The Earnings Mirage

[bgf]

One of my favorite 'bloggers' Jesse Livermore at Philosophical Economist just published another paper.

https://osam.com/Commentary/the-earnings-mirage

Some highlights as written by O'Shaughnessy in his Executive Summary:

"Inflation doesn't just distort book values--it also distorts earnings. It causes depreciation to be understated in current price terms, which causes earnings to be overstated. We believe this to be one of the main reasons why inflation has historically been associated with low valuations, i.e., low P/E multiples. During periods of high inflation, the market detects the fact that earnings are overstated, and correctly assigns lower multiples to them.

When measuring valuation and profitability in individual stocks, the risk of depreciation-related earnings overstatement highlights the importance of using free cash flow as a metric in the investment process. Free cash flow is the only fundamental metric that empirically tracks depreciation-related expenses. Unsurprisingly, when tested out as a factor, it outperforms other fundamental metrics.

Historically, high buyback firms have had high returns on equity, further bolstering our confidence in the factor.

The integrated equity methodology can be used to build a valuation measure for the overall stock market. When compared to other measures such as the Shiller CAPE, it shows a noticeably stronger correlation with long-term future equity returns."

I'm just curious to see what those here think of the findings.

[Park]

Thanks for posting this.