From Economics to Earnings: A Macro-Based Equity Earnings Growth Forecasting Model

Abstract

Earnings growth measures the change in a company’s reported net income through time. It is arguably the most widely observed measure of the growth and the profitability of a business, and a critical driver of equity returns. Though many practitioners have relied on historical averages to inform earnings growth expectations, research has found a relationship between earnings growth and prevailing economic growth. Building on prior research that connects earnings growth with real GDP growth, the authors split the earnings growth into two parts—revenue growth and changes in profit margins—and identifies multiple macroeconomic factors that have historical relationships separately with each. The authors find that revenue growth can historically be explained by world GDP growth, US GDP growth and payout ratios, and changes in profit margins can be explained by labor costs trade intensity. Upon conducting the out of sample test, this article offers a robust solution on predicting future earnings growth with macroeconomic factors and provides an important framework for understanding a key component of equity returns.