Using Financial Statement Analysis To Explain the Variation In Firms' Earnings-Price Ratios

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Conference Proceeding

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The earnings-price (E/P) ratio represents a market-based ranking of a firm's value relative to its earnings. Entities of like size operating in the same industru and enjoying similar current earnings, however may experience significantly differnet E/P ratios. This occurs because share price reflects the market's perceptions of the future earnings (and cash flow) potential of a company rather than its present earnings. Indeed, significant research exists indicating that the E/P ratio acts as a predictor of future earnings growth. Firms with high E/P shares often experience low earnings growth, while companies with low E/P stock have high earnings growth. The question that is largely ignored in the literature, though, is what factors are useful in explaning the variation among firms' E/P ratios? More specifically, other than current earnings, what variables influence the market's expectations concerning an entity's future earnings potential?

Ou and Penman (1989) demonstrate that several traditional financial statement variables can be used to predict whether a company will experience an increase or decrease in one-year-ahead earnings. In addition, Anderson and Brooks (2006) note that four primary factors influence E/P ratios (i.e., year, industry, size, and idiosyncratic effects). Idiosyncratic effects represent those factors unique to individual entities. Controlling your year, industry, and size, the current study develops ordinary least squares regression models to explain the variation in firms' E/P ratios using financial statement variables to caputre the idiosyncratic effects. The final model contains a parsimonious set of independent variables that explains a large portion (i.e., 62%) of the variation in the E/P ratios among firms. The primary contribution of this study lies not in the identification of a particular set of variables but rather in the overall finding that traditional financial statement analysis can be used to remove much of the mystery surrounding how the market values a firm's stock relative to its earnings.

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Allied Academies International Conference





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