Jacob K. Thomas
Columbia University
Huai Zhang
University of Illinois at Chicago
Abstract: Both prior research and the popular financial press suggest that earnings smoothing is associated with higher valuations, per dollar of reported earnings. Apparently, smoothing causes reported earnings to be a less noisy measure of “permanent” earnings that can be sustained over the long-term. We extend those results to examine whether earnings smoothing is associated with higher valuations per dollar of permanent earnings, proxied by forecasted earnings, and find that earnings smoothing is associated with higher forward P/E ratios. We then investigate the extent to which this result is due to earnings smoothing being associated with higher growth and lower risk, the two effects that generate higher P/E ratios. Our results suggest that earnings smoothing is positively related to forecast growth and negatively related to risk, with the growth effect being more evident than the risk effect.
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