Components of Bank Earnings and the Structure of Bank Share Prices

Empirical examination of the relation between common stock prices and two major components of bank earnings shows that earnings before securities gains and losses play an important role in explaining bank stock prices. The market appears to assign a significant multiple to this component of earnings, judging from regression results over the 1968-87 period. The market appears to price realized securities gains and losses differently. The multiple on securities gains and losses did not differ significantly from zero over the period studied. The evidence also suggests that securities gains and losses behave in a manner consistent with smoothing earnings. That is, investors apparently perceive that reported gains and losses in banks’ investment securities are timed by bank managements to offset losses and gains in other earnings. These findings hold whether earnings components are used to explain price levels or price changes. Furthermore, the movement of the coefficient on earnings before securities gains and losses corresponds to major economic changes that might be expected to affect banks. Over the 1972-74 period, for example, as financial conditions generally declined, the implied multiple for earnings before securities gains and losses also declined dramatically.