Market Rewards Associated with Patterns of Increasing Earnings

This study demonstrates that firms with patterns of increasing earnings have higher price-earnings multiples than other firms,1 and that this relation persists after controlling for growth and risk using proxies identified in previous research. 2 However, price-earnings multiples decline significantly when earnings decrease after a previous pattern of increasing earnings. Our inquiry is motivated by the observation that many managers seem focused on maintaining steadily increasing earnings. However, the regression equations forming the basis for our analyses derive from two valuation models, which derive from expected future dividends; we obtain consistent findings from analyses based on both models. The first is the permanent earnings model of Miller and Modigliani [1966], which relates prices to earnings under restrictive assumptions, including perfect and complete markets and that accounting earnings are a proxy for permanent earnings. The second is the accounting-based valuation model of Ohlson [1995], which relates prices to earnings and book values of equity. Cross-sectional differences in growth, risk, and earnings persistence can affect the earnings multiple in both models, so if earnings patterns capture any of these factors, the models provide a theoretical basis for increasing earnings patterns to be priced.[ read more ]