The Profitability of EP Trading Rule Based on Operating Income

• Main Author: Kang, Tony
• Format: text
• Language: English
• Published: Institutional Knowledge at Singapore Management University 2003
• Subjects: Accounting; Finance and Financial Management
• Online Access: https://ink.library.smu.edu.sg/soa_research/148
• Institution: Singapore Management University

This study examines the profitability of earnings-to-price (EP) trading rules based on two alternative measures of earnings: 1. net income before extraordinary items and discontinued operations, and 2. operating income that focuses on the operating activity of a firm. Specifically, this investigation is motivated by the fact that while prior study finds that operating income is more persistent than non-operating income, there is little evidence on the differential return predictability of the two components of income. To the extent that stock price reflects the market's expectation about future earnings, the return predictability of the two components of income should differ when they have different persistence. The study finds that while the profitability of the conventional EP trading rule is significant, it increases substantially when the earnings are defined to be operating income rather than net income before extraordinary items and discontinued operations. Further, the conventional risk factors, including market return and firm size, do not fully explain the profitability of EP trading rule based on operating income. These results highlight the importance of core operation-related information to investment decision-making.