THE RELATION BETWEEN EARNINGS COMPONENTS AND STOCK RETURN IN VIETNAMESE STOCK MARKET

MINISTRY OF EDUCATION AND TRAINING
UNIVERSITY OF ECONOMICS HO CHI MINH CITY

CHU THI KIM HUONG

THE RELATION BETWEEN EARNINGS
COMPONENTS AND STOCK RETURN
IN VIETNAMESE STOCK MARKET

A THESIS OF MASTER OF FINACE AND BANKING

Ho Chi Minh City - 2015


MINISTRY OF EDUCATION AND TRAINING
UNIVERSITY OF ECONOMICS HO CHI MINH CITY

CHU THI KIM HUONG

THE RELATION BETWEEN EARNINGS
COMPONENTS AND STOCK RETURN
IN VIETNAMESE STOCK MARKET
Major: Finance-Banking
Code: 60340201

A THESIS OF MASTER OF FINACE AND BANKING

Supervisor: Dr. Vo Xuan Vinh

Ho Chi Minh City - 2015

Contents
Contents..........................................................................................................
Abstract ..........................................................................................................
List of Figures.................................................................................................
List of Tables ..................................................................................................
CHAPTER ONE: INTRODUCTION............................................................ 1
1.1 Background ...................................................................................... 1
1.2 Research questions .............................................................................. 3
1.3 Purpose of study.................................................................................. 3
1.4 Structure of the thesis .......................................................................... 4
CHAPTER TWO: LITERATURE REVIEW ................................................ 5
2.1 Vietnam Stock Market ........................................................................ 5
2.2 Theoretical framework ........................................................................ 9
2.2.1 Market efficiency ......................................................................... 9
2.2.2 Random walk ............................................................................. 11
2.3 Prior empirical studies ....................................................................... 12
2.3.1 Cash flows and accruals information in earnings ........................ 12
2.3.2 Definition of earnings quality ..................................................... 14
2.3.3 Measuring earning quality .......................................................... 15
2.3.4 Link between earnings persistence and market pricing ............... 17
SUMMARY ........................................................................................... 18
CHAPTER THREE: METHODOLOGY .................................................... 19
3.1 Hypotheses Development .................................................................. 19
3.2 Hypothesis testing framework ........................................................... 20
3.3 Theoretical Methodology .................................................................. 21
3.3.1 Design ........................................................................................ 21
3.3.2 Data Collection........................................................................... 24
3.3.3 Variables computation ................................................................ 25
3.3.4 Testing of hypothesis.................................................................. 28

3.3.4.1 Testing of Hypothesis 1 ........................................................... 28
3.3.4.2 Testing of Hypothesis 2 ........................................................... 29
3.4 Statistical Methodology ..................................................................... 32
SUMMARY ........................................................................................... 33
CHAPTER FOUR: EMPIRICAL ANALYSIS AND RESULTS ................ 34
4.1 Descriptive statistic ........................................................................... 34
4.2 Test of Hypothesis 1: Earnings persistence result .............................. 36
4.2.1 Steps for Analyze ....................................................................... 36
4.2.2 Result ......................................................................................... 37
4.3 Test of Hypothesis 2: Stock return result ........................................... 41
4.3.1 Steps for Analyze ....................................................................... 41


4.3.2 Result ......................................................................................... 42
SUMMARY ........................................................................................... 47
CHAPTER FIVE: RESEARCH EVALUATION ........................................ 48
5.1 Reliability ......................................................................................... 48
5.2 Validity ............................................................................................. 49
CHAPTER SIX: CONCLUSION................................................................ 50
6.1 Practice Implications ......................................................................... 50
6.1.1 Implication for investors ............................................................. 50
6.1.2 Implication for researcher ........................................................... 50
6.1.3 Implication for policy maker ...................................................... 50
6.2 Further Study .................................................................................... 51
References ......................................................................................................
APPENDIX ....................................................................................................


Abstract

This study examines the information of earnings quality which is reflected by
the persistence of earnings and then investigates the link of earnings quality and
stock returns of 245 listed firms in Vietnam stock market beginning from 2007 to
2013. The results are given in research show the earnings persistence rate is average
0.627, meaning that 62,7% current earning will contribute to the next year’s
earnings. Moreover, the study finds that the cash flow component is more persist
than the accruals component in earnings. Finally, stock price in Vietnam stock
market appears that it do not reflect fully the different contribution of cash flow
component and accruals components in earnings.


List of Figures
Figure 2.1 Vietnam's inflation - Source : World Bank* ............................................ 5
Figure 2.2 Market cap in % of GDP - Source : Bloomberg ...................................... 6
Figure 2.3 Price/Earnings ratio – Source: Bloomberg .............................................. 7
Figure 2.4 Number of listed companies – Source: HSX and HNX ........................... 8
Figure 2.5 VN-index history data – Source: VNDIRECT company ......................... 9
Figure 3.1 The Framework for the Hypothesis 1 .................................................... 20
Figure 3.2 The Framework for the Hypothesis 2 .................................................... 20
Figure 3.3 The Logical Structure of the Quantitative Research Process (Alan
(1988)) .................................................................................................................. 23
Figure 3.4 Steps of Estimation Procedures for Hypothesis 1 .................................. 29
Figure 3.5 Steps of Estimation Procedures for Hypothesis 2 .................................. 32


List of Tables
TABLE 3.1 Variables Definition ........................................................................... 27
TABLE 4.1 Descriptive statistics on earnings, the accrual and cash flow
components of income and abnormal stock returns for a sample of 1,470 firm-year
observations obtained from VN-Index and Bloomberg terminal during period 2007

to 2013 .................................................................................................................. 35
TABLE 4.2 Ordinary Least Squares regressions analyzing the persistence of the
current earnings into the future earnings. Sample consists of 1,470 firm-year
observations obtained from Bloomberg terminal during period 2007 to 2013 ........ 38
TABLE 4.3 Wald Test for Ho: α1 =1...................................................................... 38
TABLE 4.4 Ordinary Least Squares regressions analyzing the persistence of the
accrual and free cash flow components of earnings. Sample consists of 1,470 firmyear observations obtained from VN-Index and Bloomberg terminal during period
2007 to 2013.......................................................................................................... 40
TABLE 4.5 Wald test for Equality of coefficient cash flow and accrual ................ 41
TABLE 4.6 Summary coefficients ......................................................................... 41
TABLE 4.7 Iterative Weighted Non-linear least squares estimation of the stock
price reaction to information in current earnings about future earnings. Sample
consists of 2,940 firm-year observations obtained from VN-Index and Bloomberg
terminal during period 2007 to 2013 ...................................................................... 43
TABLE 4.8 Wald test for Test of market efficiency Ho: α1 = α1* ........................... 44
TABLE 4.9 Iterative Weighted Non-linear least squares estimation of the stock
price reaction to information in the accrual and cash flow components of current
earnings about future earnings. Sample consists of 2,940 firm-year observations
obtained from VN-Index and Bloomberg terminal during period 2007 to 2013...... 45
TABLE 4.10 Wald test for Test of market efficiency Ho: γ1 = γ1* ; γ2 = γ2* ........... 46


1

CHAPTER ONE: INTRODUCTION
How the earnings quality of listed firms in stock market is and whether stock
price correctly reflects the information of earnings are the questions which have
been attracted numbers of researchers. It is interesting and practical to identify the
quality of earnings and how do investors response with this information that
indicates in the stock price in Vietnamese stock market. The answer is meaningful

to not only researchers, but also the market involvers who would like to understand
and make an investment decision. It helps investors see the full picture of market
and successfully set up investment strategies.
The purpose of this research is to analyze the quality of reporting earnings
and test the relation of earnings quality and stock return of listed firms in Vietnam
stock market. Through the thesis, you may have some information about a new
emerging market as Vietnam. This chapter presents the background of the topic, the
research questions, the purpose of the study and the structure of the thesis

1.1 Background
The first question is why earnings quality should be analyzed. Apparently,
participants in financial market are aware that numbers of earnings can be
manipulated. Despite the shortcomings of earnings, a majority of the market is
looking at earnings; therefore, earnings quality issue still makes sense in study
work. In investors’ perspective, before making an investment decision, except the
stock price variable, the best pick would be earnings to look at the value of a
security in one financial year or in a quarter. Sloan (2006) presented that future
earnings are more informative than intrinsic value for those interested in forecasting
stock returns over the next 3–12 months.


2

Studying earnings quality is also important because it affects investors’ buyhold-sell action. This variable is an indicator to decide which firm is good and bad.
In Vietnam stock market context, the quality of financial information of
listed companies is an existing issue. With earnings reports, a bulk of firms are
determined has not recorded properly to estimate of interest to be paid, do not
transfer the entire business management costs incurred during the period in the
income statement report. Many enterprises also use accounting policies as "the
valves" to adjusted earnings, such as changing depreciation from 15 years to 25

years to reduce depreciation expense, as consequence make an increase in their
earnings.
The case of Vitaly Joint Stock Company (code: VTA) is an example. In the
first half of 2010, to avoid the risk of being delisted, VTA leaders did everything
possible to "create" numbers to the lowest losses. In the first- half financial year
report, VTA were stopped depreciating of 5 production lines with a total cost
estimated at 5.99 billion VND. Thus, if they added depreciation cost, the after-tax
losses on the income statement in 6 months of 2010 would be loss 29.09 billion
VND instead of 19.34 billion VND.
Following is another example: SaiGon Beverages Joint Stock Company
(TRI). In the 9 months of 2010 business result, TRI posted 10.6 billion profits;
however, many investors remained cautiously with this information, since TRI was
named "erratic" stock. Because investors were cheated the same case in 2008, TRI
released profit at 750 million in 9 months of 2008 but in the fourth quarter of 2008,
they announced an unexpected loss of over 146 billion. Subsequently, in 2009, TRI
set profit target at 17 billion, but they announced a loss at 82.29 billion in the end of
this year. The story still happened in the first 6 months of 2010, the parent company
announced the loss of nearly 40 billion, but in the consolidated financial statements,
they posted nearly 42 billion profits, thanks to the transfer of financial investments
in subsidiaries Tribeco Binh Duong and Northern Tribeco right on 30th June.


3

Within three years, the story of the profit and loss of TRI like a quirky film that
investors did not know what they should act with that code. And the sad ending of
this story was that TRI delisted on 9th April, 2012.
Therefore, getting the knowledge of earnings number and underlying of that
number is the need for researchers and the investors either in the emerging market
as Vietnam stock market.

1.2 Research questions
According to the problem background, it raises questions how the earning
quality of Vietnam stock market listed firms is and whether stock price is reflected
correctly the information of earnings, specifically the components of earnings.
These answers for the following questions can give us some perspectives of the
market. It can also provide us a better understanding on the Vietnam stock market.
It can be interesting and useful to set up short and long investment strategies. The
research questions are as followed:
 How is the earnings’ quality of listed firms in Vietnam stock market?
 Which components of earning play the major role to contribute to net
income?
 Do investors use information of earnings quality to apply for their
investment action?

1.3 Purpose of study
The objectives of the research are:
-

To figure out the quality of earnings of listed firms in Vietnam stock
market;

-

To find out which part of earnings is major contribution to earnings;

-

To find out how investors react toward the information of earnings and
toward the information of components of earnings;

4

-

To suggest some implications to participants in Vietnam stock market,
especially researcher, investors and policy makers.

1.4 Structure of the thesis
Chapter Two: An introduction to Vietnam stock market, reviews relevant
literature relating to the definition of earnings quality, the content information of
cash flow and accruals. A review of the concept of random walk, market efficiency
which are also present which is a basis for measuring the two tested hypotheses
Chapter Three: I focus on the theoretical and statistical methodology. I then
explain how I approached the research and present the process for measuring the
two hypotheses based on the literature.
Chapter Four: Provide steps to analyze hypothesis and display results of
tested regressions. I find the evidence to support my predictions of persistence of
earnings. I also find interesting results from the pricing equation.
Chapter Five and Six: The two last chapters summarized the key findings
and strategy conclusions made in the thesis. A recommendation for further studies
and self-evaluation of the research is also included.


5

CHAPTER TWO: LITERATURE REVIEW
2.1 Vietnam Stock Market
This part shall give you a better overlook on Vietnamese market. Vietnam

keeps maintain developing of the land’s economy on GDP (Gross Domestic
Product) and to control the inflation. The inflation rate is peak in 2008 and 2011 at
22.7% and 21.3% respectively. The recent tightening of monetary policy had some
impact in cooling the economy; inflation slowed down in 2012 and dropped sharply
to 4.8% in 2013(World Bank1).

Figure 2.1 Vietnam's inflation - Source : World Bank*

To control the inflation into single digits, stabilize the macro economics, and
to grow the stock market are among the priority goals of Vietnam.
Vietnam’s stock market capitalization represented nearly 23% of GDP in
2013, it is a low market cap/ GDP 2relative to ASEAN nations. This is a positive
sign for the economy and suggests that the stock market still has strong
1
2

Vietnam’s inflation data is obtained at />See Appendix 1


6

development potentials. In the meantime, The Ministry of Finance has planned to
change numbers of security decrees and circulars to create system of legal
documents for the local stock market in the coming time in hopes of attracting more
foreign funds. The changes would help promote liquidity on the market, such as
allowing investor to open many transaction accounts, and buy and sell the same
stock on the same single session.

Figure 2.2 Market cap in % of GDP - Source : Bloomberg

Vietnam’s overall Price/Earning ratio3 is relatively low — just over 12 as of
December, 2013. It is below in relative with Asian nations such as Thailand (14.59),
and Indonesia (19,72) etc.
Vietnam hosts two large stock exchanges; the Ho Chi Minh City Stock
Exchange (HOSE), the Vietnam's largest stock exchange, and the Hanoi Stock
Exchange (HNX).

3

See Appendix 1


7

Established in 2000, HOSE currently lists 301 companies as of December
2013. Originally, it was named the Ho Chi Minh City Securities Trading Center
(HoSTC). The exchange was officially inaugurated on July 20, 2000, and trading
commenced on July 28, 2000. Initially, two companies were listed, Refrigeration
Electrical Engineering Joint Stock Corporation (REE) and Saigon Cable and

Figure 2.3 Price/Earnings ratio – Source: Bloomberg

Telecommunication Material Joint Stock Company (SACOM). At the beginning, an
overall foreign ownership is limited of 20% for equities and 40% for bonds were
implemented. In July 2003, in a bid to improve liquidity, the government raised the
foreign ownership limitation for equities to 30% and totally removed the foreign
ownership limitation of a particular issuer’s bonds. On 8th August 2007, HoSTC
was renamed and upgraded to the Ho Chi Minh Stock Exchange.
Hanoi Stock Exchange (HNX), formerly the Hanoi Securities Trading Center
(Hanoi STC), was launched in March 2005 and handles auctions and trading of

stocks and bonds. The Hanoi STC was renamed to the Hanoi Stock Exchange in
2009. It was the second security trading center to open in Vietnam after Ho Chi


8

Minh City Securities Trading Center. The HNX hosts 377 companies by the end of
December 2013.

Figure 2.4 Number of listed companies – Source: HSX and HNX

According to the historical data, I noted that Vietnam market has had many
changes and volatiles in the past 13 years. In the first three years 2000-2003, firstly
market grew up strongly; VN-Index heated to the top of 571.04 points at June 25
2001, and fell deeply to 203.12 after 14 weeks, on October 5 2001. The downtrend
period took place with the lower Index at 180.73 points at March 11, 2002 and
down to 139.64 points in April 1, 2003. The second period 2004-2005, VN-Index
was moved between 213.4 and 307.05 points (Feb 6, 2004 to 307,05points on Dec
30, 2005). In the period 2006-2009, VN-Index reached to top on Feb 02 2007 at
1167.36 points before financial crisis. The lowest level felt on Feb 24, 2009 at 235.5
points. Index was at 504.63 on Dec 31, 2013.


9

Figure 2.5 VN-index history data – Source: VNDIRECT company

2.2 Theoretical framework
2.2.1 Market efficiency
Numbers of researchers have studied and mentioned about ―efficient

market‖. What it actually means in financial theory and its perspectives which
concerned to the research can be considered by the below literature.
The concept of market efficiency is mentioned by Haugen A. (2001) that if
new information becomes known about a particular company, how quickly do
market participants find out about the information and buy or sell the securities of
the company? How quickly do the prices of the securities adjust to reflect the new


10

information? If prices respond to all relevant new information in a rapid fashion, we
can say the market is relatively efficient.
The word ―efficient‖ refers to how fast the market prices change when new
information is released. Thus an efficient market is one in which the prices of the
stock fully reflect available information. ―All the empirical research on the theory of
efficient markets has been concerned with whether prices fully reflect particular
subsets of available information‖ (Fama et al. (1969)).
To definite the efficient market in the relationship among ―dividend
announcement, security performance and capital market efficiency‖,

Pettit has

mentioned that in an efficient market, current prices fully and without bias reflect
all published, widely available information.‖ It also implies that the return expected
from a security in one period is independent of all information available in the
previous periods since the price of stock already reflects the effect of this
information (Petit and Richardson ( 1972)).
The market is neither strictly efficient nor strictly inefficient. The question is
how efficient the market is. In order to measure what types of information,
encompassed by the total set of all available information, are reflected in stock

prices, Haugen A. (2001) grouped ―Information‖ into three groups which related to
the main three different forms of hypothesis. First, it represented all information
relevant to the valuation of a particular stock that is currently ―knowable‖. This
includes publicly available information about company, its industry, the domestic
and world macro economy. Second, information represents the part of the
information set that has been publicly announced and publicly available, for
examples the information of the accounting reports, the report of firms, announced
information relating to the state of the economy or information relevant to the
valuation of the firm. Third, represents any information relevant to the valuation of
the stock that can be learned by analyzing the history of market price of the stock


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2.2.2 Random walk
An efficient market implied a random. According to G.Burton (1999) ―a
random walk is one in which future steps or directions cannot be predicted on the
basis of the past actions‖. When we apply it to the stock market, it means that there
is a short run changes in stock market prices that cannot be predicted. Following to
G.Burton (1999), the technical analysis, earnings predictions or chart analysis are
useless in the random walk hypothesis.
G.Burton (1999) argued that ―if the flow of information is unimpeded, then
tomorrow’s price change in speculative markets will reflect only tomorrow’s
―news‖ and will be independent of the price change today. But ―news‖ by definition
is unpredictable and thus the resulting price changes must also be unpredictable and
random‖. ―Random walk‖ characterizes that the stock price changes are randomly
from previous prices and the investment returns are serially independent. ―The
earliest empirical work on the random walk hypothesis generally found that stock
price changes from time to time were essentially independent of (or unrelated to)
each other. Their probability distributions are constant through time.‖

The attempt to predict accurately the future stock price in order to sell or buy
in appropriate time is one of the investor’s most persistent endeavors. Technical or
fundamental analysis which is the two methods we have known up to now. While
fundamental analysis is the technique of applying the tenets of the firm-foundation
theory to the selection of individual stocks by attempt to estimate the stock’s
intrinsic value. The technical analysis is essentially the making and interpreting of
stock charts. They interest on the past, and both the movements of stock prices and
the volume of trading, for a clue to the direction of future change. Most of chartists
believe that the market is only 10 percent logical and 90 percent psychological,
oppositely fundamental analysis believe the market to be 90 percent logical and
only 10 percent psychological. (G.Burton (1999):117).


12

Following to the personal point of view, numbers of investors also claim that
the stock market adjusts so quickly and perfectly to new information that the
amateurs buying can do just as well as the professionals. This idea has certainly not
been believed by numbers of professional advisers or portfolio managers or
researchers who believe and support to the non-random walk theory. A presence or
an absence of random walk has important implications for not only researchers but
also for investors, trading strategies, portfolio or fund manager, assets pricing
models and consequently for financial and economic development.
With the development of the above theories, some contradicting studies of
anomalies have existed. Numbers of studies on the information of accounting
earnings and the link of this information to stock returns have been investigated for
more than two decades. The results indicated that stock prices are found that failing
to reflect fully information contained in earnings and in accrual and cash flows
components of earnings. Those studies verified mainly in the US market ( Bernard
and Thomas (1990); Sloan (1996); Richardson (2005))

Whether the application of ―random walk‖ theory is also valid in the
emerging markets as Vietnam or not is also a question. That is if the information of
earnings and its components do not effect to share prices in Vietnam stock market
as United States markets. The test of earnings and earnings components in related
with stock price in Vietnam stock market has not been extensively researched.

2.3 Prior empirical studies
2.3.1 Cash flows and accruals information in earnings
Capital market researchers have examined the empirical question as whether
cash flows or accrual component is to improve or reduce the ability of earnings to
measure firm performance. Major studies are tested whether stock prices accurately
reflect the economic performance of a firm by the earnings information.


13

Early research focused on whether accruals have information content. Ball
and Brown (1968) find that the association between security returns and earnings is
higher than the association between security returns and operating cash flows. Since
the difference between earnings and cash flows equals accruals, this result suggest
that accruals improve the ability of accounting income to reflect firm performance.
Research by Wilson (1986) , Rayburn (1986), Bowen et al. (1986),Wilson
(1986), Bernard and Skinner (1996) and Livnat and Zarowin (1990) showed that the
accrual and cash flow components of earnings have information content in
evaluating earnings.
Ali (1994) extends this previous research by allowing for nonlinear relations
between returns and the performance variables earning, accruals and cash flows. Ali
(1994) shows nonlinear relations between returns and earning, accruals and cash
flows.
Dechow (1994) results demonstrate that cash flows and accruals are the

measure of firm performance with hypothesis that the cash flow and accrual
components of earnings should have similar forecasting information. Sloan (1996)
challenges this hypothesis, suggesting that accruals may be less informative than
cash flows because they are less reliable. In support of this hypothesis, Sloan shows
that accruals are, on average, less informative than cash flows in forecasting future
earnings. The results indicate that earnings performance is contributed by the
accrual component of earnings lower persistence than earnings performance
contributed by the cash flow component of earnings. However, stock prices do not
fully reflect information in accruals and cash flows about future earnings.
The research discussed up till now examines whether cash flows and accruals
are significant in a regression where abnormal stock returns are the dependent
variable.


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2.3.2 Definition of earnings quality
The purpose of financial reporting is to provide information that is useful for
business and investment decisions. Given the focus on decision usefulness, the
quality of financial reporting is of interest of those who use financial reports for
contracting purposes and for investment decision making. A major interest in
financial reporting is the earnings quality, which is part of the overall financial
reporting quality.
Lev (1989) see quality as the characteristic of earnings and studies following
Lev (1989) finds that research on earnings quality is useful for equity valuation
model. The literature holds several definitions of earnings quality and some authors
see persistence of earnings is indicator of earning quality. Persistence has to be
understood in the sense that the company can maintain its profit in the long term, in
other words that current earnings provide a good indication of future earnings.
Sloan (1996) can be seen as the leader in this field and subsequent researches

provide evidence support for his work. Beneish and Vargus (2002) define earnings
quality in terms of persistence; Scott A. Richardson et al. (2001), (Li et al., 2011)
and Richardson (2005) see earnings quality in terms of persistence, but more
precisely the persistence of accruals; Ahmed et al. (1999) are aware of that earnings
persistence is a measure of earnings quality; Lev and Nissim (2004) interpret
earnings quality in terms of earnings persistence.; Hanlon (2005) finds that the
persistence of earnings is used to infer earnings quality. A number of survey papers
of earnings quality predate this review: Healy et al. (1999);

P.Dechow and

D.Skinner (2000); McNichols (2000); Fields et al. (2001); Imhoff (2003);Penman
(2003);Schipper and Vincent (2003); Dechow et al. (2010); …
Persistent earnings are often referred to as sustainable or core earnings,
where sustainable earnings are considered high quality earnings. Penman and Zhang
(2002) for instance define earnings quality:


15

“Reported earning is of good quality if it is a good indicator of future
earnings. Thus we consider high-quality earnings to be “sustainable earnings”
Correspondingly, when an accounting treatment produces unsustainable earnings,
we deem those unsustainable earnings to be of poor quality.”
In this research, when earnings quality is mentioned, it will be understood
that earning persistence as implication of earnings quality.
2.3.3 Measuring earning quality
There are several constructs that attempt to reflect earnings quality in finance
research. One construct typically used in financial accounting research to examine
earnings quality is related to the time series properties of earnings (e.g.Kormendi

and Lipe (1987), Sloan (1996)), in another word, it is earnings persistence.
Persistent earnings are associated with investor responses to reported
earnings. Earnings persistence is a value relevant characteristic of earnings as made
explicit in the Feltham and Ohlson (1995) valuation model.
It is commonly suggested in the finance literature that the time series
behavior of earnings are well estimated by a "random walk" model, that is, changes
in earnings cannot be predicted. Freeman et al. (1982) is one of the first studies that
examined this idea. Freeman et al. (1982) show that current book rate-of-return
provides a basis for predicting future earnings changes. A low rate-of-return implies
that earnings are "temporarily depressed"; similarly, a high rate-of- return implies
that earnings are ―unusually good‖. The evidence thus suggests that, the "random
walk hypothesis" is quite robust with the use of the past earnings information, and
earnings are considered to be predictable. This study suggests that future earnings
are predictable.
Ou and Penman (1989) expand this analysis by showing that not only
return-on-assets determines future earnings. They find that a large set of financial


16

statement items determine future earnings. They outline a method of financial
statement analysis by extracting figures from financial statements. The measure is
an indicator of the direction of future earnings. This suggests that future earnings
can be predicted by analyzing financial statements.
Kormendi and Lipe (1987) use firm-level regressions of current earnings on
last year’s earnings to estimate the slope-coefficient estimates of earnings
persistence. Kormendi and Lipe (1987) use firm-level regressions of current
earnings on last year’s earnings to estimate the slope-coefficient estimates of
earnings persistence. Kormendi and Lipe (1987) uses the following equation:

Where:
Earn(j,t) : Firm’s net income in year t; and
Earn(j,t-1) : Firm’s net income in year t-1
The measure capturing earnings persistence is based on the slope- coefficient
estimated (δ1, hereafter, Persist). Value of δ1 close to one (or greater than one)
indicates highly persistent earnings while values close to zero imply highly
transitory earnings. Persistent earnings are viewed as higher quality, while
transitory earnings are viewed as lower quality.
Sloan (1996) evaluates whether cash flow from operations and accruals have
different implications for the persistence of future. Sloan tested the ability of
earnings and earnings components to forecast future earnings. While, to measure
persistence, researchers generally estimate a regression of the future value of the
variable on its current value (Dechow et al. (2006), Richardson (2005) etc.) .


17

2.3.4 Link between earnings persistence and market pricing
An important question to analyst is how investors behave with information of
future earnings by pricing equities in stock market. Follow up with Dechow et al.
(2010), the empirical evidence is mixed in the literature:
The first prediction is the more persistent earnings will yield a higher equity
market valuation and, therefore, persistence will yield positive equity market
returns. Early research by Collins and Kothari (1989), Kormendi and Lipe (1987),
and Easton and Zmijewski (1989) provide evidence that more persistent earnings
have a stronger stock price response.
The second prediction is the researcher attempts to find that whether
investors are aware of the differential contribution of components on earnings
persistence. A key result is of Sloan (1996) who shows that investors are not fully
aware of the differing persistence levels of the accrual and cash flow components of

earnings. Follow up Sloan, a number of researches have extended his work by
providing more evidence of Sloan’s result such as Scott A. Richardson et al. (2001);
Richardson (2005); Dechow et al. (2006)
At this date, and to the best of my knowledge, there are not many published
papers investigating the relationship between earnings quality and stock return in
Vietnam context.


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SUMMARY
Chapter two give an attractive view of Vietnamese stock market, in which
inflation rate is controlled at low rate, price/earnings ratio is compelling in compare
with ASEAN nations and the developing of securities regulations and laws.
This chapter also reviews relevant literatures that show that the content of
cash flow and accruals is informative in earnings. Moreover, definition of earnings
quality is discussed and also given the measurement of this parameter. A review of
the concept of random walk, market efficiency which are also present which is a
basis for measuring the two tested hypotheses