Mean reversion in annual earnings and its implications for security valuation

  • Robert Lipe
  • Roger Kormendi
Article

Abstract

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 words

earnings persistence mean reversion security valuation higher-order properties 

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Copyright information

© Kluwer Academic Publishers 1994

Authors and Affiliations

  • Robert Lipe
    • 1
  • Roger Kormendi
    • 2
  1. 1.College of Business and AdministrationUniversity of ColoradoBoulder
  2. 2.School of Business AdministrationUniversity of MichiganAnn Arbor

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