Improving Profitability Forecasts with Information on Earnings Quality

Abstract

Prior literature documents the usefulness of the DuPont disaggregation for predicting firms’ future profitability, operating income, and stock market returns. In addition, research also emphasizes the importance of earnings quality information. However, there is a lack of research examining how earnings quality affects forecasts of profitability. This paper explores whether different earnings quality factors moderate the accuracy of profitability forecasts. This study contributes to the existing literature along three dimensions. First, contrary to financial statement analysis studies, I find that changes in profit margin provide incremental information for predicting changes in future return on assets. After controlling for earnings quality factors, the incremental usefulness of this accounting signal increases significantly. Second, this paper contributes to the earnings quality literature by providing an approach as how to include this information into forecasts of profitability. In doing so, I incorporate the main drivers of earnings quality (i.e. fundamental performance and the accounting system) into profitability forecasts. Last, the paper adds to the literature on how capital market participants perceive accounting information. I document that both analysts and investors appear to efficiently incorporate earnings quality information in their investment decisions.