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