How does the second derivative (acceleration) of earnings relate to stock returns? In their March 2007 paper entitled “Does Earnings Acceleration Convey Information?”, Ying Cao, Linda Myers and Theodore Sougiannis investigate how the change in earnings growth rate (earnings acceleration) relates to stock returns. They examine separately conditions in which earnings growth rate and earnings acceleration have the same and opposite signs. Using a large sample of U.S. non-financial and non-utility firms over the period 1965 to 2002 (66,150 firm-year observations), they conclude that:
- Earnings acceleration augments the explanatory power of earnings growth rate for both annual stock returns (from 17.4% to 21.2%) and short-term stock returns around earnings announcements (from 1.3% to 2%).
- This incremental explanatory power may stem from the ability of earnings acceleration to improve forecasts of future earnings (by about 2%).
- Investors view earnings acceleration as important only when it has the same sign as earnings growth rate (both positive or both negative). Investors derate extreme values of earnings acceleration, apparently regarding them as unsustainable.
- Financial analysts do not fully incorporate the implications of earnings acceleration (especially when it is positive) in revising their earnings forecasts. However, investors appear to adjust for some of the information that analysts miss.
In summary, earnings acceleration helps explain stock returns, most notably when it amplifies the direction of earnings growth (both positive or both negative).
