Accounting Measurement, Price-Earnings Ratio and the Information Content of Security Prices

In this paper we show that information in prices that leads (future) earnings is contained in financial statements. While accrual accounting rules produce an earnings number which reflects the information in stock prices with a lag, they also produce a large array of additional numbers presented in the income statement, balance sheet, and statement of changes in financial position. We demonstrate that certain of these numbers can be summarized into one measure that predicts future earnings. Like P/E, this measure provides a correction to current earnings as an indicator of future earnings because it distinguishes earnings that will be repeated in the future from those that are due to temporary phenomena.