Friday, April 24, 2009

S & P earnings...Fama and French comment

This issue keeps coming back like a bad penny. The issue of how S&P computes earnings ratios. My last post on it was here.

Fama and French have weighed in and argued that they use the method used by S&P, which in "normal" circumstances probably makes sense. But I disagree with them on this comment...

It is easy to see the logic if you imagine merging all of the firms into one giant conglomerate. The new firm's earnings and market equity are just the sum of the individual firms' earnings and market equity.
The S&P 500 is not a giant conglomerate. If a massive firm goes bankrupt and posts massive losses that outweigh it's market value, those losses are not absorbed by the other firms in the index as in a conglomerate. Once the firm has zero value, that's it. The losses are then absorbed by the creditors.