Financial Education

Trailing or forward earnings may not accurately reflect the earnings power of a company, particularly if the company’s earnings are cyclical. In such cases, a high P/E may simply reflect depressed earnings at the cycle trough, and a low P/E multiple may suggest that earnings have reached the cyclical peak. In such cases it is appropriate to normalize P/E with respect to the business cycle.

Although there are several ways to do this, a simple yet fairly robust way is to measure the ROE over the full previous cycle. Normalized EPS is then the average ROE over the cycle times the current book value. For example, if a company posted ROE of 12%, 10%, 10%, 8%, 10% during its last cycle it would have a cyclical average ROE of 10%. If its current book value per share is $23.00 its normalized earnings are $23.00 x 10% = $2.30.

An even shorter method would be to simply average the earnings per share over the full cycle, but this does not factor in any growth from one cycle to the next.

For more information, see all articles on: Investing in Stocks, Valuation

See also:

The Justified Price/Earnings Multiple

Price Multiples

Industry Classification: Business Cycle Reaction

Stages of the Business Cycle

Earnings Surprise and Future Excess Returns