November 2nd, 2009

Impact of Earnings Volatility on Price/Book Ratios

Posted at 1:00 AM ET

Financial Intelligence Team
Contact

The link between a company’s earnings and its share price is intuitive and well documented. Equally logical, although far less studied, is the correlation between the volatility of earnings and share price. The favorable impact of stable earnings on market valuation is intuitive considering market capitalization represents a view of future discounted cash flows and unexpected earnings volatility reduces the predictability of those cash flows.

Guy Carpenter studied the statistical relationship between quarterly earnings volatility and price/book. The initial study looked at 40 quarters of data (1998Q2 to 2008Q1) for publicly traded insurers. The companies were split into three groups based on their historic quarterly earnings volatility. A statistical regression line was fit to express the relationship between price/book for companies considered to have high, medium or low quarterly earnings volatility.

The statistical regression clearly shows that the benefit of increased returns is reduced as volatility increases. Specifically, for each percentage point increase in return on equity (ROE), the price/book ratio for a company with low ROE volatility would be expected to increase by 8.4 percentage points. By comparison, the corresponding increases are 6.7 percentage points for companies with medium volatility and 1.9 percentage points for companies with high volatility.

There is one exception to the finding that stable earnings result in a higher valuation — i.e., when a company’s annual ROE is below 8 percent. When ROE reaches this threshold, stable earnings actually hurt price/book ratios, presumably because investors would hope that a low ROE is not actually reflective of future earnings and thus would reward volatility. Importantly, for ROEs of 8 percent and above, the data presents a compelling argument for volatility-reducing actions to strengthen the earnings signal.

Additional Resources:

Contributors

  • Susan Witcraft, Managing Director, Minneapolis +1 952.832.2143
  • Frank Achtert, Managing Director, Munich +49 89.28.66.03.361
  • Iain Boyer, Managing Director, Norwalk +1 203.229.8807
  • Michelle Harnick, Managing Director, New York +1 917.937.3125
  • Dave Lightfoot, Managing Director, Seattle +1 206.621.2929
  • Scott Lohman, Managing Director, Seattle +1 206.621.2929
  • Don Mango, Managing Director, Morristown +1 973.285.7914
  • Eddy Vanbeneden, Managing Director, Brussels +32 2.674.98.11
  • Gina Carlson, Senior Vice President, Minneapolis +1 952.832.2224
  • Debbie Griffin, Senior Vice President, New York +1 917.937.3119
  • David Flandro, Senior Vice President, London +44 (0)20 7357 3267
  • Jeff Bellmont, Vice President, Minneapolis +1 952.832.2157
  • Sebastien Portman, Vice President, Zurich +41 44.285.9322
  • Benoit Butel, Vice President, Paris +33 1.56.76.48.26

Additional support was provided by John Major, Aaron Friedman and Reed Bouchelle.

AddThis Feed Button
Bookmark and Share


Related Posts