Earnings Quality and the Equity Risk Premium: A Benchmark Model

This article provides a benchmark model that links earnings quality to the equity risk premium in an infinite-horizon consumption CAPM economy. In the model, risk-averse traders hold diversified portfolios consisting of a risk-free bond and shares of many risky firms. When constructing their portfolios, traders rely on noisy reported earnings and dividend payments for information about the risky firms. The new element of the model is an explicit representation of earnings quality that includes accrual errors that reverse in subsequent periods. The model shows that earnings quality only magnifies fundamental risk. Absent fundamental risk, poor earnings quality cannot affect the equity risk premium. Moreover, only the systematic (undiversified) component of earnings quality risk contributes to the equity risk premium. In contrast, all components of earnings quality risk affect earnings capitalization factors. The model ties together consumption-CAPM and accounting-based valuation research into one benchmark formula linking earnings quality to the equity risk premium and earnings capitalization factors.