Frino, A. and Tibbits, G., Earnings as an Explanatory Variable for Returns: A Note, School of Accounting & Finance, University of Wollongong, Working Paper 35, 1992.
Easton and Harris (1991) [herein EH], in a recent article, "investigate whether the level of earnings divided by price at the beginning of the stock return period is relevant for evaluating earnings/returns associations" [p 19]. As stated by EH, the contribution of their study stems from their variable of interest, which is not the earnings-to-price ratio based on contemporaneous (past) earnings and contemporaneous (past) price which has dominated earlier studies. Despite their excellent empirical work, unfortunately, their theorising is somewhat ad hoc and they admit that for certain aspects of their theorising "we provide a more heuristic analysis" [footnote, p. 8]. It is the purpose of this paper to provide a derivation of the relationship between the level of earnings divided by the beginning of period stock price and stock returns, using the well known and widely accepted Gordon growth model of stock valuation originally attributed to Gordon and Shapiro (1956), and the behavioural dividend model originally developed and tested by Lintner (1959). The model derived provides alternative interpretations of the parameters of the empirical model estimated by EH, and suggests that one of the variables and the fundamental model estimated by EH is mis-specified.