Modeling Sustainable Earnings and P/E Ratios with Financial Statement Analysis

Forthcoming

57 Pages Posted: 31 Jul 2002 Last revised: 17 Aug 2011

See all articles by Stephen H. Penman

Stephen H. Penman

Columbia Business School - Department of Accounting

Xiao-Jun Zhang

University of California, Berkeley - Accounting Group; China Academy of Financial Research (CAFR)

Date Written: June 1, 2002

Abstract

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.

Keywords: sustainable earnings, earnings quality, financial statement analysis, price-earnings ratios

JEL Classification: M41, G12, G14, G29

Suggested Citation

Penman, Stephen H. and Zhang, Xiao-Jun, Modeling Sustainable Earnings and P/E Ratios with Financial Statement Analysis (June 1, 2002). Available at SSRN: https://ssrn.com/abstract=318967 or http://dx.doi.org/10.2139/ssrn.318967

Stephen H. Penman (Contact Author)

Columbia Business School - Department of Accounting ( email )

3022 Broadway
New York, NY 10027
United States
212-854-9151 (Phone)
212-316-9219 (Fax)

Xiao-Jun Zhang

University of California, Berkeley - Accounting Group ( email )

545 Student Services Building
SPC 1900
Berkeley, CA 94720
United States
(510) 642-4789 (Phone)
(510) 642-4700 (Fax)

China Academy of Financial Research (CAFR)

1954 Huashan Road
Shanghai P.R.China, 200030
China

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