SNA VIII Solo, 15 ? 16 September 2005
1
THE EFFECT OF TRANSITORY EARNINGS
ON THE USE OF E/P RATIOS IN CORPORATE VALUATION:
EMPIRICAL EVIDENCE FROM INDONESIA
ERNI EKAWATI
Fakultas Ekonomi Universitas Kristen Duta Wacana
ABSTRACT
The purposes of this study are, firstly, to confirm the findings of the previous
study, whether earnings contain transitory components. Secondly, to investigate how E/P
ratios are affected when firms experience transitory earning changes. Thirdly, to examine
whether the differences in E/P ratios across firms due to differences in the magnitude of
transitory earnings will quickly disappear in subsequent years.
Using financial data of companies listed in Jakarta Stock Exchange (JSE) from
the periods of 1993 to 2003, the study finds that earning changes exhibit a transitory
component. Under the condition of transitory earnings, firm's E/P ratio is positively
affected by the changes in earnings. Industry-adjusted earning changes variable is shown
to have a high explanatory power in predicting firm's E/P ratio. As the variation of firm's
E/P ratios are mainly explained by the transitory component of earnings, time series
pattern of E/P ratios reflects transitory deviations due to the transitory component of
earnings changes.
A. INTRODUCTION
Many practitioners subscribe to the view that accounting earnings and earning-toprice
(E/P) ratios are among the most important figures in making investment decisions.
E/P has also drawn much attention from academicians, and has been interpreted in
various ways. Some popular interpretations of E/P ratios have been an earning
capitalization rate (Graham et al., 1962), an indicator of mis-priced stocks (Basu, 1977
and Jaffee et al., 1989 ...