Taxable Income, Future Earnings, and Equity Values
Coauthor(s): Baruch Lev.
We investigate the ability of a tax-based fundamental?the
ratio of tax-to-book income?to predict earnings growth and stock
returns and to explain the earnings-price ratio. This tax fundamental
reflects both temporary and permanent book-tax differences as well as
tax accruals, such as changes in the tax valuation allowance. We find
that the tax-to-book income ratio predicts subsequent five-year
earnings changes, both before and after the implementation of Statement of Financial Accounting Standards (SFAS) No. 109 in 1993. For the pre-SFAS No. 109 period, the tax information is unrelated to
contemporaneous earnings-price ratios and strongly related to
subsequent stock returns. Conversely, for the post-SFAS No. 109 period, the tax fundamental is strongly related to contemporaneous
earnings-price ratios and only weakly related to subsequent stock
returns, indicating improvement over time in investors' perceptions of
the implications of the tax information for future earnings. Deferred
taxes, a component of our tax fundamental and the focus of recent
research, exhibits relatively modest ability to predict earnings or
stock returns both before and after the implementation of SFAS No. 109. Finally, throughout the examined period, the taxable income information about future earnings is incremental to that in accruals and cash flows.
Source: Accounting Review
Lev, Baruch, and Doron Nissim. "Taxable Income, Future Earnings, and Equity Values." Accounting Review 79 (October 2004): 1039-74.