Reading 42: Market-Based Valuation: Price and Enterprise Val 2010, face, justify, center, common

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Session 12: Equity Investments: Valuation Models
Reading 42: Market-Based Valuation: Price and Enterprise Value Multiples

LOS h: Explain and justify the use of earnings yield (i.e., EPS divided by share price).

 

 

 

A common pitfall in interpreting earnings yields in valuation is:

A) using underlying earnings.

B) using negative earnings.

C) look-ahead bias.

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

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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.

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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.

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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) Dividend discount model.

B) Dividend yield.

C) Earnings yield.

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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.