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Random and Nonrandom Relationships Among Financial Variables: A Financial Model

Published online by Cambridge University Press:  19 October 2009

Joseph E. Murphy Jr.  and
J. Russell Nelson
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Extract

Careful examination of the behavior of financial variables over time uncovers an important distinction: variables expressed in dollars, such as earnings per share, behave very differently from percentage changes in those same variables. Similarly, financial ratios, such as the price/earnings ratio, behave quite differently from percentage changes in financial ratios. Variables expressed in dollars and financial ratios appear comparatively stable and predictable over time. Successive values are fair approximations of one another. Percentage changes in dollar and financial ratio variables-i.e., growth variables on the other hand, tend to be erratic, volatile, and unpredictable over time. Successive values bear little relation to one another. This distinction between dollar and ratio variables, on the one hand, and percentage changes in these variables-i.e., growth variables-on the other, serves as a useful basis for a financial model.

Type
Investments II
Information
Journal of Financial and Quantitative Analysis , Volume 6 , Issue 2 , March 1971 , pp. 875 - 885
Copyright
Copyright © School of Business Administration, University of Washington 1971

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References

1 Acknowledgement is made to the Management Information Systems Research Center of the School of Business Administration, University of Minnesota, for use of computer facilities and to Lowell Chesborough for programming assistance.

2 The results presented here reflect the substantial background of the work on the random-walk theory of prices and earnings. Evidence on the random-walk theory of stock prices is given in Cootner, P. H., ed., The Random Character of Stock Prices (Cambridge, Mass.: M.I.T. Press, 1964)Google Scholar. Evidence on the randomwalk theory of earnings changes is given in Rayner, A. C. and Little, I.M.D., Higgledy Piggledy Growth Again (Oxford: Basil Blackwell, 1966)Google Scholar; Murphy, J. E., “Relative Growth of Earnings Per Share—Past and Future,” Financial Analysts Journal (November–December 1966), pp. 73–76Google Scholar; and Brealey, R. A., “Statistical Properties of Successive Changes in Earnings“ (Chicago, Ill.: March 1967), and An Introduction to Risk and Return (Cambridge, Mass.: The M.I.T. Press) pp. 88–103.Google Scholar

3 Earlier studies were conducted on the relationships between specific variables. All of the conclusions in the earlier studies are covered by the three general postulates developed in this paper. Some of the earlier studies include: Stevenson, H. W. and Murphy, J. E., “Price/Earnings Ratios and Future Growth of Earnings and Dividends,” Financial Analysts Journal (November–December 1967), pp. 111–114Google Scholar; Murphy, J. E., “Return on Equity Capital, Dividend Payout and Growth of Earnings Per Share,” Financial Analysts Journal (May–June 1967), pp. 91–93, and “Effect of Leverage on Profitability, Growth and Market Valuation of Common Stock,” Financial Analysts Journal (July-August 1968), pp. 121–123Google Scholar; and Nelson, J. R. and Murphy, J. E., “A Note on the Stability of P/E Ratios,” Financial Analysts Journal (March–April 1969), pp. 77–80.Google Scholar