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This paper indicates that the inclusion of impact of different
growthopportunities among firms can improve the misspecification
of the relationsbetween accounting earnings and contemporaneous
annual stockrate of returns presented in traditional studies.
Through the deduction oftheoretical equity valuation models and
the analysis of empirical studies,the true effect of firms''
capital investments in addition to accountingearnings on rate of
returns can be identified further. According to finance theory,
market''s expectation of the net presentvalue from investment
should be reflected in stock prices when firmswith growth
opportunities invest in profitable capital expenditure projects.
Nonetheless, it is inevitable for accounting earnings and
contemporaneousstock returns not to coincide with each other in
the short run,because the primary purpose of historical cost
accounting measurementprocess is not designed to fully reflect
investors'' expectations of futurenet cash flows on a timely
basis. If the impact of firms'' capital investmentsis included in
the equity valuation models, then not only the levelof discord
between accounting earnings and contemporaneous stock returnscan
be reduced, but also it can be further clarified that the
magnitudeof the returns-earnings relations varies for firms with
diversegrowth opportunities. First of all, this paper
introduces a simple and practical equityvaluation model with
debts for empirical purpose to explain the ways andextent to
which accounting earnings and capital investments affect
stockreturns. And because accounting earnings is the only
explanatoryvariable for stock returns in some earlier
researches, the next step is toexamine the inflating phenomenon
of earnings regression coefficient on theempirical stage based
on the derived theoretical model. Besides, thesemodels are also
helpful to examine the extent to which the naive modelfits in
the literature. Here are the empirical conclusions based on the
analytical models: 1. According to the model, investors''
expected stock returns are exactlythe same as the expected
earnings of the firms after subtracting theeffect of investment
net present value. If the regression analysis ofreturns-earnings
relations is conducted without consideration of
growthopportunities, then the explanatory power of investments
on rate of returnswill be transferred to the earnings variable,
and thus exceeds thetheoretically expected value. 2. Naive
model can be applied to the mature type of firms defined inthis
paper, that is, expected stock returns equal expected
accountingearnings of the firms. With regard to the empirical
results for fourdifferent accounting earnings measures,
including net income, cash flowsfrom operation, taxes adjusted
operating profit and the latter plusinvestment revenue, taxes
adjusted operating profit is apparently more inconformity with
the assumptions in the model derived, which requiresearnings to
be generated consistently in the future, and thus much morelike
the permanent earnings. 3. The fact that investment
opportunities are the sources of stockvalue is demonstrated in
the model with capital investments. The earningsregression
coefficient is exactly one in the regression of stock
pricedeflated accounting earnings on stock rate of returns, so
it doesn''t varywith growth opportunities. On the other hand, the
explanatory power ofinvestment variable is positively correlated
with growth opportunities. Ifthe impact of investment
opportunities and earnings measurement erroron regression
analysis of returns-earnings relations can be
resolvedeffectively, then there will be no cross-sectional
variation in earningsregression coefficients for four different
earnings measures based on themodel with capital investments.
4. Investment term in the final valuation model represents the
presentvalue of all such future opportunities. There will be no
correlationbetween stock returns and next period earnings for
regression analysis ifthe impact of investment opportunities is
included properly.
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