Both the economic nature of events and extant accounting rules cause reported earnings to have different components, each with different valuation implications. The price-earnings link is described better by separating components of unexpected earnings and multiplying each by a different response coefficient, rather than applying a single earnings response coefficient (ERC) to aggregate unexpected earnings. Using a simple model that assumes three types of innovations to reported earnings (permanent, transitory, and price-irrelevant), we develop systematic links among current earnings components, future earnings, and stock prices. Empirical tests of the model's predictions confirm the validity of our characterization of the price-earnings link. Attempts to understand better the effects of growth and (beta) risk result in little improvement.
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