35 The Response of Stock Prices to Permanent and Transitory Shocks to Accounting Earnings Chiawen Liu * Assistant Professor, Department of Accounting Yuan Ze University Taychang Wang Professor, Department of Accounting National Taiwan University ABSTRACT The purpose of this research is to use stock return and price-earnings ratio to study the impacts of earnings shocks on stock prices. We assume that the stochastic process of earnings and stock price consist of a permanent and a transitory components. What distinguishes this paper from most accounting and finance research is that the permanent part of stock price or earnings need not be random walk. The stock valuation model in Miller and Modigliani (1961) and Miller and Rock (1985) helps link a company’s earnings and stock price. Since we do not assume that the permanent part of earnings is random walk, there will be an identification problem with building a bivariate time series model, which can be handled by invoking the aforementioned theoretical relation. Through variance decomposition and impulse response analysis, we are able to see how stock return and price-earnings ratio dynamically respond to the permanent and temporary shocks to accounting earnings, which tells us how stock returns are determined. The results of the analysis show that a considerable part of the variation in stock returns can be explained by the transitory shocks to earnings, which suggests that the investors fail to distinguish between the permanent and transitory parts of earnings unmistakably. The mean-reverting behavior of stock returns can also be explained by the existence of a significant temporary component in the stock returns. The price-earnings ratios are mainly explained by the temporary shocks to earnings. This signifies that, induced by the temporary component of earnings, stock prices respond excessively to earnings. Keywords: Permanent earnings; Transitory earnings; Stock prices; Bivariate time series model 1. INTRODUCTION It is clear that all the events that may create or destroy a company’s value will eventually reflect in earnings. The market value of a company approximately equals the book value during the start-up and the liquidating periods. In the long run there must be a fundamental connection between the changes in market value (stock return) * We are grateful for the support from National Science Council (Grant No. NSC 88-2416-H-002-010). pp. 35-54