Quality and Pricing of Earnings Under Sustained Growth

Abstract

I examine the effect of various business strategies aimed at sustaining growth on quality and pricing of earnings. Earnings quality is predicted to be high when earnings growth results from sales increases, rather than cost reductions or income management of core and non-core operations, because firms signal competitive advantages in products. One implication of high earnings quality is that pricing of earnings will also be high. Consistent with the predictions, earnings multiples are the highest when earnings growth is sustained through sales growth. Firms that use income from core and non-core operations to sustain growth have high earnings multiples once growth rates are sustained for at least three years. These multiples are lower than those of firms with sustained sales and earnings increases. Firms almost never reduce operating costs over long periods to sustain earnings growth. Finally, I find that earnings multiples are high when sales are growing over successive years even when earnings do not increase.