Is Residual Income Really Uninformative About Stock Returns ?

Prior research found that Residual Income (RI) is, at best, minimally informative about stock returns relative to Earnings, despite strong support for RI in theory and among practitioners. We examine three possible explanations for this puzzle. First, the empirical literature ignores some salient feature of practice or theory. Second, the market does not fully impound all of the information from residual income into current returns. Third, the theory abstracts away some real world feature captured in prior empirical results. We find that while the incremental contribution of RI to earnings is modest in explaining current returns, conditioning on whether or not RI increased or decreased affects the relationship between earnings and returns. Further, the market only partially impounds the information in residual income into current returns. A strategy of going long on firms with the greatest increase in RI and short on firms with the greatest decrease in RI generates significant positive excess returns that persist after controlling for risk factors. Our results are consistent with the first two explanations above. Specifically, benchmarking earnings versus the cost of capital is an important feature of how accountants interpret residual income; incorporating this feature of residual income increases the information content of earnings. Furthermore, our results on future returns indicate that tests of the association of changes in RI with current returns present only a partial picture of the usefulness of RI. We would like to thank Tim Baldenius for his comments. We appreciate research assistance from Columbia Business School. All errors are our own. Please contact Sudhakar Balachandran at [email protected] or Partha Mohanram at [email protected] with questions and comments.