LOS e: Explain and justify the use of earnings yield (E/P).

Q1. A common pitfall in interpreting earnings yields in valuation is:

A)   look-ahead bias.

B)   using underlying earnings.

C)   using negative earnings.

Q2. A common justification for using earnings yields in valuation is that:

A)   earnings are more stable than dividends.

B)   negative earnings render P/E ratios meaningless and prices are never negative.

C)   earnings are usually greater than free cash flows.

Q3. The observation that negative price to earnings (P/E) ratios are meaningless and prices are never negative is used to justify which valuation approach?

A)   Earnings yield.

B)   Dividend discount model.

C)   Dividend yield.

LOS e: Explain and justify the use of earnings yield (E/P). fficeffice" />

Q1. A common pitfall in interpreting earnings yields in valuation is:

A)   look-ahead bias.

B)   using underlying earnings.

C)   using negative earnings.

 Correct answer is A)

A common pitfall is look-ahead bias, wherein the analyst uses information that was not available to the investor when calculating the earnings yield.

Q2. A common justification for using earnings yields in valuation is that:

A)   earnings are more stable than dividends.

B)   negative earnings render P/E ratios meaningless and prices are never negative.

C)   earnings are usually greater than free cash flows.

Correct answer is B)

Negative earnings render P/E ratios meaningless. In such cases, it is common to use normalized earnings per share (EPS) and/or restate the ratio as the earnings yield or E/P because price is never negative. Price to earnings (P/E) ranking can then proceed as usual.

Q3. The observation that negative price to earnings (P/E) ratios are meaningless and prices are never negative is used to justify which valuation approach?

A)   Earnings yield.

B)   Dividend discount model.

C)   Dividend yield.

Correct answer is A)

The observation is used to justify the earnings yield approach. Negative P/E ratios are meaningless. In such cases, it is common to use normalized earnings per share (EPS) and/or restate the ratio as the earnings yield or E/P because price is never negative. Price to earnings (P/E) ranking can then proceed as usual.