The answer to question 2B on p.558 of Equity CFAI text rates Hand over Somersault. Both have negative earnings, so E/P is used (P/E would be meaningless). Hand’s earnings were -$2.20 and the price is $22. Somersault’s earnings were -$1.25 and the price is $10. Hand’s E/P is therefore -.1; Somersault’s -.125. The rationale is that Hand has the higher E/P, so it is the better share. In the absence of any other information, when you are presented with two companies - one losing $2.20 and another losing $1.25 - which would you pick? I would go for the smaller loser. In fact, I wouldn’t pick, because the information is obviously insufficient. Negative earnings give meaningless P/Es, but are their E/P’s any more helpful? Put another way, Hand’s E/P would go from -.1 to -.01 if its price were $100 instead of $10. -.01 is a higher number than -.1, so that would make it a better buy at ten times the price! What am I missing here? I just don’t get this…
would you rather buy a stock that is losing 10% of its value or the one losing 12.5% of its value.
Thanks, kurupt1, now I feel stupid! Anyway, v nicely & succinctly put.
can someone explain the concept of E/P? i get that negative p/e is meaningless. so the theory is you invery it to get e/p and look for the largest ratio to be the best. fine but any negative number inverted is still a negative #. am i missing something?
negative E/P can still be ranked. -0.125 < -0.1 < 0 < 10 < 20… you would be able to rank the companies - even if they had negative earnings. selecting the company with 20 - is a good choice in the list above.
so E/P still retains the negatives in the ratio, but the difference is that you can use them for purposes of relative comparison (to other negative and also to positive E/Ps)?
It all seemed so clear when I first read kurupt1’s post, but either I’ve taken a step backwards or the explanation doesn’t quite work. It is true that you would prefer the company which is shedding the smaller percentage of its value, as you would one yielding the larger. However, aren’t we confusing price with value here? If price equals value (i.e. markets are perfectly efficient) then ranking stocks is anyway futile, because lower E/Ps will be more “expensive”, but deservedly so. If price does not necessarily equal value (which has to be the assumption when we’re ranking stocks in this way), we cannot weigh the earnings against the price/value in this way. A positive earnings yield is informative, because in the absence of other information and all things being equal, we elect the stock with the higher return. A negative earnings yield is not informative, because were it to persist, the company would be worthless. In the absence of other information, and all things being equal we should pay less (if at all) per share for any losing company (no matter the size of the loss). Were we to compare earnings to a more meaningul metric, such as book value, then it would make sense to rank negative yields in this way - we could say the company is worth x, and it’s rate of depletion is therefore y/x - choose the slowest depletion rate in the hope of a timely turnaround. Unfortunately, because price cannot be assumed meaningfully to equal value in this case, justifying a price by assuming it represents an objective value is circular. As far as I can see there is no meaningful symmetry between positive and negative E/Ps. The going concern assumption (i.e. persistence of earnings, approximated by the current figure) cannot hold in a negative situation.
i think the idea of E/P is not to go into the entire whole analysis you did above. But the simple thought process is as follows: If you had 3 companies you were comparing, all with negative P/E - and you wanted to invest in 1 of them, definitely - which one would you choose? When you are comparing positive P/E companies - lower is better… relatively. but when you have a company with a negative earnings - it is lower than the +ve numbers - so is lower better still? or would you just pass on the opportunity of investment in the company because it had negative earnings which might be due to temporary effects - and miss out on the investment opp? Go one step further - and all your companies you are analysing had negative earnings - and that’s all your investment universe was…
cpk123, if my stock universe contained only two companies and only the following limited information, and I was forced with a gun to my head to price them… Company A lost $1/share last year. Company B lost $2/share last year. Applying the same E/P of, say -.1, I arrive at: Company A is worth $10, and Company B is worth $20. Bearing in mind that we have NO info on relative BVs or anything to suggest the likely magnitude of the earnings reversal we’re presumably in it for, shouldn’t I be either equally or more suspicious of the higher price per share (which is after all buying me larger losses per share)? With a gun to my head, because the fundamentals could be absolutely anything and relative valuation is meaningless (from the standpoint of ignorance), I would want to pay less per losing share in absolute terms. Put another way, if there were a group of completely disparate companies, all for different and unknown reasons losing $1/share, and they were each randomly priced between $10 and $20 a share, wouldn’t you pick the cheapest one if you were forced to choose? The random pricing is important here, because any reliance on price in the evaluation of price is circular; and any confusion of price with value undermines the decision process (you might as well pick anything).
lmb, you invest based on a cash amount not a number of shares… i have £500 to invest, not i am going to buy 500 shares of