Identifying components of earnings
a) Permanent earnings is the reported earnings component that is value-relevant. Permanent earnings are those earnings that are expected to continue into the future. This component roughly corresponds to income from continuing operations as reported in the income statement.
b) Transitory earnings is the earnings component that is value-relevant, but not expected to persist into the future. This component roughly corresponds to income from discontinued operations and extraordinary gains and losses as reported in the income statement.
c) Value-irrelevant earnings is the “noise” component of reported earnings. This component is unrelated to a firm’s future profitability or future cash flows, and thus irrelevant when it comes to valuation of the firm’s stock. An example would be an earnings increase due to a change in depreciation methods or assumptions (e.g., useful life) that has no impact on the firm’s future cash flows.
Consider an airline company:
An example of permanent earnings would be the earnings that arise from the firm’s ongoing passenger and cargo operations. An example of transitory earnings would be the temporary earnings generated from a one-year contract to handle charter flights for an outside travel company.
An example of value-irrelevant earnings would be the increase in earnings due to a change in the useful lives and/or salvage values of the firm’s aircraft.
Consider an automobile manufacturer:
An example of permanent earnings would be the earnings that arise from the firm’s ongoing sales and leasing of passenger cars and trucks. An example of an increase in the firm’s permanent earnings would be a contract to supply all of the new vehicles every year in the future to one of the nation’s rental car companies.
An example of transitory earnings would be the one-time earnings from a special purchase of cars by one of the nation’s rental car companies. Another example of transitory earnings is the earnings effect of a labor strike by one of the firm’s manufacturing plants.
An example of value-irrelevant earnings would be the increase in earnings due to a change in the method used to depreciate the firm’s long-term assets.
Numerous other student responses to this question are possible.
Explaining the differences in P/E ratios
In general, price/earnings (P/E) ratios are inversely related to risk, and positively related to both growth opportunities and earnings quality.
The firms in Group A are from different industries. Amazon.com is an e-commerce retailer, Microsoft is a software development company, Toyota Motors is an automobile manufacturer, and Whole Foods Market sells organic foods and natural grocery items. Here are some reasons why the P/E ratios of these companies differ:
• Differences in P/E ratios reflect differences in future growth opportunities. Toyota Motors probably has the fewest growth opportunities—automobile manufacturing is a rather mature industry with significant global competition. Microsoft has greater growth opportunities, but those too are constrained by global competition and a relatively mature software applications industry. The growth opportunities at Amazon.com and Whole Foods Market probably exceed those at Toyota and Microsoft. Amazon.com continues to expand its product and service offerings beyond just books and CDs, and e-commerce retailing is still a rather “young” industry. Whole Foods Market has few retail outlets in several areas of the United States, and is only now beginning to expand outside the U.S.
• Differences in P/E ratios reflect differences in business risk. Risky firms will have higher discount rates assigned to their future cash flows and earnings, and thus lower share prices and lower P/E...
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