The implications of retained and distributed earnings for future profitability and stock returns

Purpose – The purpose of this paper is to examine the informational content of retained and distributed earnings for future profitability and stock returns. Design/methodology/approach – The paper utilizes firm‐level cross‐sectional persistent regressions, Mishkin's econometric framework and portfolio‐level analysis. Findings – The paper shows that investors act as if the components of retained earnings (current operating accruals, non‐current operating accruals and retained cash flows) have similar implications for future profitability, leading to an overvaluation of their differential persistence. It also appears that while they cannot distinguish between the distinct properties of distributed earnings, they correctly anticipate the persistence of net cash distributions to debt holders (net debt repayment) but underestimate the persistence of net cash distributions to equity holders (dividends minus net stock issues). Overall, the findings of the paper suggest that the accrual anomaly documented in the accounting literature and the anomaly on net stock issues documented in the finance literature could be a subset of a larger anomaly on retained earnings. Originality/value – The paper enhances one's understanding of the conflicting market's reaction to the accrual and cash flow component of earnings.