Journal of Business Finance & Accounting, 36(9) & (10), 1148–1179, November/December 2009, 0306-686X doi: 10.1111/j.1468-5957.2009.02165.x Does Volatility Improve UK Earnings Forecasts? Nikola Petrovic, Stuart Manson and Jerry Coakley ∗ Abstract: We investigate the relation between UK accounting earnings volatility and the level of future earnings using a unique sample comprising some 10,480 firm-year observations for 1,481 non-financial firms over the 1985–2003 period. The findings confirm the in-sample result of an inverse volatility-earnings relation only for the 1998–2003 sub-period and for the most profitable firms. The out-of-sample forecast accuracy for the top earnings quintile improves when volatility is added as a regressor to a model including only lagged earnings. The findings are consistent with the over-investment hypothesis and the view that the earnings of the most volatile firms tend to mean revert more rapidly. Keywords: earnings volatility, under-investment, over-investment, earnings persistence 1. INTRODUCTION The importance of earnings volatility for a firm’s value has long been recognized in the accounting and finance literature. Such volatility can have an impact either through its relation to the discount rate or to expected cash flows (earnings) in valuation models. Most existing research has focused on the link to the discount rate or cost of capital. One established result in this context is a positive relationship between earnings volatility and different measures of the cost of capital. 1 Collins and Kothari (1989) and Barth, Elliott and Finn (1999) document that the market reaction to unexpected earnings decreases as the earnings volatility increases. A few recent studies directly test the link between firm value and earnings volatility for the US market. Barnes (2001) find ∗ The first author is from the School of Economics, Finance and Management, University of Bristol. The second author is from the Essex Business School, University of Essex. The third author is from the Essex Finance Centre and Essex Business School, University of Essex. They are grateful for the insightful comments and suggestions of Martin Walker (editor), an anonymous referee, Ana Gisbert, and participants at the EFMA 2006 Conference at Complutense University, Madrid. Nikola Petrovic gratefully acknowledges the financial support provided by the UK Overseas Research Studentship Award Scheme and Essex Business School at the University of Essex for a PhD scholarship. (Paper received April 2006, revised version accepted July 2009, Online publication October 2009) Address for correspondence: Stuart Manson, Essex Business School, University of Essex, UK. e-mail: manss@essex.ac.uk 1 See for example, Beaver, Kettler and Scholes (1970), Minton and Schrand (1999), Gebhardt, Lee and Swaminatham (2001) and Francis, LaFond and Olsson (2004). C  2009 The Authors Journal compilation C  2009 Blackwell Publishing Ltd, 9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA. 1148 Journal of Business Finance & Accounting