Prior research has demonstrated that the most recent annual change in a company’s net operating assets can be used to reliably predict the company’s future earnings and stock returns. One paper argues that a slightly different measure — the level of net operating assets — is a superior predictor of future earnings and stock returns.
The authors of that paper — David A. Hirshleifer, Kewei Hou, Siew Hong Teoh and Yinglei Zhang — contend that the most recent annual change in net operating assets is only a fragmentary indicator and that the level of net operating assets provides a more comprehensive measure.
Our primary objective in this note is to make a simple point. A level deflated by a lagged level is equivalent to a change. As such, the authors’ claim that their measure is more comprehensive because it picks up the cumulative amount of past changes is incorrect. Similar to previous research, their variable essentially just measures the most recent annual change in net operating assets.
We show that the authors’ measure differs in subtle ways from the change in net operating variable used in previous research. As such, its ability to predict future earnings and stock returns differs somewhat from the measures used in previous research. The signs and the magnitudes of these differences depend on the sample period and research design. We emphasize that these differences cannot be attributed to the ability of the authors’ variable to capture cumulative past changes in net operating assets. Rather, it is just an alternative way of capturing the most recent annual change in net operating assets.