Reported Earnings-True Measure Of Stock Performance

Variability Of Earnings & Risk Assessment-

Anything that increases the variability of earnings (e.g., recession, write-offs or poor business decisions) increases the unpredictability of earnings and therefore increases the risk of the stock.

A focus on definitions of earnings other than reported earnings may cause investors to underestimate the risk of a company.

If investors value a company “ Up “ the income statement and as a result believe the company is of higher quality than it might truly be, the company’s valuation will be higher & the cost of capital lower.

Investors should generally prefer to value companies “ Down “ the  income statement in order to get a better assessment of the risks of the company and to be compensated correctly for those risks.

During the Technology Bubble when investors were valuing companies on price-to-sales ratios, investors had simply handed the tug-of-war rope to the companies without even putting up a fight.

Search For Grail-

There has been strong evidence amassed regarding the efficacy of incorporating reported earnings into stock selection and style rotation strategies , but investors continual search for the ‘ Holy Grail ‘ puzzles many.

It is yet to be found strategies based on any of these supposedly superior measures that outperform reported earnings, but investors’ disbelief and their searches for “New & Improved “measures continue.

The Results-

During the last several years, valuing companies “Down “the income statement would have clearly benefitted portfolio performance.

15-Year Annualized Return Of Selected Value Strategies

Low P/E – 15.8%

Low P/CF - 13.6% (Price To Cash Flow)

Low P/S – 11.4% (Price To Sales)

Average 12-Month Price Return Of Selected Value Strategies

Low EV/EBITDA – 12.3% (Enterprise Value To EBITDA)

Low P/E – 16.7%

Low P/CF – 14.8%

Low P/B- 13.7% (Price To Book Value)

Low P/S- 13%

DDM-12.7%

Summary-

One of the prime tenets is that reported earnings are the ultimate drivers of stock prices.

Focusing on definitions of earnings other than reported earnings may cause investors to underestimate the risk of a company.

A hypothetical “Tug-Of-War “exists between the investor and company over a company’s valuation. Companies generally attempt to guide investors to value their stocks as far up the income statement as possible in order to better mask variability.

Why search for a new “Holy Grail “? We have yet to find strategies based on any of these supposedly superior measures that outperform reported earnings, but investors’ disbelief and their searches for “New & Improved” measures continue.

Questions-

Q1. Does low P/E wok across the markets equally?

Q2. P/E may work best in the US, but may be flawed when applied across borders. Enterprise value to EBITDA may work better. Your thoughts?

Q3. Were the ratios you used forward-looking or trailing?

Q4. If purchase of low P/E consistently works with and across markets, what does that say about the efficiency of markets? Why does the strategy work?