The Information Content of Disaggregated Accounting Profitability: Operating Activities Versus Financing Activities

Abstract

This paper reports three empirical findings on the differential information content of components of accounting profitability. First, the paper finds that shareholder profitability driven by operating activities has a stronger association with annual stock returns than shareholder profitability driven by financing activities. The finding provides empirical support for the FASB Financial Statement Presentation project using the annual stock return as the dependent variable. Second, the paper finds that the sustainable portion of operating profitability has a stronger association with annual stock returns than the unsustainable portion. This finding contributes to the literature by extending the two popular methods of breaking down operating profitability (DuPont analysis and operating liability leverage) into sustainable versus unsustainable operating income using the metric Penman (2010) suggests. Finally, the paper identifies the conditional persistence in Amir, Kama, and Livnat (2011) as one of the empirical attributes that affects the valuation usefulness of disaggregated accounting profitability. The conditional persistence measures the marginal contribution of disaggregated profitability to the persistence of aggregate profitability. This paper reports that the disaggregation is more useful in firms with significant differences in the conditional persistence of disaggregated components than in other firms. Test results are robust to controls for cross-sectional and time-series dependence in error terms.