Page 11 - FINAL CFA II SLIDES JUNE 2019 DAY 8

LOS 31.e: Calculate and interpret underlying READING 31: MARKET-BASED VALUATION: PRICE AND
earnings, explain methods of normalizing ENTERPRISE VALUE MULTIPLES
earnings per share (EPS), and calculate
normalized EPS. MODULE 31.4: EV AND OTHER ASPECTS

Normalized Earnings
Need for this stems from Molodovsky effect -the countercyclical tendency to have high P/Es due to lower EPS at the bottom of
the cycle and low P/Es due to high EPS at the top of the cycle. Earnings contain a transitory portion due to cyclicality; whilst
viewed as currently transitory, business cycles are expected to repeat over the long term.
Normalized (or normal) earnings per share hence is an attempt by analysts to adjust P/Es for cyclicality by estimating
EPS in the middle of the business cycle – 2 methods are used:
1. Historical average EPS
2. Average return on equity Historical average EPS ignores size effects, so the average ROE is preferred.

EXAMPLE: Calculating normalized earnings: Using the data in the following figure, calculate normalized earnings using the
method of historical average EPS and the method of average return on equity for Magnolia Enterprises.

LOS 31.f: Explain and justify the use of earnings yield (E/P).
Negative earnings render P/E ratios meaningless. In such cases, it is common to use normalized EPS and/or restate the ratio as
the earnings yield (E/P) because price is never negative.
• A high E/P (low P/E) suggests a cheap security, and
• A low E/P (high P/E) suggests an expensive security, so securities can be ranked from cheap to expensive based on E/P
ratios.