Quality of earnings inferred from the profitability of EP trading rules

In this study, we rely on the profitability of EP (earnings‐to‐price ratio) trading rules to infer the quality of earnings. Under the extrapolation hypothesis (Lakonishok, Shleifer, and Vishney 1994), the profitability of an EP trading rule that is based on higher quality earnings (i.e., earnings that are more representative of the fundamental profit generating power of the firm), should have higher return predictability. Among the four specifications of the EP ratio examined, i.e., the conventional earnings‐to‐price, core earnings‐to‐price, gross margin‐to‐price, and ex‐ante earnings‐to‐price, we find that core earnings‐to‐price and gross margin‐to‐price significantly outperform the other two in predicting returns. This result suggests that investors view the earnings components that reflect the fundamental operation of the firm, such as sales, to be of higher quality than the rest. Further, the evidence indicates that an EP trading rule based on gross margin‐to‐price generates an abnormal return not fully explained by the market, size, and book‐to‐market.