Using Residual Income to Refine the Relationship between Earnings Growth and Stock Returns

In this paper, we use the definition of residual income to develop a framework that decomposes changes in net income into different components. The two components we focus on are the change in net income driven by investment (investment-driven growth), and the change in net income driven by improvements in the productivity of existing assets (productivity-driven growth). Building on the vast literature identifying inefficient investment decisions by firms, we hypothesize that the stock markets will consider productivity-driven growth in income to be more valuable than investment-driven growth. We test this hypothesis by using our decomposition in a modified Easton and Harris (1991) regression of stock returns on earnings and decomposed changes in earnings. We find that the stock market views both forms of earnings to be valuable, but does indeed capitalize productivity-driven growth at a higher level than investment-driven growth. Further, the market does not fully impound the information about the sources of earnings growth. Future returns tests indicate that the market under-reacts to productivity-driven growth and overreacts to investment-driven growth. A long-short investment strategy based on these findings yield significant excess returns, which are independent of those of known anomalies (accruals, capital expenditure, and external financing) and persist after we control for known risk factors. Our results demonstrate the crucial informative role of residual income in allowing investors to evaluate how efficiently firms are delivering increases in earnings.