Predictability of Aggregate Earnings

Abstract

In this study, I provide evidence that aggregate earnings are predictable based on the cointegration relation between earnings and cash flows implied by the accounting identity that earnings is the sum of the cash flows and the accruals. I first show that earnings and cash flows follow random walks with drifts while accruals is stationary with zero mean. I then show that earnings and cash flows are cointegrated and the cointegration error is the accruals. I finally show that earnings is the error correction term in this cointegration relation, hence predictable. My results which are robust to various financial statement frequencies, earnings measures, universes, and periods may help to answer some of the questions which were raised regarding to the contemporaneous relationship between aggregate earnings surprises and stock returns in the recent literature.

Keywords: earnings, cash flows, accruals, cointegration