The Price of Earnings for Firms with Volatile Earnings Growth

Abstract

We examine firm valuation under the condition of volatile earnings growth. The Stochastic Earnings Valuation Model (Abaphai, Georgikopoulos, Hasnip, Jamie, Kim, and Wilmott, 1996; Li, 2003) is a relatively new model of equity valuation and is used here to derive a partial differential equation for the PE ratio of firms with volatile earnings growth. We derive an expression for the PE ratio for a firm with no debt and determine the conditions under which the solution to the SEVM is equivalent to the Dividend Discount Model (DDM). We also examine the value of firm equity, with volatile earnings growth, both in the absence and presence of debt. We find that in the presence of debt, the volatility of earnings has a significant effect on the price of earnings. We also illustrate that this relationship is non-linear. Analysis of this model yields several insights into previously documented empirical results, including the 'value' effect on equity prices along with asymmetric market responses to unexpected earnings announcements.

Keywords: PE ratio, volatile earnings growth, equity valuation, SEVM

JEL Classification: G12