The effects of uncertainty and the information environment on the relation between accounting earnings and stock returns for newly public firms.

Abstract

This research investigates how uncertainty and the information environment affect the relation between accounting earnings and stock returns for newly public firms. A theoretical model of the earnings-returns relation is developed. The model assumes that investors face uncertainty about the value of a firm's equity in the form of an unknown parameter of the earnings-generating process. In each period, investors use the current period's earnings and a noisy signal of the next period's earnings to revise their assessment of firm value and to resolve their uncertainty. The alternative information signal partially reveals future earnings in the current period, creating a relation between current returns and future earnings. The model yields predictions of how earnings response coefficients, which measure the unexpected return per unit of unanticipated earnings, are affected by uncertainty and the information environment. The response coefficient for current earnings is predicted to be larger when uncertainty is high and when alternative information is a less accurate predictor of future earnings. The response coefficient for future earnings is predicted to be larger when uncertainty is high and when alternative information is a more accurate predictor of future earnings. These predictions are tested on a sample of 226 firms that went public between 1983 and 1986. The response coefficients for both current and future earnings of high-uncertainty firms are significantly larger than those of low-uncertainty firms in the first several quarters after the offering. The response coefficients for both current and future earnings decline significantly over time, and the intertemporal declines in both coefficients are significantly greater for the high-uncertainty firms. Three conclusions are drawn from these results. First, uncertainty has an economically significant effect on the earnings-returns relation of newly-public firms. Second, the information environment also significantly affects the relation. Third, the intertemporal decline in the response coefficients of newly public firms is primarily attributable to the resolution of uncertainty rather than changes in the information environment.