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Chapter 5. Stable Earnings, Better Inves... > Measurement of Earnings Stability

Measurement of Earnings Stability

You have three broad choices when it comes to measuring the stability or volatility of earnings.

  • The first and perhaps most direct measure is to look at the variability in earnings over time. At one extreme, you would have stocks that deliver the same dollar earnings year after year and thus exhibit no volatility in earnings. At the other, you would have companies whose earnings fluctuate wildly from huge profits to large losses, creating high variance in earnings. The problem with this measure is that the variability in dollar earnings will be greater for companies with higher dollar earnings and lower for companies with smaller dollar earnings.

  • To alleviate the bias created when you work with dollar earnings, you could look at the percentage changes in earnings from period to period and look for companies that exhibit low variance in these changes. By doing this, you are shifting away from stable earnings to stable growth rates in earnings. While this measure has statistical appeal, it has a significant problem that it shares with the first measure. It treats increases in earnings and decreases in earnings equivalently when it comes to measuring risk.[1] Generally, investors do not consider increases in earnings as risky; it is declines in earnings that worry them.

  • The third measure of earnings stability focuses only on earnings decreases. A firm that reports higher earnings each year, relative to earnings in the prior year, year after year, would be viewed as safe firm. On the other hand, firms that report increases in earnings in some years and decreases in others would be viewed as risky. In fact, you could construct a measure of variance in earnings that looks at only earning decreases.


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