- CFA Exams
- 2023 Level II
- Topic 5. Equity Valuation
- Learning Module 25. Market-Based Valuation: Price and Enterprise Value Multiples
- Subject 2. Price to Earnings: Determining Earnings

### Why should I choose AnalystNotes?

AnalystNotes specializes in helping candidates pass. Period.

##### Subject 2. Price to Earnings: Determining Earnings PDF Download

Arguments for P/E ratios:

Forecasted EPS over the next 12 months = $0.60

50 million shares outstanding

Market price = $16.00

Calculate trailing and leading P/E ratios.

Trailing P/E = $16 / $0.50 = 32.

Leading P/E = $16 / $0.60 = 26.7, which is significantly lower than the trailing multiple.

Average ROE = (0.15 + 0.15 + 0.21 + 0.16) / 4 = 0.1675.

Average ROE x BVPS2004 = 0.1675 x $28.00 = $4.69.

Average EPS = (4.00 + 3.80 + 5.25 + 4.5) / 4 = $4.39.

- According to security analysts, earnings continue to be the primary driver of investment value.
- P/E is widely recognized and used by investors.
- Differences in price/earnings ratios may be related to differences in long-run average returns, according to empirical research.

Arguments against P/E ratios:

- P/E does not make economic sense with a negative EPS. As a result, only companies with positive earnings can be ranked according to their P/E ratios and a number of companies with negative earnings have to be excluded from this analysis.
- Volatile, transitory portion of earnings makes it difficult to calculate P/E, because only permanent or recurring income can be a determinant of the company's value. Splitting a company's earnings into recurring and period-specific elements is difficult.
- Management discretion in choice of accounting methods reduces comparability. For example, management may pursue income-smoothing policy which can significantly distort a company's net income and lead to inaccurate valuation of the company's stock if P/E is used.

In calculating a P/E ratio, the current price for publicly traded companies is generally easily obtained and unambiguous. Determining the earnings figure to be used in the denominator, however, is not as straightforward. Two issues are:

- The time horizon over which earnings are measured, which results in two chief alternative definitions of the price/earnings ratio; and
- Adjustments to accounting earnings that the analyst may make so that P/Es are comparable across companies.

**Alternative Definitions of P/E**The two alternative definitions of P/E are trailing P/E and leading P/E.

- A
**trailing P/E**(also**current P/E**) is a price multiple comparing the stock's current market price to the company's earnings during the last four fiscal quarters. The EPS in such calculations are sometimes referred to as trailing twelve months (TTM) EPS. Trailing P/E is the price/earnings ratio published in stock listings of financial newspapers. - A
**leading P/E**(also**forward P/E**or**prospective P/E**) is a price multiple comparing the stock's current market valuation with the company's forecasted earnings for the next full fiscal year or for the next four quarters.

*Example*2009 earnings = $25 million

Forecasted EPS over the next 12 months = $0.60

50 million shares outstanding

Market price = $16.00

Calculate trailing and leading P/E ratios.

EPS

_{2009}= $25,000,000 / 50,000,000 = $0.50.Trailing P/E = $16 / $0.50 = 32.

Leading P/E = $16 / $0.60 = 26.7, which is significantly lower than the trailing multiple.

**Trailing P/E**When calculating a P/E ratio using trailing earnings, care must be taken in determining the EPS number. The issues include:

- Transitory, nonrecurring components of earnings that are company-specific;
- Transitory components of earnings due to cyclicality (business or industry cyclicality);
- Differences in accounting methods; and
- Potential dilution of earnings per share.

Underlying earnings are earnings excluding nonrecurring components such as:

- Gains/losses on asset sales.
- Asset write-downs of impaired assets.
- Loss provisions, corporate restructurings, divestitures of business segments. Extraordinary losses from repurchase of the company's debt prior to maturity.
- Changes in accounting estimates.

*Example*2009 EPS = $8.00 Gain on asset sale = $1.40 Gain from change in accounting estimate = $0.75 Underlying earnings = $8.00 - $1.40 - $0.75 = $5.85.

__Normalized EPS__- Adjusting EPS to remove cyclical component of earningsEarnings of many big companies such as those in automobile manufacturing, residential construction and air travel industries significantly depend on the aggregate demand in the economy, and earnings trends of them approximate the direction of general economic cycle. Because of cyclic effects, the most recent four quarters of earnings may not accurately reflect the average or long-term earnings power of the business.

Analysts address the problem of cyclicality by normalizing EPS - calculating the level of EPS that the business could achieve currently under mid-cyclical conditions (normal EPS).

Two normalization methods:

- The method of average return on equity:

The averaging period for historical ROE calculation should encompass full previous economic cycle. - The method of historical average EPS

*Example*

Average return on equity method:

Average ROE = (0.15 + 0.15 + 0.21 + 0.16) / 4 = 0.1675.

Average ROE x BVPS2004 = 0.1675 x $28.00 = $4.69.

Historical average EPS method:

Average EPS = (4.00 + 3.80 + 5.25 + 4.5) / 4 = $4.39.

__Earnings Yield__P/E multiple is meaningless if the earnings is negative. An analyst should use earnings yield (E/P: the reciprocal of the P/E multiple) for the ranking purposes.

It can be used to rank stocks from low E/P to high E/P:

- High E/P: under-priced.
- Low E/P: over-priced.

**Learning Outcome Statements**

calculate and interpret underlying earnings, explain methods of normalizing earnings per share (EPS), and calculate normalized EPS;

explain and justify the use of earnings yield (E/P);

describe fundamental factors that influence alternative price multiples and dividend yield;

calculate and interpret the justified price-to-earnings ratio (P/E), price-to-book ratio (P/B), and price-to-sales ratio (P/S) for a stock, based on forecasted fundamentals;

calculate and interpret a predicted P/E, given a cross-sectional regression on fundamentals, and explain limitations to the cross-sectional regression methodology;

evaluate a stock by the method of comparables and explain the importance of fundamentals in using the method of comparables;

calculate and interpret the P/E-to-growth ratio (PEG) and explain its use in relative valuation;

calculate and explain the use of price multiples in determining terminal value in a multistage discounted cash flow (DCF) model;

explain alternative definitions of cash flow used in price and enterprise value (EV) multiples and describe limitations of each definition;

calculate and interpret EV multiples and evaluate the use of EV/EBITDA;

CFA® 2023 Level II Curriculum, Volume 4, Module 25

###
**User Contributed Comments**
3

User |
Comment |
---|---|

danlan2 |
In method 1, we use last BVPS and not the average BVPS. |

zed889 |
what does BVPS stand for? |

Vhells |
Book Value Per Share |

I am using your study notes and I know of at least 5 other friends of mine who used it and passed the exam last Dec. Keep up your great work!