It has long been accepted that the central function of security analysis is to forecast future accounting earnings for the purpose of valuation. Recent valuations, however, especially in the technology sector, have raised doubts in the minds of many investors as to the relevance of accounting earnings.
Some analysts advocate the use of free cash flows in lieu of earnings.
D. Eric Hirst and Patrick E. Hopkins tackle this crucial issue and provide persuasive evidence of the continued relevance of accounting earnings for the determination of investment value. In addition to documenting the critical relationship between accounting earnings and security prices, Hirst and Hopkins offer a comprehensive compendium of earnings classifications to help analysts distinguish between transitory earnings and those earnings that are more likely to persist and thus affect future valuations. Hirst and Hopkins use a variety of real-world examples to illustrate these earnings classifications and to show analysts how to interpret them for the purpose of fundamental analysis. Hirst and Hopkins next present the results of two original, controlled experiments to evaluate the use of accounting earnings by buy-side analysts. The first experiment reveals that analysts are often misled by opportunistic earnings management and, therefore, should focus greater attention on the sources and quality of earnings.