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The Relation of Stock Prices to Corporate Earnings Adjusted for Inflation

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Abstract

The effects of inflation adjustments of corporate earnings on market prices were tested by cross section regressions of 485 manufacturing companies for the period 1966-76 and subperiods. The basic data were company reports and stock prices. For the full period, market prices reflected the inventory valuation adjustment and the decline in real value of net financial liabilities fairly completely, but they reflected the adjustment for the understatement of depreciation to only a small extent. The surprisingly low effect of the depreciation adjustment could only be partly attributed to measurement error, but not entirely. The estimated effect of capital gains on stock prices was either in the wrong direction or negligible. The implication of the results is that market investors use a range of adjustments for the effects of inflation which differs from the estimates used in this study, though how and why they differ is not clear. The adjustments were much lower in the later period 1972-76 than in the earlier period 1966-71. This seemed inconsistent with the higher inflation rates in the later period. The explanation for the difference is not clear, but it may reflect the difficulties of judging the size of the adjustments in a period of rapid inflation.

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