The Information Content of Earnings Components: Evidence from the Chinese Stock Market

Abstract

China's listed firms report substantial non-operating revenues and expenses. We argue that these non-core earnings should have different properties and different valuation implications than operating or core earnings. Furthermore, the different types of firm ownership may have differential impacts on the information content of earnings components. Based on data from 1996 to 2008, we find that core earnings are more persistent than non-core earnings. Because of this, core earnings have a greater association with contemporaneous stock returns. However, the stock market does not fully incorporate all the information in earnings; we find that core earnings are undervalued and non-core earnings are overvalued. This effect is much reduced for privately controlled listed firms. We develop an investment trading strategy to exploit these market inefficiencies.

Acknowledgements

The authors thank the reviewers and editors, Mahmoud Ezzamel and Jason Xiao, for helpful comments and suggestions on an earlier version of the paper. The authors also thank seminar participants at the Hong Kong Polytechnic University and Sun Yat-Sen University for helpful discussions and suggestions. The authors would also like to thank the Government of the HKSAR (LU340307) for financial support for this project.

Notes

During the period of our study, large investors owned non-tradable shares. However, beginning in 2006, the non-tradable shares became tradable (Firth et al., 2010).

On average, small private investors hold shares for about two months (Poon et al., 1998).

As discussed earlier, financial analysis is new to China and is underdeveloped when compared to major financial markets. However, financial analysis is growing in importance.

Non-core operating revenues and expenses are often called ‘special items’ in the USA. We use the term ‘special items’ when reviewing the US literature.

Special treatment (ST) companies are those that have three consecutive years of losses. These firms may be delisted unless their performance improves.

The China Stock Market and Accounting Research (CSMAR) database has detailed accounting and stock return data for listed firms in China. The database is widely used and is part of the Wharton WRDS system.

SAMB-controlled firms are the base case. The coefficients on the interaction terms indicate whether SOE- and private-controlled firms are different from SAMB-controlled firms.

The continuous variables are transformed to their decile ranks (1, …, 10).

This investment strategy cannot be implemented in China at the present time because short selling is not allowed. The prohibition of short selling inhibits price discovery. The Chinese authorities plan to allow short selling of some stocks in 2010. If this experiment is deemed a success, then it will be extended to all stocks.