Can Residual Income Separate Organic Growth in Earnings from Investment-Driven Growth?

Prior research found that residual income (RI) is not as informative about stock returns as net income (NI), despite theory that demonstrates the role of residual income in valuation and a long history support for RI among practitioners. We replicate these tests and find similar results. We then consider an alternate perspective of viewing NI and RI not as competing measures in a horse race, but rather as parts of the information set available to investors. We first show that the change in NI can be decomposed into an organic growth component (change in RI), an investment-driven growth component and other components related to changes in risk and interest expense. We use this decomposition in extant models used to study the relationship between returns and earnings. We find in contemporaneous tests that growth is valued differently depending on its source. In particular, organic growth (change in RI) is more highly correlated with returns than growth due to increasing investment. Further, the market does not fully impound this information about the sources of growth in profits. Future returns tests indicate that the market under-reacts to organic growth and overreact to investment-driven growth. A long-short investment strategy based on these findings yield significant excess returns, which are independent of those of known anomalies (accruals, capital expenditure, and external financing) and persist after we control for known risk factors. Our results demonstrate the informative role of residual income in explaining variation in returns, consistent with extant valuation theory and common arguments made in economic theory. We would like to thank Stephen Penman, Tim Baldenius, Stefan Reichelstein (the editor), two anonymous referees and seminar participants at the 2006 Columbia Burton workshop and Duke University for their comments. We appreciate research assistance from Columbia Business School. All errors are our own. Please contact Sudhakar Balachandran at [email protected] or Partha Mohanram at [email protected] with questions and comments. This paper was previously titled “Is Residual Income Really Uninformative about Stock Returns?”