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Innovation, Future Earnings, and Market
Efficiency
FENG GU*
This study examines whether patent citation impact, a leading indicator
of technology firms’ innovation capabilities, is associated with future earnings
and whether this association is appropriately reflected in stock prices
and analysts’ earnings forecasts of patent-rich companies. The results
indicate that change of patent citation impact is positively associated with
future earnings, particularly in industries with relatively short time lags
between technological advances and profit realization (e.g., computers,
electronics, and medical equipment). The strength of this relation also
significantly increases with time for up to five years in the future. Market
participants, including investors and analysts, however, do not fully incorporate
the implication of enhanced innovation capabilities for future
earnings into stock prices and earnings forecasts. This bias is significantly
associated with future abnormal stock returns.
1. Introduction
A number of recent studies have been devoted to examining the valuerelevance
of nonfinancial leading indicators, motivated by the increasing importance
of these indicators and the economic phenomenon they are associated with—
the rise of intangible assets in size and contribution to corporate growth (e.g.,
AICPA [1994]; FASB [2001]; Upton [2001]; SEC [2001]; Lev [2001]).1 Valuerelevance
studies generally assume that the documented association between non-
*Department of Accounting & Law, Jacobs Management Center, State University of New York
at Buffalo
I am grateful for the helpful comments and suggestions from an anonymous reviewer, Chandra
Seethamraju (discussant), participants at the 2005 JAAF/KPMG Foundation conference and workshop
participants at Old Dominion University. All errors are my own.
1. Examples of nonfinancial leading indicators examined in value-relevance studies include market
penetration rate (Amir and Lev [1996]),...