Page 11 - FINAL CFA II SLIDES JUNE 2019 DAY 8
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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
Stems from Molodovsky effect –countercyclical (transitionary earnings) tendency towards high P/Es at bottom of business cycle
(due to lower EPS) and low P/Es at the top (due to higher EPS) and repeatedly so!
We therefore, adjust P/Es for cyclicality by estimating EPS in the middle of the business cycle: 2 methods are used:
1. Historical average EPS (not suitable as it ignores size effects)
2. Average return on equity
EXAMPLE: Using the following data, calculate normalized earnings both methods.
Historical average EPS Method:
Average return on equity
LOS 31.f: Explain and justify the use of earnings yield (E/P).
Negative EPS or a very volatile one (due to Molodovsky effect) renders P/E meaningless, hence use ‘normalized EPS’ and/or
instead of using as multiple to value stock, covert to inverse ratio 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.
Notice, when price is denominator,
interpretation of negative correlation?
