Negative EPS...

In CFAI#2 there’s a question on a company that has negative EPS one year, so we are asked to find out “… the most appropriate estimate of P/E ratio.” They solved the question by finding the average ROE for the past 3yrs, multiplied by BVPS, then got the P/E ratio…! Is it me, or would that be impossible to think up of during an exam… Has anyone else come across similar out-of-the-box thinking calculation questions?

Are you sure that you have the question right?

I probably wouldn’t have figured that out, you’re right. However, it makes sense considering … BVPS = (Total equity - preferred) / (outstanding) and ROE = NI / (Total equity) //or maybe return on common equity… The equity cancels out (see note above on preferred) and you’re left with NI / outstanding Which looks a lot like EPS, especially if you pull out preferred. That’s a pretty good party trick.

yep, you can get negative EPSs. It’s Q42 in CFAI#2 Answers say: “Using average ROE provides a better estimate of P/E when a company’s size has changed. The average ROE is 9.25; an estimate of normal EPS can be derived by multiplying avg ROE by ending BVPS”

The curriculum notes state that negative earnings result in a meaningless P/E ratio (i.e. N/A), therefore I imagine they would not throw this sort of curve ball on the exam.

agree with Zeroaffinity on that; it took me took a few mins to set out the ratios logically to come to that conclusion. party trick indeed just when i thought I hd fully covered financial ratios as well…

wouldn’t that formula lead basically to an average of the last 3 year’s reults per share?

P/E’s are used for comparison purposes with competitors and industry benchmarks. A negative P/E, cannot be meaningfully interpreted relative to its peers. These types of questions are meant to sow panic and confusion…

I think this kinda shows that CFAI really do have an approach that’s: - heavy on the Ethics (one of the Schweser profs said during the Office Hr yday that if you are a 69%-70% borderline case, they will probably use Ethics to decide whether you pass or not) - light on the very very complex options questions that Schweser has shown us - and for willing to ask us questions where we may have to play around with basic FSA formulae (rather than just plugging in numbers into formulas) – these look like they’ll give us the exta 5-7%

yeh i was stuck on that exact same question last nite… at least i’ve seen it and had a think about it before the real exam though… but yeh, i had absolutely NO IDEA how to solve that one

Yes. Remember this. It is indeed in the CFAI book. You averaged out all the positive ROE and multiply by book value per share. This give you earning per share. Then price / earning per share to get P/E.