Calculating Earnings Growth Rates for Indexes That Include Unprofitable Companies

Abstract

This article provides empirical evidence that the expected earnings growth rate used to value an index is the expected earnings growth rate of the index composed only of companies with positive earnings. In addition, this article provides evidence that the market multiple on an index’s aggregate earnings is an increasing function of the losses reported by the unprofitable companies in the index. The difference between conventionally calculated earnings growth rate forecasts and our computation of earnings growth forecasts is greatest in times of economic weakness, when the conventional approach results in earnings growth forecasts that are significantly higher than warranted. Likewise, the magnitude of reported losses is typically higher at market troughs, so market multiples should also be higher at market troughs. Therefore, before one infers that an index is too expensive or has a very strong earnings growth profile, one needs to adjust index earnings and earnings growth rates for the companies with losses.