Yale School of Management
This paper analyzes a dynamic general equilibrium model to study the impact of earnings surprises on contemporaneous stock returns. The model shows that earnings surprises can affect stock returns through two channels. On the one hand, earnings surprises affect the expected future earnings of the stock and so induce a positive earnings-returns correlation (cash flow effect). On the other hand, earnings surprises affect discount rates and so induce a negative earnings-returns correlation (discount rate effect). The authors show that the first channel is likely to dominate for most individual stocks, while the second channel can dominate for the aggregate stock market.