This paper yields a summary score that informs about the sustainability (or persistence) of earnings and about the trailing P/E ratio. The score is delivered from a model that identifies unsustainable earnings from the financial statements by exploiting accounting relations that require that unsustainable earnings leave a trail in the accounts. The paper also builds a P/E model that recognizes that investors buy future earnings, so should pay less for current earnings if those earnings cannot be sustained in the future. In out-of-sample prediction tests, the analysis reliably identifies unsustainable earnings, and also explains cross-sectional differences in P/E ratios. The paper also finds that stock returns are predictable when traded P/E ratios differ from those indicated by our P/E model.
Penman, Stephen, and Xiao-Jun Zhang. "Modeling Sustainable Earnings and P/E Ratios with Financial Statement Analysis." Working Paper, Columbia Business School, 2006.
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