Using Street Earnings to Predict Equity Returns

Is stock price-to-earnings ratio (P/E), in aggregate or by individual stock, truly predictive of returns? In their April 2024 paper entitled “Valuing Stocks With Earnings”, Sebastian Hillenbrand and Odhrain McCarthy examine relationships between P/E and future returns at both stock index and individual stock levels. They compare generally accepted accounting principles (GAAP) earnings and an alternative earnings used by Wall Street analysts and therefore designated “Street” earnings. Street earnings, constructed from Institutional Brokers’ Estimate System (I/B/E/S) data, are smoother than GAAP earnings and emphasize future fundamentals by excluding transitory items. They consider as potentially predictive metrics: GAAP P/E; GAAP P/E10 (or GAAP CAPE), based on a 10-year moving average of GAAP earnings; Street P/E; and, Street P/E3 (or Street CAPE), based on a 3-year moving average of Street earnings. They test whether: (1) aggregate GAAP and Street earnings metrics predict stock market returns; and, (2) stock-level GAAP and Street earnings yields (E/P) support profitable long-short hedge portfolios. Using quarterly GAAP and Street earnings data, S&P 500 Index levels and individual stock prices during 1988 through 2021, extended back to 1965 for some aggregate earnings tests and forward through 2023 for some portfolio tests, they find that:

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