Some years ago Michael Mauboussin and Alfred Rappaport released a great paper titled – The Trouble with Earnings and Price/Earnings Multiples, in which they discuss the shortcomings of traditional valuation metrics ROE, and P/E. Here’s an excerpt from the paper:
Wall Street is a world filled with rules of thumb and shortcuts. And while the objective of these shortcuts is to save time—ostensibly to improve investment performance—they are fraught with severe and crippling shortcomings.
The core of expectations investing is to correctly anticipate changes in the market’s implied expectations for a company’s long-term cash flows. The evidence notwithstanding, the investment community’s focus on short-term earnings and price/earnings is ubiquitous. In light of this, we address the following questions:
• How do we know the market is long-term oriented?
• Why do investors focus on earnings?
• Why are earnings unreliably linked to stock price?
• How is the earnings expectations game played and why should you avoid it?
• What are the shortcomings of the most widely used performance and investment yardsticks—return on equity (ROE) and the price/earnings (P/E) multiple
You can read the entire paper here:
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