A Stock-Price Yardstick

Abstract

THE PURPOSE of this article is to explore the dynamic relationships between industrial stock earnings and an index of stock prices, via the price-earnings ratio. A long-term trend line of earnings, adjusted for commodity price inflation, has been prepared. When reported stock earnings have increased, relative to the earnings at any given time, there has been a tendency for price-earnings ratios to decline, and conversely. This tendency has been so marked as to indicate that corporate earnings exert little or no short-run influence on an index of industrial stock prices, either simultaneously or lagged. The long-term trend line of earnings, multiplied by a constant, has constituted a useful long-term yardstick of the reasonableness of stock prices. The industrial stock-price index is quite low, relative to the valuations placed by the market on earnings generally before 1941. It is rather high, however, by the level of earnings multipliers prevailing in the years since 1941. Prior work leading up to this study has pointed strongly to the conclusion that common generally tend to sell at a relatively low multiple of their reported earnings when those earnings are abnormally high, and at a higher multiple when earnings are subnormal. This concept represents a considerable refinement over the old maxim that stocks are worth ten times earnings. Studies to date indicate sufficient potential value to these relationships to justify further investigation. The first problem is to have an earnings series available and comparable over a sufficient number of years, which will relate to of a type and quality in which institutional investors will be interested. The second problem is to determine what is normal for this series, as a prerequisite to determining where current earnings and stock prices are, in relation to normal. The first part of this study, therefore, is devoted to investigation along these lines. The second part will involve a study of the simultaneous behavior of these earnings, relative to normal, via stock price-earnings ratios, to the stock prices themselves.