Earnings Growth and Price Change in the Same Time Period

Abstract

FREQUENTLY the most important determinant of the rate of return in equity investments is the rate and direction of price change.' Success in investments, if it not be due to chance, is largely a function of the ability to predict price changes. The importance of predicting price changes has led to a number of studies aimed at discovering the determinants of price change. These studies may be conveniently classified into three groups: first, those studies that sought to predict future price changes from past price changes; second, those investigations that attempted to predict price changes from price ratios, such as the price/ earnings ratio; and third, those studies which sought to predict price changes from past changes in other variables, such as earnings. In the last decade a score of studies were made which attempted to discover whether future price changes could be predicted from past price changes. The results were generally disappointing. It was found that successive price changes tended to be independent; the price change of a stock in one period had little bearing on the price change in the next period. Moreover, the relative price change of a stock (relative to other stocks) in one period was not indicative of the relative price change of that stock in the next period.2 Although the full import of the results of these studies is not yet clear, the studies certainly have important implications for financial analysis. Some have concluded that the results call into question the very utility of fundamental financial analysis.3 This conclusion was certainly premature and may be questioned, as will be shown below. The results of the second and third groups of studies were only partly encouraging. The correlation between price ratios and future price changes, though promising, was frequently neither significant nor positive and price changes in one period tended to be independent of earnings changes in the preceding period.4 None of the studies were devoted to the question of the relation between relative earnings changes and relative price changes in the same period. This question should probably have been examined first. Even though previous e arnings growth was unrelated to present changes in prices, perhaps percentage changes in prices and earnings in the same period were highly correlated. Per share earnings growth could still have a substantial influence on simultaneous price changes. If there were little connection between relative earnings changes and p r i c e changes in the same period, then the ability to predict relative earnings changes might be of limited value. If, on the contrary, there were high correlation between relative earnings changes and relative price changes in the same period, then the ability to predict relative earnings changes would be extremely important.5 The purpose of this article is to report the results of a study of the influence of rates of growth of per share earnings on percentage changes in stock prices in the same period.