Profits and Stock Prices: The Importance of Being Earnest

By Kopcke, Richard W. | New England Economic Review, March-April 1992 | Go to article overview

Profits and Stock Prices: The Importance of Being Earnest


Kopcke, Richard W., New England Economic Review


In recent months, popular indices of the prices of common stocks have surged to new peaks. At the same time, the profitability of nonfinancial corporations has foundered, and many question whether the rising tide of economic recovery can lift earnings to meet the value of equity.

Since 1982 stock prices have more than tripled, while the operating income of corporations has risen by less than one-half. In the last three years alone, prices have increased by more than one-half, while earnings have fallen. During January of this year, the price of equity for Standard & Poor's composite of 500 stocks exceeded 23 times earnings, a comparatively high multiple by historical standards. To some analysts, stocks are priced as aggressively as they were during the prosperity of the 1960s, but the performance of corporations appears to be languishing nearly as much as it did during the 1970s. Once the gap between the value of equity and the prospects of corporations became evident during the 1970s, the price of stocks fell from 17 times earnings in the late 1960s to less than 10 times earnings in the late 1970s. The rise and subsequent collapse of stock prices has been more abrupt during the last decade: the value of equity rose 30 percent from January to late August in 1987, then fell 30 percent from late August to late October.

While the prospect for equity values naturally concerns traders and investors, it also is a concern for public policy. Because investors' wealth depends on the value of corporate equity, the demand for consumption goods can vary with the price of stocks. Furthermore, the valuation of corporations' productive assets on stock exchanges influences businesses' willingness and ability to undertake new investments.(1) If the falling price of stocks should retard the pace of capital formation in the future, it also would retard the potential growth of output and living standards.

This article examines the relationship between the earnings of nonfinancial corporations and the value of their equity. It concludes that the price of stocks corresponds more closely to the earnings that companies disclose in their financial reports than it does to the earnings for nonfinancial corporations reported in the national income accounts. This unsurprising result is not necessarily reassuring. If corporations' financial reports overstate both the magnitude and the rate of growth of their earnings because of the biases arising from their reliance on historical book values, then the lower returns reported in the national accounts may represent the performance of these corporations more accurately.

This analysis also suggests that the value of equity does not necessarily reflect corporations' incentives for undertaking investments. Therefore, a revival of domestic capital formation does not necessarily require the Dow Jones industrial average to remain near its recent record high values. Since the late 1970s, for example, corporations' rate of return on surplus increased in part because their average tax burdens declined with the various tax reforms enacted in the 1980s. Stock prices rose with earnings. Because the tax reforms adopted in 1986 tended to maintain, for a time, a lower tax burden on existing corporate assets, while raising the burden on many new investments, rising stock prices during the late 1980s did not herald a commensurate improvement in incentives for investment. Conversely, should the rate of return on existing assets and surplus for domestic corporations fall with increasing foreign competition, the prices of stocks also may fall. But, if the opportunities for profitable growth, both here and abroad, remain sufficiently attractive, lower prices of stocks would not foretell a commensurate drop in corporations' capital budgets.

I. The Value of Equity

Most descriptions of stock prices share a common pedigree: the value of common stocks essentially rests on the prospective earnings of the assets backing these shares. …

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