Alternative Price Measures—Normalized Earning Power and Composite Ratios

“The market level of common stocks is governed more by their current earnings than by their long-term average. This fact accounts in good part of the wide fluctuation in common-stock prices, which largely (though by no means invariably) parallel the changes in their earnings between good years and bad. Obviously the stock market is quite irrational in thus varying its valuation of a company proportionately with the temporary changes in its reported profits.”

—Benjamin Graham, Security Analysis (1934)

In the preceding chapter, we examined several common single-year, individual price ratios to find the best-performing measure. While we found that the earnings before interest and taxes (EBIT) variation of the enterprise multiple was arguably the best metric, we found that it did not outperform in every category. For example, the gross profits yield performed admirably on raw and risk-adjusted return analyses.

In this chapter, we examine the performance of a combined price measure constructed from different individual price ratios. We investigate whether some combination of price ratios can outperform the best individual price ratios in each category of performance. The appeal of a compound measure using a variety of price ratios is in the possibility that it offers better risk and return characteristics than its constituent individual price ratios. Such a compound measure could examine different price ...

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