Valuing Stocks With Earnings

Abstract

To address the excess volatility puzzle – the excessive movements in stock prices – researchers often study movements in valuation ratios. However, we demonstrate that movements in valuation ratios based on fundamental measures with high transitory volatility, such as commonly used earnings measures, are uninformative about movements in stock prices. To overcome this, we propose using an alternative fundamental measure: Street earnings. Street earnings, calculated before various transitory items, do not possess the high transitory volatility and provide a more informative measure of future fundamentals. Consequently, movements in the price-to-street earnings (Street PE) ratio reflect movements in stock prices, making the Street PE highly informative about the excess volatility puzzle. Accordingly, we show that the Street PE has more in- and out-of-sample explanatory power for predicting returns than other valuation ratios. Additionally, the Street PE helps reconcile conflicting views on which subjective expectations drive stock price movements, showing that expectations of short-term earnings, long-term earnings growth, and returns can all help explain the excess volatility puzzle.

Keywords: price-earnings ratio, price ratio decomposition, return predictability, subjective expectations

JEL Classification: G11, G12, G4