An investigation of financial ratios in predicting firms' future performance: An application of Pr's methodology

Ou and Penman (1989a; hereafter OP) use logistic models to aggregate a set of selected financial ratios from publicly available financial statements to estimate the probability of a one-year-ahead earnings increase, known as Pr. Based on Pr, OP are able to form a profitable zero-investment hedge portfolio. Alternatively, when extending OP's study, Holthausen and Larcker (1992, hereafter HL) report that using Pr estimated by a model which directly associates financial ratios with one-year-ahead excess returns also results in substantial positive abnormal returns. Their findings not only suggest the usefulness of financial statement information, but also imply market inefficiency. However, because the discussion of Pr's constructs is not provided to explain why these financial ratios are useful in predicting earnings changes or excess returns, many researchers are skeptical about this market anomaly resulting from the Pr strategy.;Because the targets that the financial ratios aim to predict are different for the earnings-target prediction model and the returns-target prediction model, investigating the patterns of abnormal returns or trading profitability generated by E-Pr and R-Pr can provide insights regarding their respective economic meanings. As expected, this study finds that the construct of E-Pr is different from that of R-Pr. The E-Pr based trading profitabilities curve, ranging from 2% to 24%, are monotonic increasing with the holding periods and persistent beyond 72 months. Consistent with Bernard, Thomas and Wahlen (1995), this study finds that E-Pr proxies for omitted risk factors. On the other hand, the R-Pr based trading profitabilities curve remains flat with a peak at the 9-month holding period (5.6%), and eventually declines. R-Pr signifies that the market slowly adjusts to the fundamental value. In fact, the excess returns for R-Pr are not greater than zero when one considers the transactions cost, which ranges between 4.3% and 9.5% (HL (1992)). The empirical results suggest that the market is efficient in using accounting information. Moreover, examining financial ratios that are significant in explaining future excess returns support the premise that operating profitability and growth in operating assets are the two most important pieces of accounting information to evaluate firm value as suggested in Ohlson and Feltham (1995).;Finally, this study complements Greig's study (1992) by further examining whether Pr is merely a manifestation of the firm size effect. (Abstract shortened by UMI.);Based on a typical firm valuation model, returns can be expressed as a function of both profitability and risk. If the change of earnings magnitude captures mainly profitability and is not associated with risk, then, by construction, the construct of OP's earnings-target Pr (hereafter E-Pr) should be mainly related to profitability and HL's returns-target Pr (hereafter R-Pr) should be affected by both profitability and risk. Hence, comparing the relationships of a common set of financial ratios with respect to future unexpected earnings and future excess returns can be used to characterize the attributes of the financial ratios. Accordingly, the types of financial ratios that are useful to predict firms' future performance are better understood. From 59 financial ratios that were originally investigated by OP and HL, this study uses principal component analysis to identify a set of 16 essentially uncorrelated financial ratios that capture distinct aspects of firm characteristics.