O’Shaughnessy Asset Management explores how inflation and accounting conventions distort reported earnings, arguing that corporate profits may systematically overstate economic reality. The paper challenges the reliability of ROE and earnings-based valuation, suggesting true profitability could be 20–25% lower and that free cash flow offers a clearer lens for investors.
The Earnings Mirage: Why Corporate Profits are Overstated and What It Means for Investors
O’Shaughnessy Asset Management
Jesse Livermore
Research
108 Pages
Key Takeaways
Earnings Overstatement Magnitude: Reported corporate earnings may be inflated by roughly 20–25% due to understated depreciation tied to historical cost accounting during inflationary periods.
Profitability Gap Explained: Using data from 1871–2018, adjusted return on equity consistently trails earnings yield, highlighting a persistent mismatch driven by accounting distortions rather than capital misallocation.
Free Cash Flow Superiority: Empirical tests show free cash flow-based strategies outperform traditional metrics, better capturing real economic costs and improving long-term return predictability across multiple decades.
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