 1hH HDqit 1u Dbit 1d Dbit1 1eit ; ExRit 5a1b xit 1g Dxit 1eit : 10 10a 11
ExRit is the annual market-adjusted stock return from the 4th month after the prior fiscal year end to the 3rd month after the current fiscal year end; xit = Xit / Vit21 is the earnings in year t (Xit) scaled by the beginning market value of equity (Vit21); Dxit = (Xit 2 Xit21) / Vit21 is the earnings change in year t relative to year t 2 1 scaled by Vit21; Dqit = (qit2qit21) is the profitability change of year t relative to year t 2 1, with qit = Xit / Bit21; Dbit21 = (Bit21 2 Bit22) / Vit21 is the capital investment in year t 2 1 scaled by Vit21; and Dbit = (Bit 2 Bit21) / Vit21 is the current years capital investment scaled by Vit21. H is a dummy variable equal to 1 for firms whose profitability is larger than the annual median level. The t statistics in the parentheses are adjusted for firm-year two-way clustering. ***indicates the Vuongs Z statistics for comparing the balance-sheet information integrated model (Model [10a] and its variants) with earnings-only model (Model [11]) being significant at the .01 level. The Z statistics for these models are 27.63 (row [i]), 24.57 (row [ii]), 24.30 (row [iv]), 10.30 (row [v]), 9.80 (row [vi]), 16.16 (row [vii]), 24.78 (row [viii]), and 26.60 (row [ix]), respectively, in favor of balance-sheet-information-integrated models. a,b and c indicate the coefficient being significantly different from 0 at the .01, .05, and .1 levels, respectively. d indicates the coefficient is not significantly different from the predicted value of one at the .01 level.
by the significant Vuongs Z statistics. The IEP of the balance-sheet information ranges from .6% (year 1984) to 8% (year 1969), with a mean of 2.4% (t = 7.31). Moreover, the average annual R2 is 13.9% for Model (10a), compared with that of 11.5% for Model (11). Following Ball, Kothari, and Robin (2000), we perform a t test and find that the time series
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Table 4. Annual Regression Results and the IEP of Balance-Sheet Information Year Mean 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 Intercept 0.07 (2.66) 0.07a (2.86) 20.27a (217.31) 0.01 (0.57) 0.04b (2.53) 20.18a (211.89) 20.27a (220.79) 20.21a (211.08) 0.23a (9.71) 20.07a (23.71) 0.02 (1.07) 0.16a (8.02) 0.15a (6.77) 0.47a (18.35) 20.15a (210.05) 0.38a (16.61) 0.08a (5.12) 20.10a (29.32) 0.23a (16.99) 0.11a (10.09) 20.06a (26.25) 0.04a (3.96) 0.05a (4.35) 0.01 (0.75) 0.23a xit 1.26a (7.76) 2.45a,*** (5.72) 1.59a,** (5.60) 3.30a,*** (11.62) 1.99a,*** (7.86) 1.08a (4.85) 0.94a (7.03) 1.23a (8.18) 1.44a,** (7.03) 1.90a,*** (11.16) 1.18a (6.91) 0.28*** (1.56) 20.47b,*** (22.46) 20.36c,*** (21.65) 1.70a,*** (11.35) 1.33a (6.03) 3.21a,*** (15.06) 2.15a,*** (16.95) 1.56a,*** (8.66) 2.39a,*** (13.04) 1.28a,* (7.88) 1.61a,*** (11.16) 0.81a (4.78) 0.90a (4.55) 1.11a Dxit 0.41a (4.71) 0.91c (1.76) 20.44 (21.41) 20.78a (23.03) 0.61b (2.26) 0.06 (0.24) 0.59a (3.36) 0.66a (4.37) 0.43b (2.49) 0.65a (4.14) 1.29a (8.25) 1.03a (5.74) 1.80a (9.79) 1.42a (7.18) 20.09 (20.62) 0.10 (0.53) 0.17 (0.91) 20.10 (20.82) 20.10 (20.67) 20.14 (20.91) 0.31b (2.20) 0.15 (1.08) 0.44a (2.72) 0.43b (2.23) 0.21 Dqit 0.21a (4.61) 0.40b (2.49) 20.24b (22.30) 20.55a (24.21) 0.09 (0.81) 20.09 (20.83) 0.06 (0.67) 20.14 (21.49) 0.20c (1.67) 20.11 (21.16) 20.03 (20.34) 0.08 (0.92) 0.13 (1.37) 0.57a (5.39) 0.05 (0.69) 0.11 (0.96) 20.08 (20.84) 20.09 (21.53) 0.22a (2.68) 20.10 (21.26) 0.01 (0.16) 0.03 (0.50) 0.26a (3.28) 0.20b (2.20) 0.36a Dbit 0.16a (3.78) 0.03 (0.13) 0.94a (6.66) 0.90a (4.05) 0.14 (0.62) 0.44b (2.11) 0.42b (2.26) 0.23 (1.13) 0.37c (1.89) 20.20 (21.25) 20.17 (21.00) 0.31 (1.60) 20.12 (20.77) 0.25 (1.32) 0.44a (3.80) 0.58a (3.90) 20.35a (22.28) 0.25a (2.85) 0.47a (4.37) 0.30a (2.88) 0.12 (1.38) 0.22b (2.26) 0.36a (3.11) 0.33a (2.59) 0.18 Dbit21 20.09b (22.54) 20.35 (21.49) 20.35a (23.08) 20.16 (21.39) 0.26b (2.26) 20.12 (21.20) 20.15b (22.11) 20.15c (21.69) 0.06 (0.51) 0.09 (0.88) 0.25a (2.64) 0.40a (3.90) 0.18 (1.62) 0.35a (2.76) 20.10 (21.06) 20.08 (20.78) 20.23c (21.93) 20.06 (20.89) 20.22 (22.66) 20.20b (22.42) 20.13c (21.94) 20.05 (20.79) 0.19b (2.44) 0.05 (0.48) 20.07 H*Dqit 0.43a (7.68) 1.07a (3.98) 20.35b (22.27) 0.54c (2.03) 0.46b (2.05) 1.01a (4.62) 0.69a (4.03) 0.74a (4.07) 0.37a (1.88) 0.65a (4.28) 1.06a (6.52) 1.06a (5.75) 0.75a (4.54) 0.54a (2.79) 0.15 (1.16) 0.58a (3.20) 0.61a (3.76) 20.09 (20.95) 0.15 (1.23) 0.16 (1.48) 0.28a (3.01) 0.23b (2.34) 0.26b (2.21) 0.39a (2.81) 0.81a
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R2 .139 .167 .135 .162 .149 .098 .224 .211 .182 .181 .238 .161 .139 .156 .160 .118 .144 .181 .150 .166 .122 .171 .152 .117 .124
(continued)
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Table 4. (continued) Year 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Intercept (14.48) 0.07a (6.12) 0.15a (13.05) 0.06a (5.58) 0.30a (21.61) 0.03a (3.00) 0.28a (22.35) 20.07a (26.21) 0.28a (15.92) 0.10a (6.11) 0.12a (7.97) 20.13a (211.80) 0.44a (29.43) 0.06a (5.00) 0.24a (16.80) 0.08a (7.41) 20.05a (23.56) xit (4.94) 1.52a,*** (7.89) 1.02a (5.82) 0.79a (4.78) 20.22*** (21.11) 1.96a,*** (11.41) 1.43a,** (7.79) 0.79a (4.27) 22.01a,*** (28.04) 0.45b,** (2.08) 2.88a,*** (13.66) 1.96a,*** (10.56) 20.04*** (20.18) 2.22a,*** (10.72) 0.51b,** (2.05) 1.07a (5.66) 1.31a (5.39) Dxit (1.04) 0.55a (3.49) 0.55a (3.67) 0.29c (1.97) 0.50a (2.74) 20.21 (21.31) 0.40b (2.41) 0.09 (0.49) 0.51b (2.11) 0.23 (1.02) 20.35b (21.82) 20.08 (20.49) 1.34a (6.28) 0.46b (2.24) 1.21a (4.62) 0.09 (0.48) 1.03a (4.35) Dqit (3.64) 0.08 (1.11) 0.11 (1.47) 0.26a (3.57) 0.64a (7.42) 0.28a (4.08) 0.40a (5.34) 0.10 (1.24) 0.89a (7.70) 0.81a (7.76) 0.13 (1.24) 0.09 (1.17) 0.41a (3.79) 0.12 (1.32) 0.27b (2.51) 0.34a (3.73) 0.22b (2.10)
Dbit (1.32) 0.12 (1.07) 0.18c (1.95) 0.18b (2.10) 0.28a (2.78) 0.19a (2.67) 0.08 (1.06) 0.25a (3.13) 0.24c (1.68) 0.41a (3.10) 0.06 (0.64) 0.09 (0.79) 20.49a (22.64) 20.06 (20.47) 0.00 (20.01) 0.42a (3.83) 20.14 (21.07)
Dbit21 (20.66) 20.10 (21.17) 0.17b (2.33) 20.15b (22.19) 20.14 (21.45) 20.32a (23.59) 0.02 (0.29) 20.28a (23.36) 20.31a (22.68) 20.39a (23.39) 20.57a (25.89) 20.37a (23.99) 20.25a (22.58) 20.40a (23.75) 0.19 (1.53) 20.32a (23.37) 0.15 (1.31)
H*Dqit (5.32) 0.42a (3.68) 0.35a (3.29) 0.15c (1.69) 0.26c (2.32) 0.10 (1.11) 0.35a (3.61) 0.20b (2.25) 0.46a (3.02) 20.11 (20.76) 0.82a (6.37) 0.13 (1.14) 1.14a (5.86) 0.18 (1.50) 0.53a (3.55) 20.13 (21.20) 0.43a (3.24)
R2 .149 .113 .088 .080 .109 .112 .063 .073 .091 .194 .113 .095 .140 .100 .121 .126
Panel A reports the regression results of Model (10a) from the annual samples: Rit 5a1b xit 1g Dxit 1h Dqit 1hH H Dqit 1u Dbit 1d Dbit1 1eit , where Rit is the annual stock return from the 4th month after the prior fiscal year end to the 3rd month after the current fiscal year end; xit = Xit / Vit21 is the earnings in year t (Xit) scaled by the beginning market value of equity (Vit21); Dxit = (Xit 2 Xit21) / Vit-1 is the earnings change in year t relative to year t 2 1 scaled by Vit21; Dqit = (qit 2 qit21) is the profitability change of year t relative to year t 2 1, with qit = Xit / Bit21; Dbit21 = (Bit21 2 Bit22) / Vit21 is the capital investment in year t 2 1 scaled by Vit21; and Dbit = (Bit2Bit-1) / Vit21 is the current years capital investment scaled by Vit21. H is a dummy variable equal to 1 for firms whose profitability is larger than the annual median level. In the row of mean, the t statistics in parentheses are computed with FamaMacBeth methodology and adjusted for heteroscedasticity and autocorrelation of six lags with NeweyWest approach. a b , , and c indicate the coefficient being significantly different from 0 at the .01, .05, and .1 levels, respectively. ***, **, and * indicate the coefficient being significantly different from 1 at .01, .05, and .1 levels, respectively.
(continued)
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Panel B: This panel reports the R2s of Models (10a) and (11) and the incremental explanatory power of balance-sheet information for annual samples. Year R2 of Model (11) (1) Mean 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 .115 .126 .055 .104 .140 .055 .174 .182 .173 .172 .215 .123 .127 .126 .143 .091 .136 .174 .123 .147 .107 .157 .131 .095 .090 .130 .096 .073 .049 .094 .095 .042 .040 .059 .151 .102 .063 .132 .085 .104 .116 R2 of Model (10a) (2) .139 .167 .135 .162 .149 .098 .224 .211 .182 .181 .238 .161 .139 .156 .160 .118 .144 .181 .150 .166 .122 .171 .152 .117 .124 .149 .113 .088 .080 .109 .112 .063 .073 .091 .194 .113 .095 .140 .100 .121 .126 Difference in R2 (2)2(1) .024 .041 .080 .057 .009 .044 .050 .029 .009 .009 .023 .038 .012 .030 .017 .027 .007 .006 .027 .019 .015 .014 .021 .023 .034 .019 .016 .015 .031 .015 .017 .021 .033 .032 .043 .011 .032 .008 .015 .018 .010 Vuongs test 7.31a 4.21*** 7.60*** 6.79*** 2.46** 5.28*** 7.33*** 5.27*** 3.05*** 1.63* 3.67*** 6.03*** 2.49** 6.10*** 4.81*** 5.38*** 1.86* 2.94*** 6.05*** 4.99*** 3.79*** 4.01*** 4.88*** 4.62*** 5.05*** 4.26*** 4.21*** 4.64*** 6.82*** 4.99*** 4.88*** 5.61*** 6.72*** 6.29*** 5.85*** 3.35*** 4.10*** 2.95*** 3.11*** 4.27*** 2.08**
Note: Annual regression results and the IEP of Balance-Sheet Information. Panel B reports the annual regression R2s of Model (10a) above those of Model (11), Rit 5a1b xit 1g Dxit 1eit ; and the incremental explanatory powers of balance-sheet information. a indicates the t statistics for comparing the difference in mean R2 between Model (10a) and (11) being significant at the 0.01 level. t statistics is computed with FamaMacBeth methodology and adjusted for heteroscedasticity and autocorrelation of six lags with NeweyWest approach. ***,**, and * indicate Vuongs Z statistics for comparing balance-sheet information integrated model (Model [10a]) with earnings-only model (Model [11]) being significant at the .01, .05, and .1 levels, respectively.
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IEP; R-squares 0.250
R-squares of earnings-only model IEP of balance-sheet related variables
0.200
0.150
0.100
0.050
0.000 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 year
Figure 1. IEP of balance-sheet information. This figure plots the IEP of balance-sheet information, computed as the R2 of Model (10a) minus that of Model (11), relative to the R2 of Model (11). Note: IEP = incremental explanatory power.
average R2 of Model (10a) is significantly higher than that of Model (11) at the .01 level. Figure 1 plots the IEP of the balance-sheet variables in Model (10a) against the explanatory power of the earnings variables in Model (11) across the years. Rit 5a1b xit 1g Dxit 1h Dqit 1hH H Dqit 1u Dbit 1d Dbit 1 1eit ; 10a
Rit 5a1b xit 1g Dxit 1eit :
11
To summarize, our empirical results show that the balance sheetrelated variables (Dqit, Dbi,t, and Dbit21) generally have significant effects, and they enhance the power to explain stock returns after controlling for earnings and the earnings change. The directions of these effects are generally consistent with the theoretical predictions, and their magnitudes are economically important. Overall, in both statistical and economic terms, the balance-sheet information improves the explanatory power of the return model relative to that of the earnings onlybased benchmark model.
Complementarity Between Balance-Sheet and Income-Statement Information

In this section, we explore how the incremental usefulness of balance sheetrelated variables varies over time and in cross sections. With the balance sheet and the income statement reporting complementary data about a firms operations, we conjecture that the information from the two statements is also complementary in explaining stock returns. We
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Table 5. Relationship Between the IEP of Balance-Sheet Information and the Explanatory Power of Earnings Over Time Intercept 0.04a (5.31) 0.06a (7.39) R2 (earnings)t 2.11c (21.90) 2.19a (23.76) Timet Adjusted R2 .063 20.08a (24.16) .344
Note: IEP = incremental explanatory power. This table provides the result of time-series regressions of the IEP of balance-sheet information on the explanatory power of earnings. The specification is as follows: IEP(BS)t 5a0 1a1 R2 (earnings)t 1a2 Timet 1ut where IEP(BS)t is the IEP of balance-sheet information, calculated as the R2 of Model (10a) in year t minus that of Model (11) in year t, R2(earnings)t is the R2 of Model (11), and Timet is time index computed as year minus 1968. For ease of exposition, we multiply the coefficient on Timet by 100. a and c indicate the coefficient being significantly different from 0 at the .01, .05, and .1 levels, respectively.
therefore explore whether balance sheetbased information is incrementally more useful in situations in which earnings variables are less informative about returns.
Time-Series Analysis
We first take a time-series perspective to examine how the usefulness of balance-sheet information in explaining returns is related to that of earnings information. Over time, the explanatory power of earnings variables, denoted as R2(earnings), fluctuates, as does the IEP of information constructed with balance sheet, denoted as IEP(BS). We find a significantly negative correlation between R2(earnings) and IEP(BS), with a Pearson correlation of 2.29 (t = 1.90), which suggests that balance-sheet information complements earnings variables to a greater extent in years in which the latter are less powerful in explaining returns. Previous evidence suggests that there may be a time trend in the power of financial statement information to explain returns (see, for example, Collins et al., 1997). To control for a possible time trend, we also run a regression of IEP(BS) on R2(earnings) and a time index (Time = 0,. . . ,39) as follows:17 IEP (BS)t 5a0 1a1 R2 (earnings)t 1a2 Timet 1ut : 12
As reported in Table 5, IEP(BS) is negatively related to R2(earnings), both with and without a time trend. The coefficient on R2(earnings) is 20.11 (t = 1.90) without a time index and is 20.19 (t = 3.76) with a time index. This provides evidence that balance-sheet information supplements earnings variables more in years in which the latter are less informative about stock returns. We also note that the coefficient on the time index is significantly negative, indicating a declining trend in the IEP of balance-sheet information in explaining cross-sectional returns.18
Cross-Sectional Analysis
We now turn to the complementarity issue in cross sections. Based on both economic intuition and previous findings, we identify three subsamples of firms with earnings that are
286
considered to be less informative or with future earnings that are more difficult to forecast. They are firms with negative (vs. positive) earnings, young (vs. mature) firms, and firms with a high (vs. low) degree of uncertainty about future earnings. We examine whether balance-sheet information is incrementally more useful in these subsamples. Loss versus profit firms. Rational economic behavior implies that a firms losses will not be sustained (a loss-making firm will either have to improve its performance or face termination). This suggests that negative earnings are less informative about future cash flows than are positive earnings (Hayn, 1995). Collins, Pincus, and Xie (1999) find that equity book value becomes more important in explaining the stock prices of firms with negative (vs. positive) earnings. In our context, we posit that balance sheetbased information plays a greater role in explaining stock returns for loss firms than for profit firms. Panel A of Table 6 compares the IEP of balance-sheet information between firms with negative and positive earnings.19 The average R2 across the years of Model (11), in which only earnings variables are used, is 4.6% for loss firms and 13.9% for profit firms. After adding the balance sheetrelated variables, we obtain an average IEP of 4.3% for loss firms. In contrast, the IEP of balance-sheet information is 2.1% for profit firms.20 The difference in IEP between the two groups is 2.2% (t = 3.46), significant at the .01 level. Thus, balance-sheet information is incrementally more useful in explaining returns for firms with negative earnings than for firms with positive earnings. We note that for loss firms, the coefficient on xit is significantly negative and lower than 1, whether or not we include the balance sheetrelated variables. This might be an indication of investors belief that losses will be mean reverting. However, for profit firms, the coefficient on xit is significantly positive, with a magnitude significantly greater than 1, indicating that for firms making a profit investors actually place a weight on earnings that is greater than the theoretical value on overall sample as predicted by Ohlson (1995) and Zhang (2000). For loss firms, adding Dqit in regressions removes the effect of Dxit, although the coefficient on Dqit is significantly positive, suggesting that the effect of Dxit is subsumed by that of Dqit in this subsample. However, for profit firms, although adding Dqit substantially reduces the effect of Dxit, the latter remains significantly positive together with the coefficient on Dqit. Contemporaneous capital investment has a positive coefficient in both firm groups. The lagged capital investment is significantly negative, as predicted by Ohlson (1995), for loss firms, but is insignificant for profit firms. Young versus mature firms. For the purpose of our analysis, young firms refer to firms with a relatively short history of public trading, which are usually at early stages of the life cycle. We conjecture that earnings variables are less valuation relevant for young firms and so the balance sheet should play a greater incremental role to supplement earnings information. We define a firm in a given year as a young firm if it has a listing history of 8 years or less and as a mature firm otherwise, and we then divide the annual samples each into subsets of young and mature firms.21 The results in Panel B of Table 6 show that balance-sheet information explains more of the variations in stock returns for younger firms. Across the years, the average IEP of balance-sheet information for young firms is 5.2%, compared with the IEP of 2.3% for mature firms. The difference in IEP between the two groups is 3% (t = 2.21), significant at the .05 level. For mature firms, adding Dqit in regressions reduces the effect of Dxit (coefficient on Dxit reduces from 0.84 to 0.33 with t statistics of 3.08), whereas for young firms the effect of Dqit on Dxit is even substantial (coefficient on Dxit reduces from 2.02 to 0.99 with t
Table 6. IEP of Balance-Sheet Information in Cross Sections xit Dxit IEP Difference in IEP Dqit Dbit Dbit21 H 3 Dqit Average R2
Partition
Intercept
Panel A: IEP of balance-sheet information for loss and profit firms .139 0.47a (7.98) 0.05 (1.00) .046 0.34a (7.22) 0.12 (1.60) 0.18 (0.36) .089 20.20a (23.40) 0.043a (6.59) 0.022a (3.46) 0.07 (1.03) .160 0.24a (3.20) 0.021a (7.70)
Profit firm
Loss firm
20.02 (20.56) 20.01 (20.42) 0.00 (20.06) 0.02 (0.48)
2.23a (10.84) 2.04a (8.95) 20.83a (23.27) 20.63b (22.24)
1.41a (13.46) 0.70a (7.02) 0.54a (6.53) 0.04 (0.53)
Panel B: IEP of balance-sheet information for young and mature firms .118 0.18a (3.10) 0.10c (1.68) 20.12b (22.43) 0.48a (8.42) .142 .149 0.44a (2.85) 20.16 (20.92) 0.47b (2.00) 0.42a (5.12) .201 0.052a (3.35) 0.030b (2.21) 0.023a (4.67)
Mature firm
Young firm
0.07b (2.14) 0.06b (2.03) 0.13b (2.34) 0.13b (2.54)
1.33a (11.76) 1.37a (8.74) 0.48 (0.58) 0.34 (0.41)
0.84a (9.27) 0.33a (3.08) 2.02a (2.71) 0.99c (1.90)
Panel C: IEP of balance-sheet information for low, medium, and high forecast error firms .056 0.04 (0.53) 0.26a (3.91) 20.01 (20.12) 20.01 (20.13) .081 .074 0.03 (0.29) 0.32a (3.53) 20.06 (21.14) 0.43a (4.76) .107 .098 0.34a (8.33) 0.23b (2.06) 20.23a (23.73) 0.34a (4.75) .138 0.040a (6.67) 0.015b (2.35) (continued) 0.033a (5.02) 0.025a (6.19)
Low forecast error firm
Medium forecast error firm
High forecast error firm
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0.10a (3.27) 0.09a (2.94) 0.10a (2.90) 0.09a (2.93) 0.08a (3.05) 0.08a (3.43)
0.98b (2.59) 0.88b (2.43) 1.32a (5.24) 1.25a (4.33) 1.14a (10.37) 1.10a (6.19)
0.75b (2.48) 0.52b (2.56) 0.84a (4.74) 0.32a (2.62) 0.81a (6.16) 20.01 (20.10)
288
xit Dxit IEP Dqit Dbit Dbit21 H 3 Dqit Average R2 Difference in IEP .069 20.18 (21.46) .092 .089 0.07 (1.02) .072 0.34a (4.72) 0.21b (1.94) 20.23a (24.94) 0.29a (6.38) .116 0.043a (6.53) 0.020a (2.96) 0.39a (3.98) 20.03 (20.41) .123 0.39a (3.19) 0.033a (5.85) 0.31a (4.08) 20.11b (22.44) 0.23a (3.64) 0.023a (4.65) 1.56a (6.36) 1.50a (5.13) 1.13a (3.52) 1.01a (3.14) 0.68a (4.92) 0.68a (2.97) 1.05a (4.51) 0.89a (7.92) 1.14a (4.79) 0.49b (2.18) 0.76a (6.74) 20.04 (20.30)
Rit 5a1b xit 1g Dxit 1h Dqit 1hH H Dqit 1u Dbit 1d Dbit1 1eit ; Rit 5a1b xit 1g Dxit 1eit ; 10a 11
Table 6. (continued)
Partition
Intercept
Panel D: IEP of balance-sheet information for low, medium, and high forecast dispersion firms
Low forecast dispersion firm
Medium
High forecast dispersion firm
0.09a (3.55) 0.08a (2.90) 0.10a (2.83) 0.08a (2.91) 0.07a (3.14) 0.07a (3.64)
Note: IEP = incremental explanatory power. This table reports the IEP of balance-sheet information from various sample partitions. In each panel, we run annual regressions with partitioned subsamples using Models (10a) and (11), compute the average coefficients and R2s across years, and then compare the IEP across the subsamples:
where Rit is the annual stock return from the 4th month after the prior fiscal year end to the 3rd month after the current fiscal year end; xit = Xit/Vit-1 is the earnings in year t (Xit) scaled by the beginning market value of equity (Vit-1); Dxit = (Xit 2 Xit21) / Vit21 is the earnings change in year t relative to year t 2 1 scaled by Vit21; Dqit = (qit 2 qit21) is the profitability change of year t relative to year t 2 1, with qit = Xit / Bit21; Dbit21 = (Bit21 2 Bit22) / Vit21 is the capital investment in year t 2 1 scaled by Vit21; and Dbit = (Bit 2 Bit21) / Vit21 is the current years capital investment scaled by Vit21. H is the profitability dummy. We partition the annual samples into subsets based on accounting loss (Panel A), firm age (Panel B), forecast error (Panel C), and forecast dispersion (Panel D). A firm is defined as a loss firm in a year if its earnings (No. 18) are negative and a profit firm otherwise. A firm is defined as a young firm in a year if its listing period (the current year minus the 1st year when the firm is traded publicly) is less than 8 years in length and 0 otherwise. Forecast error is the absolute values of actual earnings per share minus the mean earnings forecast over the 8-month period preceding the end of forecast period, scaled by the absolute value of actual earnings per share. Forecast dispersion is measured as the standard deviation of annual earnings forecasts outstanding over the 8 months preceding the end of the forecast period, scaled by the absolute value of actual earnings per share. The IEP is the incremental explanatory power of balance-sheet information, computed as the difference in R2 between Models (10a) and (11). The t statistics in the parentheses are computed with FamaMacbeth methodology and adjusted for heteroscedasticity and autocorrelation of six lags with NeweyWest approach. a,b , and c indicate the coefficient being significantly different from 0 at the .01, .05, and .1 levels, respectively.
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statistics of 1.90). There is strong evidence of convexity in the effect of Dqit for both the young and mature firms (coefficients on HDqit are highly significant at the .01 level in both subsets), consistent with the theoretical predictions. Capital investment has a positive coefficient for both young and mature firms, as predicted. The lagged capital investment is significantly negative for mature firms and is insignificant for young firms. Firms with uncertain future earnings. We further conjecture that investors rely more on the balance sheet when they face greater uncertainty about future earnings.22 We use two proxies for investor uncertainty about future earnings: (a) the accuracy of consensus analyst forecasts, which is defined as the absolute value of actual earnings per share minus the mean forecast scaled by the absolute value of actual earnings per share and (b) the dispersion of analyst forecasts, which is defined as the standard deviation of annual earnings forecasts scaled by the absolute value of actual earnings per share.23 The need for analyst earnings forecast data in this subsection shortens the sample period to 1983 to 2007, which reduces the sample to 34,916 observations. We partition the annual samples into terciles and run regressions for each subsample. Panel C of Table 6 reports the results for the partitions by forecast error. The IEP of balance-sheet information is greater for firms with larger (absolute) earnings forecast errors (i.e., less accurate forecasts). The IEP of balance-sheet information for the largest forecast error group is 4%, whereas the IEP of that for the smallest forecast error group is 2.5%. The difference in IEP between the high and low forecast error groups is 1.5% (t = 2.35), significant at the 0.05 level. We also note that when earnings forecasts are the least (most) accurate, the response of investors to Dxit is weakest (strongest), controlling for balance-sheet information. In Model (10a), the coefficients on Dxit is insignificant for firms with high forecast errors (coefficient = 20.01 and t = 0.1) but is significant for firms with low forecast errors. However, the coefficients on Dqit and HDqit are significant in the high forecast error group but not so for the low forecast error group. These results are consistent with the view that investors rely more on balance-sheet information when earnings information is less reliable. Panel D of Table 6 provides the results for the partitions by forecast dispersion. The IEP of balance-sheet information for the highest dispersion group is 4.3%. In contrast, the IEP of balance-sheet information for the lowest dispersion group is 2.3%. The difference in IEP between these two subsamples is 2% (t = 2.96), significant at the .01 level. This shows that balance-sheet information is incrementally more useful for firms with high (vs. low) forecast dispersions. Similar to the above results, we find here also that the balance sheetrelated variables largely replace the effect of the earnings change in explaining stock returns. Once controlling for the balance sheetrelated variables, the coefficient on Dxit decreases but is still significant in the low-dispersion group, and it becomes insignificant in the highest dispersion group. For firms with the largest forecast dispersion, it is the profitability that is decision-useful. To sum up, for the subsamples of firms considered above, the balance sheetrelated variables generally have significant effects on returns, although the results on the effect of Dbit21 are weaker or insignificant in some cases. Collectively, they significantly improve the explanatory power of return models compared with earnings onlybased benchmark models. More importantly, we find that balance-sheet information plays a greater incremental role in explaining returns for firms with earnings that are less informative or with future earnings that are more uncertain, reaffirming the complementary nature of the two financial statements.
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Summary and Concluding Remarks

This study examines the usefulness of balance-sheet information in explaining stock returns beyond that of earnings information. Based on existing models of equity value, we show that returns are related to three balance sheetbased factors in addition to earnings and the earnings change: the profitability change, contemporaneous capital investment, and the previous periods capital investment. The empirical results show that each of the three balance sheetrelated variables generally has a statistically and economically significant effect on returns (although lagged capital investment is not significant in some of the subsamples) incremental to that of earnings variables and that the directions of the effects are consistent with the theoretical predictions. Our expanded return model, which combines balance-sheet and earnings variables, achieves an average explanatory power of 13.9% in annual samples, compared with that of 11.5% for an earnings-onlybased benchmark model. We further show that balance-sheet information complements the information in earnings variables. Over time, the IEP of balance-sheet information is negatively correlated with the explanatory power of earnings variables, suggesting that such information generally plays a greater role in years in which earnings are less useful in explaining returns. In cross sections, we similarly find that balance-sheet information is incrementally more useful for firms with earnings that are less informative (e.g., firms with negative earnings and firms with a short history) or with future earnings that are more uncertain (e.g, firms with high, vs. low, absolute analyst forecast errors and firms with high, vs. low, analyst forecast dispersions). Our study has implications for the question of whether to adopt a more balance sheet based or a more income-statementbased model of financial reporting. Our results indicate that each of the financial statements plays a distinctive informational role in determining stock returns. More importantly, our study shows that the usefulness of the balance sheet versus that of the income statement differs across firms, depending on a firms maturity, its operational performance (negative vs. positive earnings), and economic environment (earnings predictability). It is thus beneficial to develop reporting standards that recognize the varying role of each financial statement under different economic conditions. Declaration of Conflicting Interests
The author(s) declared no potential conflicts of interest with respect to the research, authorship, and/ or publication of this article.
Funding
The author(s) disclosed receipt of the following financial support for the research, authorship, and/or publication of this article:The authors gratefully acknowledge the financial support by the Hong Kong Polytechnic University (Project No.: 4-ZZ6L).
Notes 1. The Financial Accounting Standard Board (FASB), in its Preliminary Views of the conceptual
framework (Financial Accounting Series 1260-001), states that to help present and potential investors and creditors and others in assessing an entitys ability to generate net cash inflows, financial reporting should provide information about the economic resources of the entity (its assets) and the claims to those resources (its liabilities and equity). Information about the effects of transactions and other events and circumstances that change resources and claims to them is also essential (FASB, 2006).
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2. A long-standing debate in the standard setting field is whether to adopt a more balance sheet
based or a more income statementbased approach to financial reporting. In recent decades, the position of standard setting bodies such as the FASB of the United States and the International Accounting Standard Board has shifted toward a balance sheetbased model; see, for example, the Preliminary Views of the conceptual framework for financial reporting (FASB, 2006). However, some academics have expressed concerns about this, arguing instead for an income statementbased approach (Dichev, 2008). The distinction between profit and profitability has also been made in studies using residual income or EVA as a performance measure (e.g., Biddle, Bowen, & Wallace, 1997; Stewart, 1994) and in studies that separate earnings growth driven by profitability from that by capital investment in refining the return-earnings relation (e.g., Balachandran & Mohanram, in press; Harris & Nissim, 2006). There is growing evidence of nonlinearity in equity valuation; see, for example, Burgstahler and Dichev (1997), Hao, Jin, and Zhang (2011), and Yee (2000). A recent study by Chen and Zhang (2007) has developed a return model incorporating data from both the balance sheet and the income statement together with information from other sources (such as growth opportunities and discount rates). Chen and Zhang (2007) do not focus on the role of balance sheet per se; specifically, they do not address how much of a difference balance sheetrelated variables make in explaining returns and for what types of firms these variables are most useful. Note that the linear model mentioned here, as used in Barth, Beaver, and Landsman (1998); Collins, Pincus, and Xie (1999); and Collins, Maydew, and Weiss (1997), is not equivalent to Ohlsons (1995) model that is used to motivate some of the explanatory factors in our study. Obviously, there is also information from sources other than financial statements that is important for investors, such as information from voluntary disclosures (e.g., Francis, Schipper, & Vincent, 2002). These sources are beyond the scope of this study, and we omit the unspecified other information in Ohlsons model. In our analysis, we use the reduced-form relations between value and accounting data as developed in Ohlson (1995) and Zhang (2000). These relations rely on certain assumptions about the dynamic behavior of cash flow (or residual income). Dechow, Hutton, and Sloan (1999) have empirically examined Ohlsons linear information dynamics, and Biddle et al. (2001) have examined nonlinearities in the residual income dynamic as implied in Zhang (2000). Numerous studies have empirically tested or applied the Ohlsons model (see, for example, Collins et al., 1997; 1999; Dechow et al., 1999). Ohlson (1995) shows that (net) dividends (or, equivalently, capital investment) affect equity market value dollar for dollar; as a result, investors are neither made better off nor worse off by current capital investment (divestment). Also see Biddle et al. (2001) for a related discussion. In contrast to the linear information dynamic in Ohlson (1995), contingent investment decisions in Zhang (2000) lead to a convex relation between current and period-ahead residual income. The derivation here is a simplified version of that given in Chen and Zhang (2007). Here, we ignore information from outside financial statements. Strictly speaking, the profitability of capital investment relates to a firms marginal (as opposed to average) market-to-book ratio. However, in the simplified context of Zhang (2000), the two are assumed to be equal. Following Brown et al. (1999), we use unadjusted R2s to compute the IEPs. Although the I/B/E/S summary file covers a longer time period, it suffers from the problem of stale earnings forecasts, which has the effect of reducing the standard deviations of earnings forecasts (Zhang, 2006), a variable that is of interest in cross-sectional analyses. For this reason, we use the detailed file that starts from 1983. In the following sections where we perform annual and subsample regressions, we also use market-adjusted returns as the dependent variable in addition to using raw returns, and we find
3.
4. 5.
6. 7.
8.
9. 10. 11. 12. 13. 14. 15.
16.
292

similar results for the two versions of the dependent variable. For brevity, we present only the results using raw returns as the dependent variable in the sections below; the results based on market-adjusted returns are available on request. For ease of exposition, we multiply the coefficient on Timet by 100. A decline in the IEP of balance sheetrelated information over time may be due to a changing information environment brought about by increased company disclosures (which act as competing information for financial statement information) or increased private information production by analysts (Francis et al., 2002). In this section, profitability dummy H is set to 1 if a firms return of equity is above the annual median within a subsample and 0 otherwise. As indicated in Table 6, the IEP of our balance-sheet variables is statistically significant at the 0.01 level in all the subsamples examined in this section. We also use 5 years and 10 years as the cutoff points and find similar results. Chen et al. (2002) provide evidence that firms are more likely to disclose balance-sheet information to compensate for inefficiencies in analyst earnings forecasts. The mean forecast (forecast dispersion) is computed as the average (standard deviation) of the individual earnings forecasts issued over a period of 8 months preceding the fiscal year end. If an analyst issues multiple forecasts during the period, then only the latest is retained.
17. 18.
19. 20. 21. 22. 23.
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An Examination

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An Examination of the Incremental Usefulness of Balance-Sheet Information Beyond Earnings in Explaining Stock Returns

Yuan Huang1 and Guochang Zhang2

Journal of Accounting, Auditing & Finance

Journal of Accounting, Auditing & Finance

Incorporating Balance-Sheet Information Into Return Models

Fundamental Factors for Explaining Returns According to Ohlsons Model

Fundamental Factors for Explaining Returns According to Zhangs Model

Huang DVt 11 1Dt 11 DBt 11 Bt D 5v 1v0 Dqt 11 1 t 11 : Vt Vt Vt Vt DBt 11 B D t t 1 1 5 1v0 Dqt 11 1 : Bt Vt Vt

Empirical Research Design and Sample Research Design

Journal of Accounting, Auditing & Finance

Huang Rit 5a1b xit 1g Dxit 1eit :

The Sample and Descriptive Statistics

Journal of Accounting, Auditing & Finance

25% 20.13 0.04 20.02 0.02 20.06 0.02

50% 0.09 0.07 0.01 0.06 0.00 0.05

75% 0.36 0.11 0.03 0.10 0.04 0.10

99% 1.82 0.21 0.33 0.53 0.43 0.44

Results From Broad-Based Samples

Results From the Pooled Sample

Journal of Accounting, Auditing & Finance

Results From the Annual Samples

Journal of Accounting, Auditing & Finance

Journal of Accounting, Auditing & Finance

Journal of Accounting, Auditing & Finance

R-squares of earnings-only model IEP of balance-sheet related variables

Rit 5a1b xit 1g Dxit 1eit :

Complementarity Between Balance-Sheet and Income-Statement Information

Journal of Accounting, Auditing & Finance

20.02 (20.56) 20.01 (20.42) 0.00 (20.06) 0.02 (0.48)

2.23a (10.84) 2.04a (8.95) 20.83a (23.27) 20.63b (22.24)

1.41a (13.46) 0.70a (7.02) 0.54a (6.53) 0.04 (0.53)

0.07b (2.14) 0.06b (2.03) 0.13b (2.34) 0.13b (2.54)

1.33a (11.76) 1.37a (8.74) 0.48 (0.58) 0.34 (0.41)

0.84a (9.27) 0.33a (3.08) 2.02a (2.71) 0.99c (1.90)

Low forecast error firm

Medium forecast error firm

High forecast error firm

Low forecast dispersion firm

High forecast dispersion firm

Journal of Accounting, Auditing & Finance

Summary and Concluding Remarks

9. 10. 11. 12. 13. 14. 15.

Journal of Accounting, Auditing & Finance

19. 20. 21. 22. 23.

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