CFA Practice Question

There are 191 practice questions for this study session.

CFA Practice Question

Which of the following statements is the LEAST accurate with respect to the rationales and drawbacks of using the price-earnings (P/E) ratio for valuation purposes?
A. When earnings are negative, P/E will be meaningless and thus should not be used.
B. Earnings influence valuations heavily. Differences in P/E ratios simply reflect fundamental differences between companies and thus the ratio should be used.
C. Some stocks are illiquid and thus their prices might not be efficient; consequently, P/E should not be used.
Explanation: Even if a stock is illiquid, in most likelihood its price reflects this illiquidity discount. However, P/E is really used to compare the valuation of stocks relative to each other. Thus, if the stock price is undervalued, there is a stronger argument to use the P/E ratio so that this attractive investment may be identified.

User Contributed Comments 3

User Comment
wollogo If you used P/E on an illiquid stock wouldn't you find that the actual price you are able to purchase stock could be different from the last traded price that you use in the analysis?
ascruggs92 ^Yes, I'm not sure what you're getting at though. Large spreads (higher transaction costs) and the risk that you may not be able to find a buyer when you want to sell, make illiquid stocks more risky. Because of the added risk, illiquid stocks will most likely trade at a lower P/E multiple, compared to its peers, giving the impression that it is undervalued, when in reality the lower multiple is a reflection of higher risk.
ascruggs92 In other words, C is false because the P/E will be reflective of the additional risk, so to say P/E shouldn't be used because it is priced inefficiently is not true.
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