{"id":10991,"date":"2021-02-11T05:00:28","date_gmt":"2021-02-11T05:00:28","guid":{"rendered":"https:\/\/analystprep.com\/study-notes\/?p=10991"},"modified":"2025-12-12T20:31:18","modified_gmt":"2025-12-12T20:31:18","slug":"mean-reversion-earnings","status":"publish","type":"post","link":"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/mean-reversion-earnings\/","title":{"rendered":"Mean Reversion in Earnings"},"content":{"rendered":"<script type=\"application\/ld+json\">\r\n{\r\n  \"@context\": \"https:\/\/schema.org\",\r\n  \"@type\": \"QAPage\",\r\n  \"mainEntity\": {\r\n    \"@type\": \"Question\",\r\n    \"name\": \"Elodie Juliet, a research analyst, is analyzing the earnings quality for ABC Ltd. She compares ABC\u2019s financial statements with those of a peer competitor. Both companies have similar, above-average returns on equity (ROE), although ABC Ltd. has a higher cash flow component of earnings. Juliet applies the mean reversion concept in her forecasts of the two firms\u2019 future ROE.\\n\\nJuliet should forecast that the return on equity (ROE) for ABC Ltd. is most likely to decrease:\",\r\n    \"acceptedAnswer\": {\r\n      \"@type\": \"Answer\",\r\n      \"text\": \"The correct answer is C.\\n\\nAccording to the mean reversion phenomena, the high ROE for both firms should revert towards the average (mean). ABC Ltd. has a higher cash flow to its earnings (returns) than the peer company. This implies that its high return on common equity is likely to persist longer than that of the peer company.\"\r\n    },\r\n    \"suggestedAnswer\": [\r\n      {\r\n        \"@type\": \"Answer\",\r\n        \"text\": \"Faster than that of the peer competitor.\"\r\n      },\r\n      {\r\n        \"@type\": \"Answer\",\r\n        \"text\": \"At the same rate as the peer competitor.\"\r\n      },\r\n      {\r\n        \"@type\": \"Answer\",\r\n        \"text\": \"Slower than that of the peer competitor.\"\r\n      }\r\n    ],\r\n    \"answerCount\": 3\r\n  }\r\n}\r\n<\/script>\r\n<script type=\"application\/ld+json\">\r\n{\r\n  \"@context\": \"https:\/\/schema.org\",\r\n  \"@type\": \"VideoObject\",\r\n  \"name\": \"Evaluating Quality of Financial Reports (2025 Level II CFA\u00ae Exam \u2013 FRA\u2013Module 5)\",\r\n  \"description\": \"Prep Packages for the CFA\u00ae Program offered by AnalystPrep (study notes, video lessons, question bank, mock exams, and much more).\",\r\n  \"uploadDate\": \"2022-01-01\",\r\n  \"thumbnailUrl\": \"https:\/\/i.ytimg.com\/vi\/dVSE9osby10\/hqdefault.jpg\",  \r\n  \"contentUrl\": \"https:\/\/www.youtube.com\/watch?v=dVSE9osby10\",\r\n  \"embedUrl\": \"https:\/\/www.youtube.com\/embed\/dVSE9osby10\",\r\n  \"duration\": \"PT57M17S\"\r\n}\r\n<\/script>\r\n\r\n<p><iframe loading=\"lazy\" src=\"\/\/www.youtube.com\/embed\/dVSE9osby10\" width=\"611\" height=\"343\" allowfullscreen=\"allowfullscreen\"><\/iframe><\/p>\r\n\r\n<p>Recall from the previous section that earnings at extreme levels, both high and low, tend to revert to normal levels over time, a phenomenon called mean reversion. This is a typical characteristic of competitive markets. When a company realizes low earnings, it will abandon its harmful value projects, resulting in improved earnings. Conversely, when it realizes abnormally high profits, it attracts competition leading to a reduction in prices.<\/p>\r\n<p>Because of mean reversion, analysts should not expect severe earnings (high or low) to continue indefinitely. Earnings comprise of cash flows and accruals. They are more sustainable and persistent when the cash flows dominate earnings. Additionally, when earnings have a significant accruals component, mean reversion occurs faster\u2014and even more so when the accruals are mostly discretionary.<\/p>\r\n<blockquote>\r\n<h2>Question<\/h2>\r\n<p>Elodie Juliet, a research analyst, is analyzing the earnings quality for ABC Ltd. She compares ABC\u2019s financial statements with those of a peer competitor. Both companies have similar, above-average returns on equity (ROE), although ABC Ltd. has a higher cash flow component of earnings. Juliet applies the mean reversion concept in her forecasts of the two firms\u2019 future ROE.<\/p>\r\n<p>Juliet should forecast that the return on equity (ROE) for ABC Ltd. is <em>most likely<\/em> to decrease:<\/p>\r\n<p>\u00a0 \u00a0 A. Faster than that of the peer competitor.<\/p>\r\n<p>\u00a0 \u00a0 B. At the same rate as the peer competitor.<\/p>\r\n<p>\u00a0 \u00a0 C. Slower than that of the peer competitor.<\/p>\r\n<h4>Solution<\/h4>\r\n<p><strong>The correct answer is C.<\/strong><\/p>\r\n<p>According to the mean reversion phenomena, the high ROE for both firms should revert towards the average (mean). ABC Ltd. has a higher cash flow to its earnings (returns) than the peer company. This implies that its high return on common equity is likely to persist longer than that of the peer company.<\/p>\r\n<p><strong>A and B are incorrect.<\/strong>\u00a0The peer company has a higher accruals component, so it is likely to revert more quickly than ABC Ltd.<\/p>\r\n<\/blockquote>\r\n<p>Reading 15: Evaluating Quality of Financial Reports\u00a0<\/p>\r\n<p><em>LOS 15 (g) Explain mean reversion in earnings and how the accruals component of earnings affects the speed of mean reversion.<\/em><\/p>","protected":false},"excerpt":{"rendered":"<p>Recall from the previous section that earnings at extreme levels, both high and low, tend to revert to normal levels over time, a phenomenon called mean reversion. This is a typical characteristic of competitive markets. When a company realizes low&#8230;<\/p>\n","protected":false},"author":5,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[102,312],"tags":[216,313,171],"class_list":["post-10991","post","type-post","status-publish","format-standard","hentry","category-cfa-level-2","category-financial-reporting-and-analysis-fra","tag-cfa-level-2","tag-financial-reporting-and-analysis-fra","tag-mean-reversion-in-earnings","blog-post","no-post-thumbnail","animate"],"acf":[],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v26.9 - https:\/\/yoast.com\/product\/yoast-seo-wordpress\/ -->\n<title>Mean Reversion in Earnings - CFA, FRM, and Actuarial Exams Study Notes<\/title>\n<meta name=\"description\" content=\"Learn how the accruals component affects the speed of mean reversion, helping analysts forecast future returns on equity (ROE) for companies.\" \/>\n<meta name=\"robots\" content=\"index, follow, max-snippet:-1, max-image-preview:large, max-video-preview:-1\" \/>\n<link rel=\"canonical\" href=\"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/mean-reversion-earnings\/\" \/>\n<meta property=\"og:locale\" content=\"en_US\" \/>\n<meta property=\"og:type\" content=\"article\" \/>\n<meta property=\"og:title\" content=\"Mean Reversion in Earnings - 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