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The Roots of Risk and Return

Guilford C. Babcock
Financial Analysts Journal
Vol. 36, No. 1 (Jan. - Feb., 1980), pp. 56-63
Published by: CFA Institute
Stable URL: http://www.jstor.org/stable/4478312
Page Count: 8
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The Roots of Risk and Return
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Abstract

In a 1970 article in this journal, the author showed how earnings per share and changes in earnings per share cna be explained by five financial statement items--margin, turnover, leverage, pullthrough and book value of equity per share. Book value comprises two different elements--a nonsustainable factor deriving from the effects of sales of new shares and one-shot accounting adjustments, and a sustainable factor deriving from the retention rate. Sustainable changes in earnings depend on the levels of margin, turnover, leverage, pullthrough and sustainable changes in book value; nonsustainable changes result from changes in the first four factors plus nonsustainable changes in book value. Over a series of reporting periods, the factors contributing to sustainable changes in earnings determine the earnings trend, while the factors contributing to nonsustainable earnings changes produce volatility about the trend. The magnitude of the sustainable change in earnings relative to the nonsustainable change indicates the statistical significance of the earnings trend. The investor who analyzes earnings trend and volatility using this framework can trace return and risk back to their roots. The author demonstrates the application of these concepts to the paper and forest products industry and summarizes results for four other industries.

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