CFA Practice Question

CFA Practice Question

Historically, the EPS figure for a stock market series has been less volatile than the earnings multiplier for the same series. Which of the following best characterizes the primary reason for the greater volatility experienced by the earnings multiplier? Choose the best answer.
A. The EPS figure is less volatile due to accounting manipulations and the malleability of international and domestic accounting standards, including GAAP.
B. The earnings multiplier is more sensitive to fluctuations in the equity markets than is the EPS figure (i.e., the earnings multiplier is "forward looking").
C. The price-to-earnings ratio is more sensitive to changes in the spread between the required rate of return and the anticipated future growth rate.
Explanation: The greater relative volatility of the earnings multiplier versus the EPS figure is primarily attributable to an increased sensitivity to changes in the spread between the required rate of return "k" and the anticipated growth rate "g." Remember that the equation used to determine the appropriate earnings multiplier for a stock market series is the following:

{P/E = [D/E / (k - g)]} Where: P/E = the earnings multiplier, or Price-to-Earnings ratio, D/E = the dividend payout ratio at t1, k = the required rate of return, and g = the anticipated growth rate of dividends.

As you can see, changes in the spread between the required rate of return and the anticipated growth rate can have a dramatic effect on the earnings multiplier for a stock market series. While the earnings multiplier is sensitive to changes in the dividend payout ratio, volatility in this figure is not cause for the increased volatility of the earnings multiplier versus the EPS figure.

User Contributed Comments 8

User Comment
rrichmondo Yes - I needed to read the question more carefully
apiccion Right. The price used is not necessarily the same as the market price of the stock.
mekc earning multiplier using the intrinsic P rather than the market P?
cjpatel mekc: where does it say earnings multiplier using intrinsic value and not market price..
HolzGe1 I didn't get "earnings multiplier = P/E". Time to go to bed.
nfressell2 I just woke up 2 hours ago HolzGe1, should I go back to bed ?
mlaique So,

EPS vs P/E (earning multiplier)

Notice- there is no rate or expected return, hence there is less room for subjectivity
EPS = NI / Shares

Whereas, in the P/E ratio, both K and G are subject to some degree of input from the market participants.
P/E = D/E / K-G

Ngana Good Explanation by Analystnotes there
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