Earnings response coefficient

Introduction

The earnings response coefficient, or ERC, is the estimated relationship between equity returns and the unexpected portion of (i.e., new information in) companies' earnings announcements.

In financial economics, arbitrage pricing theory describes the theoretical relationship between information that is known to market participants about a particular equity (e.g., a common stock share of a particular company) and the price of that equity. Under the efficient market hypothesis, equity prices are expected in the aggregate to reflect all relevant information at a given time. Market participants with superior information are expected to exploit that information until share prices have effectively impounded the information. Therefore, in the aggregate, a portion of changes in a company's share price is expected to result from changes in the relevant information available to the market. The ERC is an estimate of the change in a company's stock price due to the information provided in a company's earnings announcement.

The ERC is expressed mathematically as follows:

$R\; =\; a\; +\; b(ern-u)\; +\; e$

:R = the expected return:a = benchmark rate:b = earning response coefficient:(ern-u) = (actual earnings less expected earnings) = unexpected earnings :e = random movement

Use & Debate

ERCs are used primarily in research in Accounting and Finance. In particular, ERCs have been used in research in Positive Accounting, a branch of Financial Accounting research, as they theoretically describe how markets react to different information events. Research in Finance has used ERCs to study, among other things, how different investors react to information events. (Hotchkiss & Strickland 2003)

There is some debate concerning the true nature and strength of the ERC relationship. As demonstrated in the above model, the ERC is generally considered to be the slope coefficient of a linear equation between unexpected earnings and equity return. However, certain research results suggest that the relationship is nonlinear.(Freeman & Tse 1992)

ee also

* Capital asset pricing model
* Post earnings announcement drift

References

# Collins, D. W. and S. P. Kothari (1989), 'An Analysis of Intertemporal and Cross-Sectional Determinants of Earnings Response Coefficients', "Journal of Accounting & Economics", Vol.11, No.2/3 (July), pp. 143-81.
# Chambers, Dennis J.; Freeman, Robert N.; Koch, Adam S (2005) The Effect of Risk on Price Responses to Unexpected Earnings. "Journal of Accounting, Auditing & Finance", Vol. 20 Issue 4, p461-482
# Kormendi, Roger & Lipe, Robert, 1987. "Earnings Innovations, Earnings Persistence, and Stock Returns," "Journal of Business", University of Chicago Press, vol. 60(3), pages 323-45.
# Hotchkiss, Edith S. and Deon Strickland, 2003. "Does Shareholder Composition Matter? Evidence from the Market Reaction to Corporate Earnings Announcements," "Journal of Finance", 58(4), pp. 1469-1498.
# Freeman, Robert and Senyo Tse, 1992. "A Nonlinear Model of Security Price Responses to Unexpected Earnings," "Journal of Accounting Research", Vol. 30 No. 2 (Autumn), pp. 185-209.