Posted on August 22, 2021 by Florian Buschek
Interesting paper from Sanjeev Bhojraj and Ashish Ochani.
Using realized earnings over long periods of time, we investigate errors in earnings expectations implied
by stock prices of firms. We compute lifetime earnings for 10,129 domestic initial public offerings (IPOs)
of equity for the years 1975-2019 and compare such earnings to the IPO offer price or stock price prevailing
at the end of every year. Of the 10,129 IPOs, 2,267 survived till 2019, 4,687 merged with other firms and
3,175 were delisted for other reasons. On average, lifetime earnings for a firm is roughly equal to its IPO
price. However, that average masks significant variation and skewness. Only 8% (32%) of stocks report
enough lifetime earnings, excluding (including) a terminal/merger value, to recover their IPO offer price.
Mergers account for most of such success. Surprisingly, even for merged firms, only half pay back the IPO
investor in lifetime earnings inclusive of merger consideration. Focusing on the sample of firms that were
listed before 2006 and survived till 2019, 40% pay back their IPO investment in earnings and take an
average of 11 years to do so. The remaining 60% are unable to pay back their investment despite staying
listed for an average of 23 years. The average (median) ratio of lifetime earnings per share, including
terminal value, to lifetime stock market wealth created per share is 0.61 (0.47). Thus, stock price-based
wealth creation significantly overstates the underlying earnings-based value added. Ranks of firms based
on stock price wealth creation differ significantly from those based on lifetime earnings.
This skew in returns, a few huge winners and many losers/mediocre stocks, is well know as I have discussed here. It is why indexing works so well. You are guaranteed to own the winners and the losers will decline in weight. On the other hand it shows how fertile the ground for active stock pickers can be…. or how dangerous.