In a previous post, we highlighted an article that showed how useful accounting numbers are. In this post, we will present a concrete example of an application of accounting numbers in portfolio management.
Reference [1] showed that the Price-to-Earnings ratio is a mean-reverting process, and it can be accurately estimated by AR(1), an econometric model. Earnings, on the other hand, follow a trend process and can be modeled by a first-order integrated process with a constant factor that captures relative earnings growth.
I propose a model of expected returns by decomposing stock price into two constituents: earnings and price-to-earnings (PE) ratio. The PE ratio is a mean-reverting process that can be forecasted for short to medium horizons. On the other hand, earnings follow a trend process and can be characterized by a first-order integrated process. Growth in earnings is responsible for the growth of stock prices, but the cyclical nature of the PE process imparts time-series predictability to prices.
After calibrating the models, the author constructed a long-only investment strategy that switches between stocks and bonds.
Using the expected return model, I propose a portfolio switching strategy where investor switches between stocks and bonds based on current expected returns on market-wide stock index and risk-free government bond yields. My strategy provides better risk-adjusted returns by avoiding equity investments in periods of low expected returns. The strategy is suitable for retail investors because it only involves market-wide stock index and bond yield. Moreover, my strategy does not require short-selling of stocks which can be difficult for retail investors.
In short, accounting numbers can be used in econometric models in order to develop an asset allocation strategy that offers better risk-adjusted returns.
The article showed that Earnings and Price-to-Earnings ratio have practical and useful applications. In our opinion, revenue and revenue growth are also important accounting numbers that can be used effectively in portfolio management.
References
[1] N. Vidhani, Return Predictability using Price-to-Earnings Ratio, 2021, https://ssrn.com/abstract=3910641
Further questions
What's your question? Ask it in the discussion forum
Have an answer to the questions below? Post it here or in the forum
CALGARY, Alberta, May 20, 2025 (GLOBE NEWSWIRE) — Inventronics Limited (“Inventronics” or the “Corporation”) (IVX:TSX Venture) announces the grant of options to purchase common shares of the Corporation to members of the management team and Board of Directors of the Corporation. Each of the four…
Thrive Enables Organizations to Protect Data, Enhance Security, and Meet Regulatory Standards BOSTON, May 20, 2025 (GLOBE NEWSWIRE) — Thrive, a global technology outsourcing provider for cybersecurity, Cloud, and IT managed services, today announced its new Compliance Center. The Compliance Center provides mid-market businesses and…
Key nCino Platform enhancements released to help banks, credit unions, and IMBs gain a competitive advantage through intelligence-driven automation Company launches nCino Research Institute to deliver economic insights and actionable strategies for banking growth WILMINGTON, N.C., May 20, 2025 (GLOBE NEWSWIRE) — nCino, Inc. (NASDAQ:…
Company to Showcase Novel Water Treatment Solutions for Potable Water CORSICANA, Texas, May 20, 2025 (GLOBE NEWSWIRE) — Birchtech Corp. (TSX: BCHT) (OTCQB: BCHT) (“Birchtech” or the “Company”), a leader in specialty activated carbon technologies for sustainable air and water treatment, today announced management will…
Your vote is important no matter how many shares you own. Vote today. Shareholders who have questions or need assistance with voting should contact KP Tissue’s proxy solicitation agent and shareholder communications advisor, Laurel Hill Advisory Group, by telephone at 1-877-452-7184 or by email at…
