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1561/1400000036

Financial Statement
Analysis and Earnings
Forecasting
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Financial Statement Analysis

and Earnings Forecasting

Steven J. Monahan
INSEAD, Europe Campus
Boulevard de Constance
77305 Fontainebleau, France
[Link]@[Link]

Boston — Delft
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Foundations and Trends R in Accounting

Volume 12, Issue 2, 2017
Editorial Board
Executive Editors
Robert Bushman
The University of North Carolina at Chapel Hill
Sunil Dutta
University of California at Berkeley
Stephen Penman
Columbia University
Stefan J. Reichelstein, Managing editor
Stanford University
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Editorial Scope
Topics
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Foundations and Trends R in Accounting, 2017, Volume 12, 4 issues.
ISSN paper version 1554-0642. ISSN online version 1554-0650. Also
available as a combined paper and online subscription.
 Full text available at: [Link]

Contents

1 Introduction 3

2 Why Earnings? 7
2.1 The information perspective . . . . . . . . . . . . . . . . . 8
2.2 The importance of DPI . . . . . . . . . . . . . . . . . . . 9
2.3 The meaning of earnings within the information perspective 10
2.4 Going beyond the information perspective:
Accounting-based valuation . . . . . . . . . . . . . . . . . 11
2.5 Empirical evidence . . . . . . . . . . . . . . . . . . . . . . 23
2.6 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . 27

3 Selecting an Earnings Metric 29

3.1 Enterprise- versus equity-level . . . . . . . . . . . . . . . . 30
3.2 Comprehensive income versus income per
the income statement . . . . . . . . . . . . . . . . . . . . 32
3.3 Earnings versus abnormal earnings growth versus
residual income . . . . . . . . . . . . . . . . . . . . . . . 33
3.4 Profitability ratios versus unscaled earnings . . . . . . . . 35
3.5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . 37

4 The Role of Econometric Modeling 38

4.1 Bringing order out of confusion . . . . . . . . . . . . . . . 39
 Full text available at: [Link]

4.2 Objectivity and replicability . . . . . . . . . . . . . . . . . 40

4.3 Benchmarking . . . . . . . . . . . . . . . . . . . . . . . . 40
4.4 Usefulness is the goal . . . . . . . . . . . . . . . . . . . . 41
4.5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . 42

5 Time-series Models 44
5.1 An overview of ARIMA models . . . . . . . . . . . . . . . 45
5.2 The ARIMA(0, 1, 1) model . . . . . . . . . . . . . . . . . 46
5.3 The ARIMA(1, 0, 0) model . . . . . . . . . . . . . . . . . 48
5.4 Model selection and estimation . . . . . . . . . . . . . . . 50
5.5 Extant evidence . . . . . . . . . . . . . . . . . . . . . . . 52
5.6 Interpreting the success of the random-walk model . . . . 52
5.7 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . 56

6 Panel-data Approaches 58
6.1 An overview of panel-data approaches . . . . . . . . . . . 59
6.2 Choose what to predict . . . . . . . . . . . . . . . . . . . 59
6.3 Choose the predictors . . . . . . . . . . . . . . . . . . . . 60
6.4 Choose the estimator . . . . . . . . . . . . . . . . . . . . 67
6.5 Choose the estimation sample . . . . . . . . . . . . . . . . 69
6.6 Choose how to evaluate the predictions . . . . . . . . . . 71
6.7 Advantages of panel-data approaches . . . . . . . . . . . . 77
6.8 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . 79

7 Accounting Measurement and Earnings Predictability 80

7.1 Accounting measurement and the properties of reported
earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . 81
7.2 The relative persistence of cash flows and accruals . . . . . 82
7.3 Accounting conservatism and earnings predictability . . . . 84
7.4 Summary and segue to the next chapter . . . . . . . . . . 88

8 Forecasting the Higher Moments of Future Earnings 90

8.1 The economic relevance of the higher moments
of future earnings . . . . . . . . . . . . . . . . . . . . . . 90
8.2 Empirical issues and empirical evidence . . . . . . . . . . . 93
8.3 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . 99
 Full text available at: [Link]

9 Summary 100

Acknowledgements 103

References 104
 Full text available at: [Link]

Financial Statement Analysis

and Earnings Forecasting
Steven J. Monahan ∗
INSEAD, Europe Campus, Boulevard de Constance,
77305 Fontainebleau, France; [Link]@[Link]

ABSTRACT
I synthesize and discuss academic research on financial
statement analysis and earnings forecasting. I begin by
discussing analytical and empirical evidence that shows that
earnings, not dividends or free cash flows, are the payoffs
that investors forecast when estimating value. This result is
fundamental and it provides clear motivation for studying
earnings forecasting and the role that historical accounting
numbers play in the earnings-forecasting process. I then
provide a detailed discussion of the research design choices
that are made when developing and evaluating an earnings-
forecasting approach. I describe the tradeoffs involved when
making these choices and I review the extant empirical
literature. An overarching theme of this discussion is that
there are substantial research opportunities. For example:

• The random-walk model performs too well on a rela-

tive basis. It is inconsistent with standard economic
assumptions, accounting practice and the way financial
statement analysis is practiced and taught. Nonetheless,
it tends to be as accurate and sometimes more accurate
than other extant approaches.
∗
This monograph is dedicated to Larissa Ignatieva and my parents: Leo John
Monahan (deceased) and Mary Eleanor Monahan.

Steven J. Monahan (2017), “Financial Statement Analysis and Earnings Forecasting”,

Foundations and Trends R in Accounting: Vol. 12, No. 2, pp 105–215. DOI:
10.1561/1400000036.
 Full text available at: [Link]

• Panel-data approaches that use a mix of cross-sectional

and time-series data are very flexible in terms of the:
(1) choice of earnings metric to predict; (2) choice of
predictors; (3) choice of estimator; and (4) choice of
estimation sample. At present, these approaches have
not been used to their full potential.
• There is insufficient evidence regarding how to identify
peers and the role that peer analysis plays in the
forecasting process.
• There is insufficient evidence regarding approaches for
forecasting the higher moments of future earnings, how
to evaluate these forecasts and their role in determining
value. Moreover, the role that accounting measurement
plays in the determination of the higher moments of
earnings and how accounting-measurement rules affect
the usefulness of historical accounting numbers for
predicting the higher moments of future earnings is not
well understood.
 Full text available at: [Link]

1
Introduction

I synthesize and discuss academic research on financial statement

analysis and earnings forecasting, which is the process of analyzing
historical financial statement data for the purpose of developing forecasts
of future earnings. This process is important because it is central to the
valuation of companies and the securities they issue.
Valuation is a crucial economic activity. As discussed in Hayek
(1945), security prices determine how finite resources are allocated to
firms and individuals. Moreover, as discussed in Arrow (1964), when
people have access to a broad set of securities, they can form diversified
portfolios and share risks. Hence, to fully understand the economic
role of accounting, it is imperative that we understand the role that
accounting numbers play in valuation.
The above provokes an immediate question: Why earnings? Specifi-
cally, given equity values are determined by expected future dividends
and enterprise value can be expressed as a function of expected future
free cash flows, why study earnings? Aren’t dividends and free cash flows
the primitive variables that investors forecast? These are valid questions
and, if they cannot be answered, the premise underlying this monograph
comes into question. With this in mind, in Section 2, I delve into the

3
 Full text available at: [Link]

4 Introduction

question: Why earnings? I focus on dividend policy irrelevance, which

implies that forecasting dividends is futile. I describe key analytical
results that imply that, assuming dividend policy irrelevance, expected
earnings are the fundamental determinant of both equity and enterprise
value. I then finish the section by discussing key empirical results that
imply that: (1) accrual-accounting earnings are more informative about
changes in value than either dividends or cash flows and (2) accrual-
accounting earnings, not dividends or free cash flows, are what investors
forecast when estimating equity value.
Given the primacy of earnings, the motivation for forecasting them
is clear. However, to do this, the researcher must first select the
earnings metric that she will forecast. In Section 3, I discuss the issues
involved in making this decision. As I explain in that section, the
choice depends on the research context as well as data availability and
the statistical properties of the different earnings metrics. Hence, the
decision ultimately involves making a subjective tradeoff. Consequently,
best practice is to clearly motivate the research question, describe the
logic for selecting a particular metric or metrics, and then discuss the
consequent pros and cons.
Once an earnings metric has been chosen, the natural question to
ask is: How useful are historical accounting numbers for developing
forecasts of that metric? In Sections 4–8, I focus on this question. In
Section 4, I discuss the general role of econometric modeling. I make
three points. First, when studying earnings forecasting, the goal is not
to find the “best” model; rather, it is to identify models that are useful.
Second, within the contexts of empirical capital markets research and
practical valuation, useful models are those that are objective, replicable,
generate accurate forecasts for large samples at a low cost and provide
useful guidance regarding best practice. Finally, extant models are too
inaccurate and, if taken at face value, extant results lead to seemingly
absurd conclusions regarding best practice. Given the central role that
earnings forecasting plays in valuation and the importance of valuation,
these results imply that further research is necessary.
After discussing econometric modeling in general, I discuss specific
types of models. In Section 5, I discuss time-series models, which were
the default choice in early research studies. A key result is that, of
 Full text available at: [Link]

the various time-series models evaluated, the random-walk model is

the best. The superiority of the random-walk model is counterintuitive
because, as discussed in Section 5, it is inconsistent with standard
economic assumptions and accounting practice. However, as I argue in
that section, this result is misleading because time-series models are
ill-suited for developing forecasts of earnings. Hence, the fact that the
random-walk model is the best time-series model does not imply that it
is the best approach.
Given the limitations of time-series models, they are no longer the
default choice. Rather, recent studies tend to use panel-data approaches.
These approaches allow the researcher to combine cross-sectional and
time-series data to arrive at a forecast of earnings. Hence, they are
more flexible than time-series models and they have numerous a priori
advantages vis-à-vis these models. In Section 6, I discuss the choices
a researcher makes when using panel-data approaches and I describe
the advantages of these approaches. I then discuss the extant empirical
evidence. I conclude that, with regards to the usefulness of panel-data
approaches, the jury is still out. Although extant results imply that
panel-data approaches are not much better than the random-walk model,
these studies do not exploit the full potential of panel-data approaches.
Hence, in my opinion, further study of panel-data approaches is a
promising research agenda.
In Section 7, I discuss the role of accounting measurement in deter-
mining the usefulness of historical accounting numbers for developing
forecasts of future earnings. I begin by explaining how accounting
measurement determines accruals, which, is the non-cash component of
earnings. I then discuss two topics that are directly related to accounting
measurement: (1) the relative persistence of cash flows and accruals
and (2) accounting conservatism. The main point of the section is that,
perhaps not surprisingly, accounting measurement matters. Extreme
accruals imply less persistent earnings. Moreover, conservative account-
ing rules can lead to historical trends in profitability ratios that are
misleading about future profitability ratios. Hence, colloquially speaking,
either too much accounting — that is, extreme accruals — or too little
accounting — that is, conservative-accounting rules — lead to historical
earnings that are less useful for developing forecasts of future earnings.
 Full text available at: [Link]

6 Introduction

In Section 8, I discuss approaches for forecasting the higher moments

of future earnings. At present, this issue has not received much attention.
Hence, there are ample research opportunities. I explain why higher
moments are important and I briefly discuss the extant studies that
develop and evaluate forecasts of them. Finally, in Section 9, I provide
a summary of the monograph.
Some general caveats are warranted. First, I focus on the academic
literature that relates to the pursuit of financial statement analysis
for the purpose of developing forecasts of earnings. However, financial
statement analysis is a broad topic and developing earnings forecasts is
only one of its objectives. Nonetheless. to maintain focus and for the sake
of brevity, I ignore other objectives such as the identification of mispriced
securities, default prediction, employee performance evaluation, etc.
Second, I concentrate on studies in which the objective is to develop
and evaluate different approaches for forecasting earnings. Hence,
although I use valuation to motivate my focus on earnings forecasting,
I do not attempt to survey and synthesize the large and important
capital-markets literature that relates to the association between
accounting numbers and security prices. Third, my primary focus is on
studies that consider annual earnings. There is a large and important
literature that evaluates approaches for forecasting quarterly earnings.
However, a thorough treatment of that literature is beyond the scope
of this monograph.
Finally, I focus on studies that develop statistical approaches for
forecasting earnings. I do not discuss the literature on analysts’ forecasts
and their properties. My reasons are twofold. First, comprehensive
reviews of this literature can be found in Ramnath et al. (2008) and
Bradshaw et al. (2016). Second, my aim is to describe the literature that
evaluates the role of historical accounting numbers in the forecasting
process. Within this context, analysts’ forecasts are a “black box.” That
is, the process that analysts follow when developing their forecasts and
the role that accounting numbers play in that process are not observable.
 Full text available at: [Link]

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