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Abstract
The sign of stock return has been widely used to proxy for news in the conditional conservatism model. Under discount cash flow model, firm value changes are caused by either cash flow news or discount rate news. Simply using the sign of stock returns to define good (bad) news can be problematic. Following the classic return decomposition method, this paper decomposes return news into cash flow news and discount rate news. We find that cash flow news component demonstrates consistent results with previous findings. However, with respect to discount rate news, positive return news turns out to be recognized more quickly in earnings. The conventional timeliness asymmetry even disappears in the highest quintile of discount rate news shock magnitude. In additional tests, we also document weakened timeliness asymmetry conditional on a battery of proxy variables for discount rate news. Our findings suggest that we should use stock return sign with caution in conditional conservatism tests, especially when discount rate news shock is large.
Acknowledgments
We would like to thank the editor Hong Hwang, the associate editor Anup Srivastava, and an anonymous referee for their suggestions. We are grateful to Mozaffar Khan, Charles Hsu, Juan Manuel García Lara and seminar participants at the 2015 EAA Annual Congress for their helpful comments. Shengmin Hung acknowledges the financial support of the Ministry of Science and Technology, Taiwan (Project No. MOST 102-2410-H-031-022). Zheng Qiao acknowledges the financial support of the MOE (Ministry of Education in China) Project of Humanities and Social Sciences (16YJC790082) and the Fundamental Research Funds for Central Universities (20720151130). All errors are ours.
Notes
* Accepted by Hong Hwang upon recommendation by Anup Srivastava.
1. Cash flow news is based on the notion initially proposed by Campbell (Citation1991). Different from cash flow items in the accounting statements, its economic meaning is to capture the future cash flows in the numerator of DCF valuation model. If a firm’s number of positive NPV projects increases, it is expected to have higher cash flow news. In other words, it is a ‘profitability measure’ of expected future operating performance of a firm.
2. We delete observations with upper or lower 1% percentile for continuous variables.