Abstract
In this paper we examine how sales affect earnings and in turn the stock price using a model in which sales contribute to earnings by a fixed sales margin rate and the stock price responds more sensitively to sales-induced earnings than to non-sales-induced earnings. We report that the regression coefficient of the sales margin (2.54) is about three times the earnings response coefficient (0.85) for the full sample and can be as high as 19 times the earnings response coefficient for an industry (i.e., 11.95 vs. 0.62 for restaurants). We contribute to the literature by identifying and documenting factors that make separating out the sources of earnings more important in equity pricing.
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Notes
In a related study Ghosh et al. (2005) provide evidence that earnings growth sustained through revenue increases is valued more than earnings growth through cost reduction.
The relatively small difference (0.86 vs. 0.76) in our result is roughly comparable to what ELM obtain (0.52 vs. 0.41).
More precisely, 0.86 = 2.54 − (1.78 × 0.946). 0.946 = 1 − sales margin (0.054).
Out of ten selected four-digit industries (Table 9) five show the sales margin response coefficient greater than three times the earnings response coefficient. In particular, the two retail industries show the greatest differences between the two response coefficients, with the ratios of 10.0 and 19.4. For example, the sales margin response coefficient in the restaurant industry (SIC 5812) is 11.95 and the earnings response coefficient is merely 0.62.
There are a variety of interesting decomposition of earnings in the literature. Examples include income statement line items (Lipe 1986), accrual vs. cash flows (Barth et al. 1999), core earnings vs. transitory earnings (Ramakrishnan and Thomas 1998; Ohlson 1999; Pope and Wang 2005), foreign vs. domestic earnings (Bodnar and Weintop 1997; Thomas 1999), and industry segment reporting (Tse 1989). Determinants of ERC are identified in Collins and Kothari (1989) and Lipe (1990).
More precisely, \(0.85=2.54-\left(1.78\times \frac{20}{1+20}\right).\)
Prior studies that examine how sales affect earnings and stock price include Hopwood and McKeown (1985) and Swaminathan and Weintrop (1991). They examine the information content of the sales information in addition to earnings. Among rather indirectly related work in the literature, numerous return-earnings studies (e.g., Easton and Harris 1991; Kormendi and Lipe 1987) examine how income statement components of earnings are associated with return (e.g., Lipe 1986; Ohlson and Penman 1992) and there are many papers about accruals and cash flows (e.g., Wilson 1987; Dechow et al. 1998).
The differenced-price model is used because differencing often yields a stationary series and some of the econometric problems in using the price model can be overcome by using the first differences (Christie 1987).
Our empirical tests are conducted by cross-section regressions with the exception of Table 2 where we form portfolios based on time-series sales margin rates. Table 2 is a minor result for our study and the time-series regression is based on an implicit assumption that the firm-specific earnings/sales relation is not structurally changed over our estimation period of 10 years. For our cross-sectional regressions we use the annual window instead of a short-window around earnings announcements because we want to measure the total contemporaneous effect of current sales on earnings and equity price. The choice of annual data instead of quarterly data is made to ensure that the contemporaneous effect of sales is a large part of the total, i.e., contemporaneous and lagged, effect. For example, if we take a 10-year window, most of the association between returns and earnings would be caused by the contemporaneous effect and very little by the lagged effect as demonstrated by Easton et al. (1992). Moreover, the annual data is not subject to seasonality.
Teets and Wasley (1996) show why ERC from the firm-specific regression is always larger than ERC from the pooled cross-sectional regression. Our sample was not an exception because our ERC from the firm-specific estimation (0.0694) was larger than ERC from the pooled estimation (0.0539).
We have split our sample into value, growth, and other stocks based on the market-to-book ratio and dividend yield following ELM (2003). We find that SMAR is much more important for growth firms than for value firms. For example, the slope coefficient on SMAR is 6.55 for growth stocks and 1.03 for value stocks. This is consistent with ELM (2003). In addition, we split our sample period (1980–1997) into two periods to see whether our test results are sensitive to the time period. The earlier period is from 1980 to 1988 and the later period is from 1989 to 1997. The two periods exhibit qualitatively the same pattern.
The negative cross-sectional association between sales and stock return in this petroleum refining industry may be related to the fact that demand for gasoline is rather inelastic so that a decrease in sales may result in an increase in profit.
We have classified our manufacturing companies into durable goods manufacturers and non-durables goods manufacturers following Barth et al. (2005).
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Acknowledgments
Kim and Lim thank Robert H. Smith School of Business of University of Maryland and the Charles Tandy American Enterprise Center at TCU, respectively, for financial support.
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Kim, O., Lim, S.C. & Park, T. Measuring the impact of sales on earnings and equity price. Rev Quant Finan Acc 32, 145–168 (2009). https://doi.org/10.1007/s11156-008-0086-7
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DOI: https://doi.org/10.1007/s11156-008-0086-7