Expected EPS × Trailing P/E
Itzhak Ben‐David, Alex Chinco · National Bureau of Economic Research · 2024
All of asset-pricing theory currently stems from one key assumption: price equals expected discounted payoff.And much of what we think we know about discount rates comes from studying a particular kind of expected payoff: the earnings forecasts in analyst reports.Researchers typically access these numbers through an easy-to-use database and never read the underlying documents.This is unfortunate because the text of each report contains an explicit description of how the analyst priced their own earnings forecast.We study a sample of 513 reports and find that most analysts use a trailing P/E (price-to-earnings) ratio not a discount rate.Instead of computing the present value of a company's future earnings, they ask: "How would a firm with similar earnings have been priced last year?"Even if other investors do things differently, it does not make sense to put discount rates at the center of every asset-pricing model if market participants do not always use one.There are other options.Trailing twelve-month P/E ratios account for 91% of the variation in analysts' price targets.We construct a new kind of asset-pricing model around this fact and show that it explains the market response to earnings surprises.