Previous articles in this journal have argued that sustainable income — GAAP income minus realized holding gains — provides a better indication of a firm’s performance than GAAP income. The question naturally arises: Which measure of income correlates more closely with stockholder returns?
The authors examined 80 companies, representing nine major industry groups, over the six-year period 1972 through 1977, inclusive. Averaged over the 80 companies, the correlation between changes in sustainable income and stock returns was greater than the correlation between changes in GAAP income and stock returns. There is only one chance in eight that the magnitude of the observed difference would have been as large as it was if the true correlations were in fact equal.
Correlations differed sharply across industry groups, however. Companies in some groups tend to use LIFO and accelerated depreciation for reporting under GAAP, hence report a GAAP income figure that is virtually identical to sustainable income.