Equity Valuation and Negative Earnings

Abstract

The assumption of a positive and homogeneous price-earnings relation across earnings realizations is examined. We seek to explain an anomalous negative price-earnings relation for firms reporting losses, and hypothesize the negative relation is caused by one or more omitted variables positively correlated with stock price but negatively correlated with current earnings. We consider three such correlated omitted variables -- earnings turnaround, prospects of becoming a takeover target, and book value of equity -- based on valuation or econometric arguments for their inclusion in a price-earnings model specification. We find that including beginning-of-year book value of equity eliminates the negative price-earnings relation for loss firms. Thus, the simple earnings capitalization model is misspecified, and the negative price-earnings relation is an outcome of this misspecification. We also show that the coefficient on earnings in the simple earnings capitalization model is positively biased for profit firms, and that the price-earnings relation is not homogeneous across profit and loss firms even after controlling for book value of equity. Additional analyses suggest book value of equity serves as a value-relevant variable rather than as a control for scale differences.

JEL Classification: M41, G14, C21