Valuing Stocks With Earnings

By: Sebastian Hillenbrand and Odhrain McCarthy

Format:Print
| Language:English
| Pages:50

Abstract

We show that commonly used aggregate earnings are several times as volatile as stock prices over the last three decades. Movements in the price-earnings ratio are thus entirely explained by earnings growth and unrelated to future returns. As an alternative to the commonly used GAAP earnings, we propose using Street earnings to scale stock prices. Street earnings are smoother than stock prices and contain more information about future fundamentals because they exclude transitory items. We show that the Street price-earnings ratio can predict stock returns out of sample, for both the aggregate market and the cross-section of stocks. The choice of earnings also determines which subjective expectations can explain movements in the price-earnings ratio.