In the previous chapter we saw that both earnings and growth in earnings play a key role in valuation models. In this chapter we examine both the nature of earnings and some models for forecasting future earnings.1
We start this chapter by briefly reviewing some of the ambiguities associated with the term earnings. Different firms and even the same firm, at different times, can define earnings in alternative ways. A logical question is, If earnings can be defined differently, does the figure earnings per share, which shows up on the firm's income statement, have any impact on valuation? This question is examined in the second section of this chapter. As we will see, despite the ambiguous meaning of reported earnings, there is a real payoff from being able to forecast it.
The final two sections of this chapter examine models for forecasting future earnings. The first of the two sections examines the time series behavior of earnings, while the second discusses the relationship between earnings and other fundamental firm characteristics.
The value of any asset is determined by its future earning power and not by what it cost at some time in the past. An economist would define earnings as cash flow plus the change in market value of an asset. Consider a bond originally purchased for $100 that carries a 10% interest rate. Assume the bond is worth $95 after one period. What has the earnings been on this investment over the period? ...