Modeling Sustainable Earnings and P/E Ratios with Financial Statement Analysis
Stephen H. Penman
Columbia University - Department of Accounting
University of California, Berkeley; China Academy of Financial Research (CAFR)
June 1, 2002
This paper yields a summary score that informs about the sustainability (or persistence) of earnings and about the trailing P/E ratio. The score is delivered from a model that identifies unsustainable earnings from the financial statements by exploiting accounting relations that require that unsustainable earnings leave a trail in the accounts. The paper also builds a P/E model that recognizes that investors buy future earnings, so should pay less for current earnings if those earnings cannot be sustained in the future. In out-of-sample prediction tests, the analysis reliably identifies unsustainable earnings, and also explains cross-sectional differences in P/E ratios. The paper also finds that stock returns are predictable when traded P/E ratios differ from those indicated by our P/E model.
Number of Pages in PDF File: 57
Keywords: sustainable earnings, earnings quality, financial statement analysis, price-earnings ratios
JEL Classification: M41, G12, G14, G29working papers series
Date posted: July 31, 2002 ; Last revised: August 17, 2011
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