CFA Practice Question

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CFA Practice Question

A high price/earnings ratio indicates _______.

A. investor confidence in high future earnings
B. that the stock is probably overvalued
C. that the stock is probably undervalued
Correct Answer: A

A high price/earnings ratio indicates optimism about a company's future. That positive outlook may be due to anticipated increases in earnings and growth of the company.

User Contributed Comments 7

User Comment
pranit Could someone explain when a stock is considered overvalued or undervalued.
mordja say an industry has a set of companies that are very similar, say they all produce widgets, are the same size, same capital funding, etc etc etc (not typical but the simplest example).

Say then that they the average Price / Earnings (P/E) ratio of all the companies in that industry was 10.

If all things being equal company XYZ had a price to earnings ratio of 20. If there was nothing that differentiated this company from the others in the industry (ie no reason for the greater certainty of earnings), one could argue that this company was overvalued, relatively to the rest. Vice versa if a company had a P/E of 5 it may be seen as undervalued.

In reality no two companies are the same and comparisons are difficult due to sources of capital, capex expenditures, different products etc, thus P/E ratios are only an indicator and a conclusion.
mordja Should read "and not a conclusion"

Pardon my terrible grammar above, long day and written hastily.
hannovanwyk My understanding of undervalued or overvalued is, calculate price of security with fundamental approach(intrinsic value, eg. with dividend discount model or any other valuation model. Compare your price calculated with a fundamental approach to the market value. if;
Market value > intrinsic value = overvalued
Market value < intrinsic value = undervalued
This comes down to the investment decision.

feel free to comment!
kutta2102 What hannovanwyk explains is done at Morningstar - comparing the market value to intrinsic value. It's important to remember that intrinsic value calculation also has many assumptions depending on the model being used to project future earnings.
ascruggs92 hannonvanwyk's explanation is on point. Intrinsic value is subjective, so to say something is probably under/overvalued is wrong regardless because the value one places on a stock is based on their subjective inputs
Rashid111 As per my understanding a high P/E ratio is bad eg: ABC & XYZ has stock price of $18 and EPS of $2 and $6 respectively then the P/E Ratios are;

ABC ==> 18/2 = 9 i.e. $9 dollars investment for every $1 earned
XYZ ==> 18/6 = 3 i.e. $3 dollars investment for every $1 earned

in this case the lower ratio of XYZ is better right ??
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