Mean reversion in annual earnings and its implications for security valuation
- Cite this article as:
- Lipe, R. & Kormendi, R. Rev Quant Finan Acc (1994) 4: 27. doi:10.1007/BF01082663
This article documents the long-horizon mean reverting character of annual earnings and tests the implications of such mean reversion for security valuation. First, both theory-based and nonparametric measures of earnings persistence decrease as the estimation order increases, revealing 40 percent less long-horizon persistence than expected under the commonly used random walk model. Second, the return responses to the earnings shocks are more closely related across firms to the higher-order measures of persistence that reflect significant long-horizon mean reversion. Third, the persistence measure derived from classical valuation theory outperforms the generic measure in explaining the return responses. Taken as a whole, these results provide evidence for significant mean reversion in the higher-order properties of earnings and for the stock market incorporating these properties in a manner consistent with classical valuation theory.
Key wordsearnings persistence mean reversion security valuation higher-order properties
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