Taxable income, future profitability, and stock returns

• Date: 01 July 2020
• Author: Michael A. Mayberry,Bradley Blaylock,Bradley P. Lawson
• DOI: http://doi.org/10.1111/jbfa.12448
• Published date: 01 July 2020

DOI: 10.1111/jbfa.12448

Taxable income, future profitability, and stock

returns

Bradley Blaylock1Bradley P. Lawson2Michael A. Mayberry3

1John T.Steed School of Accounting, University

of Oklahoma, USA

2Spears School of Business, Oklahoma State

University, USA

3Fisher School of Accounting, University of

Florida, USA

Correspondence

MichaelA. Mayberry, University of Florida,

WarringtonCollege of Business, PO Box 117166,

Gainesville,Florida 32611-7166, USA.

Email:michael.mayberry@warrington.ufl.edu

Abstract

Prior research suggests that investors behave ‘as if’ taxable income

contains information about future performance by providing evi-

dence of a positive association between taxable income and stock

returns. We drawon the fundamental analysis literature and provide

direct evidence on this assertion by examining whether taxable

income predicts future pretax performance. We find that taxable

income positively predicts future pretax cash flows, pretax book

income, and ‘Street’ pretax earnings, suggesting that taxable income

provides incremental information to book income regarding perfor-

mance. Moreover, we find a positive association between taxable

income and analysts’ pretax forecasts, consistent with analysts

utilizing the information in taxable income when forming earnings

expectations.We do not find an association between taxable income

and future analyst forecast errors, implying analysts do not overre-

act or underreact to taxable income’s performance signal. Overall,

we find that taxable income provides a signal of fundamental value

and corroborate the implications of prior research.

KEYWORDS

analyst forecasts, fundamental analysis, taxable income

JEL CLASSIFICATION

G32, H25, H32, M41

1INTRODUCTION

Using a fundamental analysis framework, we investigatethe information content of taxable income through its associ-

ation with future, pretax performance.1Prior research consistently finds a significantly positive association between

contemporaneous stock returns and taxable income, both in the United States (Ayers,Jiang, & Laplante, 2009; Hanlon,

Laplante, & Shevlin, 2005) and elsewhere (Kerr, 2019). Prior research interprets this positive association as taxable

income serving as a proxy for profitability.That is, taxable income captures economic fundamentals not summarized

1We refer to taxable income in lieu of ‘estimatedtaxable income’. Firms are not required to disclose their taxable income. However, estimates of it may be

derivedfrom financial statement data. These estimates of taxable income are highly correlated with actual taxable income (Plesko, 1999, 2006).

858 c

2020 John Wiley & Sons Ltd wileyonlinelibrary.com/journal/jbfa JBus Fin Acc. 2020;47:858–881.

BLAYLOCKET AL.859

in pretax book income to a greater extent than it matches tax burdens to economic events (Thomas & Zhang, 2014).

Yet, as recognized by the fundamental analysis literature,stock prices are a function of both cash flows and discount

rates in the discounted cash flow model (Abarbanell & Bushee, 1997; Bradshaw,Richardson, & Sloan, 2001; Penman,

1992). Thus, prior research implies, but does not directly test for, an association between taxable income and future

performance.

Whether taxable income is associated with pretax, future income is an empirical question. Specifically, it maywell

be the case that the prior research documenting a link between taxable income and stock returns simply captures a link

between taxable income and firm risk, rather than with future levels of profitability per se. Taxable income may there-

fore be positively related to stock returns because higher taxable income implies lower discount rates, i.e. a reduction

in the denominator of the discounted cash flow model. A negative relation between taxable income and discount rates

could arise for at least two reasons. First, if taxable income does capture dimensions of economic performance not

summarized by book income, it should also predict discount rates.2Increases in performance—whether measured by

book income or taxable income—decrease discount rates because they lower investoruncertainty by signaling higher,

future earnings (Callen, Livnat, & Segal, 2009; Penman & Yehuda,2019). Indeed, Henry (2018) finds increases in tax

expense are negatively related to discount rate shocks. Second, taxable income can be negatively related to discount

rates due to tax avoidance. For instance, lower taxable income in the form of higher tax avoidanceis associated with

incrementally higher risk of future negative outcomes, such as fines, penalties, and litigation costs, as well as consumer

backlash and boycotts(Austin & Wilson, 2017; Hanlon & Slemrod, 2009). Moreover, investors appear sensitive to these

risks as there is some evidence that greater tax avoidanceincreases firms’ costs of capital (Cook, Moser, & Omer,2017;

Hutchens & Rego, 2015; Taylor, Richardson, Al-Hadi, & Obaydin, 2018).3

Since the prediction of accounting earnings and cash flows is the central task of fundamental analysis (Abarbanell

& Bushee, 1997; Bradshaw et al., 2001; Quirin, Berry, & O’Brien, 2000), we begin byexamining how taxable income

relatesto future performance. We measure performance along three different dimensions: (1) future pretax cash flows,

(2) future pretax book income, and (3) future ‘Street’ pretax earnings.4Using a sample of firms from 2002 to 2016, we

regress one, two, and three-year ahead future performance measures on taxable income. We control for either pretax

book income or its components (i.e. cash flows and accruals) in all specifications. Overall, we find that taxable income

is positively associated with future pretax cash flows, pretax book income, and Street pretax earnings over a three-

year horizon. For example,we find a one standard deviation increase in taxable income predicts a between 9.18% and

24.74% increase in future performance for yeart+1. The positive associations that we find suggest that taxable income

predicts future period performance and contains information that is incremental to book income, pretax accruals, and

pretax cash flows. Overall, our results are consistent with taxable income being a signal of firms’ fundamental values.

That is, higher taxable income predicts stronger future performance.

We next examinewhether capital market participants understand the relation between taxable income and future

performance. Specifically, we assess whether analysts incorporate taxable income’s future performance information

into their forecasts of future pretax earnings. Following Bradshaw et al. (2001), we regress forecasts of future pretax

earnings for years t+1, t+2, and t+3 on taxable income, as well as pretax book income and its components. We find

a significantly positive association between taxable income and future pretax forecasts across all time horizons. This

evidence suggests that taxable income not only predicts future pretax performance, but also influences analysts’

2Thus, if taxable income predicts both higher performance and lower discount rates, one cannot disentangle the extent to which taxable income predicts

performancefrom a stock return association test.

3Weemphasize that while we provide evidence consistent with taxable income predicting performance, we do not rule out or refute any association between

taxableincome and discount rates.

4We note that we measure performance on a pretax rather than an after-tax basis in our primary specifications. In addition to serving as a proxyfor prof-

itability,taxable income may also serve a matching role. That is, taxable income may be informative about performance because of its ability to predict future

tax burdens. Our intention is to directly test the proxy-for-profitability role of taxable income. However,we measure performance on an after-tax basis in

additionalanalysis.