Profits and Stock Prices: The Importance of Being Earnest Profits and Stock Prices: The Importance of Being Earnest

March 31, 1992

While the prospect for equity values naturally concerns traders and investors, it also is a concern for public policy. Because investors' wealth depends on the value of corporate equity, the demand for consumption goods can vary with the price of stocks. The valuation of corporations' productive assets on stock exchanges also influences businesses' willingness and ability to undertake new investments. If the falling price of stocks should retard the pace of capital formation in the future, it also would retard the potential growth of output and living standards.

This article examines the relationship between the earnings of non financial corporations and the value of their equity. It concludes that the price of stocks corresponds more closely to the earnings that companies disclose in their financial reports than it does to the earnings for nonfinancial corporations reported in the national income accounts. This analysis also suggests that the value of equity does not necessarily reflect corporations' incentives for undertaking investments. If the opportunities for profitable growth, both here and abroad, remain sufficiently attractive, lower prices of stocks would not foretell a commensurate drop in corporations' capital budgets.

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