An examination of the incremental usefulness of balance-sheet information beyond earnings in explaining stock returns

Abstract

Until recently, studies in accounting research have predominantly focused on using earnings information to explain stock returns. This article examines how information provided by the other primary financial statement-the balance sheet-is incrementally useful for determining returns. Based on existing models of equity value, the author shows theoretically that returns should be related to three balance sheet-related variables-the previous period's (equity) capital investment, contemporaneous capital investment, and the profitability change-in addition to the earnings variables used in previous studies. Our empirical analysis yields the following results. First, the three balance sheet-related variables each have a statistically and economically significant effect that is incremental to those of the earnings variables on equity returns, and together they improve the explanatory power of an earnings-only-based model from 11.5% to 13.9% in annual cross-sectional samples. Second, over time, the incremental explanatory power (IEP) of the balance-sheet variables is negatively correlated with the explanatory power of earnings. Third, in cross sections, the balance sheet-related variables have a greater IEP for firms whose earnings are less informative (negative vs. positive earnings firms and young vs. mature firms) and for firms whose future earnings are more uncertain (firms with high vs. low analyst forecast errors, and firms with high vs. low analyst forecast dispersions). These results suggest that information from the balance sheet complements that contained in the income statement about equity returns. © 2012 The Author(s).