EPS Figure vs. Earnings Multiplier Volatility

Understanding the Volatility of Earnings Multipliers

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Question

Historically, the EPS figure for a stock market series has been less volatile than the earnings multiplier for the same series. Which of the following best characterizes the primary reason for the greater volatility experienced by the earnings multiplier? Choose the best answer.

Answers

A. None of these answers is correct.

B. The EPS figure is less volatile due to accounting manipulations and the malleability of international and domestic accounting standards including GAAP.

C. The price-to-earnings figure experiences a tax leveraging effect that is not passed on to the EPS figure.

D. The earnings multiplier is more sensitive to fluctuations in the equity markets than is the EPS figure; i.e. the earnings multiplier is "forward looking."

E. The price-to-earnings ratio is more sensitive to changes in the spread between the required rate of return and the anticipated future growth rate.

F. The earnings multiplier is more sensitive to changes in dividend policies than is the EPS figure.

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Explanations

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A. B. C. D. E. F.

The greater relative volatility of the earnings multiplier versus the EPS figure is primarily attributable to an increased sensitivity to changes in the spread between the required rate of return "k" and the anticipated growth rate "g." Remember that the equation used to determine the appropriate earnings multiplier for a stock market series is the following:

{P/E = [D/E / (k - g)]}

Where: P/E = the earnings multiplier, or Price-to-Earnings ratio, D/E = the dividend payout ratio at t1, k = the required rate of return, and g = the anticipated growth rate of dividends.

As you can see, changes in the spread between the required rate of return and the anticipated growth rate can have a dramatic effect on the earnings multiplier for a stock market series. While the earnings multiplier is sensitive to changes in the dividend payout ratio, volatility in this figure is not cause for the increased volatility of the earnings multiplier versus the EPS figure.

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