Is the asymmetric impact of aggregate revenue and aggregate earnings on the stock index in accordance with the prospect theory?

• Published date: 01 March 2022
• Author: Vinay Goyal,Subrata K. Mitra
• Date: 01 March 2022
• DOI: http://doi.org/10.1111/irfi.12350

ORIGINAL ARTICLE

Is the asymmetric impact of aggregate revenue

and aggregate earnings on the stock index in

accordance with the prospect theory?

Vinay Goyal

1

| Subrata K. Mitra

2

1

SP Jain Institute of Management & Research,

Andheri West Mumbai, Maharashtra, India

2

Institute of Management Technology (IMT)

Nagpur, Nagpur, Maharashtra, India

Correspondence

Vinay Goyal, SP Jain Institute of

Management & Research, Andheri West,

Mumbai, Maharashtra, India.

Email: profvinaygoyal@gmail.com, vinay.

goyal@spjimr.org

Abstract

This study examines the asymmetric impact on the US S&P

500 stock index due to the changes in aggregate revenue

and aggregate earnings of the index constituents. We

applied the nonlinear autoregressive distributed lag model

of Shin et al. (Festschrift in honor of Peter Schmidt, 2014,

Springer, 281–314) to determine the long run and the short

run asymmetries. The presence of a cointegrating relation-

ship confirms that despite short-run departures, the rela-

tionship remains stable in the long run. The nonlinear

autoregressive distributed lag model estimates that when

aggregate revenue increases by $1,000, the S&P index is

expected to increase by 8.64 points, but when the aggre-

gate revenue decreases by the same amount, the market

decreases by 31.4 points. Similarly, when the aggregate

income increases by $1,000, the S&P index is likely to

increase by 22.59 points, whereas if the aggregate income

decreases by the same amount, the index would decrease

more steeply by 32.11 points. Based on these findings, the

present study establishes an asymmetric relationship

between two important accounting variables. The study

also confirms the validation of prospect theory in the S&P

index valuation of its constituent stocks' financial perfor-

mance. Aside from using the model on aggregate data for

the S&P index, we also analyzed 28 individual US stocks to

validate the findings.

Received: 22 December 2019 Revised: 3 March 2021 Accepted: 23 March 2021

DOI: 10.1111/irfi.12350

© 2021 International Review of Finance Ltd.

200 International Review of Finance. 2022;22:200–222.wileyonlinelibrary.com/journal/irfi

KEYWORDS

aggregate earnings, aggregate revenue, asymmetric impact,

nonlinear autoregressive distributed lag model, prospect theory,

US S&P 500 stock index

1|INTRODUCTION

Many accounting and financial variables have been identified in the literature that influences individual stock prices

and the overall market index. However, the investors' most valued accounting and finance variables remain unan-

swered (Barton, Hansen, & Pownall, 2010). Accounting research primarily concentrates on the value relevance of

financial and published accounting data. As the firm's profitability is the investors' primary interest, revenue and net

income undoubtedly become essential variables that influence the stock prices.

Among several financial and nonfinancial attributes that influence the stock market index, the revenue (top line)

and the profits or earnings (bottom line) are projected to be significant indicators of the firm's financial performance

and growth. Although several studies have documented the importance of nonfinancial variables such as environ-

mental, social, and governance indicators, corporate governance norms, regulatory compliances, and growth pros-

pects the significance of financial performance, mainly the revenue and earnings of the firm, remained high.

Jegadeesh and Livnat (2006a, 2006b) and Ertimur, Livnat, and Martikainen (2003) postulate that the individual stock

price and market index respond to both revenues and earning information. Subsequently, an extensive research body

examines how stock prices or indexes react to their revenue and earnings announcement.

Traditionally, the financeliterature suggests usingfirm-level studiesto measure the impact of accounting and finan-

cial variables onthe capital market performance; until recently, the research concentrated on aggregate-level analysis.

Furthermore, reviews by Chen (1991), Anilowski, Feng, and Skinner (2007), Ball, Sadka, and Sadka (2009), Sadka and

Sadka (2009), andHe and Hu (2014) document the importance of aggregateearnings by suggesting thatthe impact of

aggregate earning changes are more predictable rather than individual variations of the firm. Furthermore, Ball and

Sadka (2015) document that aggregate level analysis is essential to financial analysts and policymakers. Manyaccount-

ing and finance studiesare now concentrating on aggregate-level accountingvariables rather than firm-level variables.

The firm-levelearnings and revenue metricsmay be misleading indicators and maynot be relevant for diversified inves-

tors. Following the studies by Arif and Lee (2014), Sadka and Sadka (2009), Zolotoy, Frederickson, and Lyon (2017),

Gallo, Hann,and Li (2016), Gkougkousi(2014), He and Hu (2014),Shivakumar (2007),and Shivakumar and Urcan(2014),

the present study views the aggregate earnings and the aggregate revenue as a more robust indicator to understand

the impacton the capital market ratherthan firm-level studies.

The fact remains that organizational growth prospects in the future and technological growth and product devel-

opment will impact the firm's change in revenue and earnings. The resultant influence on the firm's stock price due

to such change is expected to be in the same direction. If this relationship is linear and symmetric, then a decrease in

the firms' aggregate revenues and aggregate earnings, the market index decreases. In the case of an increase in the

firm's aggregate revenue and earnings, the market index increases. Several prior studies have validated the effect on

stock prices and market index due to a change in the firm's revenue and earnings. An improvement in financial per-

formance is likely to improve market sentiments and increase the stock index. Contrarily, a decrease in the firm's

financial performance would lower the index. This paper's research question is whether changes in market valuation

are symmetric for increasing and decreasing its financial performance. We consider the firm's aggregate revenue and

aggregate earnings in the present study and attempt to analyze whether changes in these variables asymmetrically

affect market performance.

Furthermore, we consider prospect theory (Kahneman & Tversky, 1979, 2013), which embraces that investors

tend to value gains and losses differently from one another. As a result, their decisions are skewed more on apparent

losses rather than on profits. Although investors invest more in perceived gains, their reaction is high regarding the

GOYAL AND MITRA 201