What is look ahead bias and how is it related to earnings yield? A common pitfall in interpreting earnings yields in valuation is: A) using negative earnings. B) look-ahead bias. C) using normalized earnings. D) using underlying earnings. Your answer: A was incorrect. The correct answer was B) look-ahead bias. A common pitfall is look-ahead bias, wherein the analyst uses information that was not available to the investor when calculating the earnings yield.
negative earnings is one of the ADVANTAGES of earnings yield (EY). negative earnings are a great setback for P/E, but not EY. EY is better for analytical purposes. why? a PE of -1,000,000 is actually very similar to a PE of 1,000,000. How do I figure this? Suppose that the market cap is $1,000,000, and the company had a loss of $1. The PE is the former. Now, suppose that the company earned just $1. The PE is now 1,000,000x. Also, PE can’t equal 0. so the variable “SWINGS WILDLY” between these two values for small changes in the earnings. EY, however, is more robust. The EY for both cases is between -0.000001 - 0.000001.
some researchers come up with “great” trading systems that “buy” stocks at the beginning of the year using P/E numbers that come out several weeks later. On paper such strategies will look great but testing is not reliable because when the decision to buy a stock is made P/E is not known yet. That’s called look-ahead bias.