CFA Practice Question

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CFA Practice Question

The following statements are rationales to use P/E for equity valuation except for ______.

I. Earnings are the chief driver of investment value.
II. Differences in P/Es are empirically related to differences in long-run average returns.
III. P/E is more stable than P/BV since historical cost-based approach of GAAP leads to depressed asset value.
IV. P/E is often employed for valuation of cyclical, unprofitable and mature companies.
Correct Answer: III and IV

User Contributed Comments 3

User Comment
Rotigga III. P/E is definitely not more stable then P/BV since earnings fluctuate more than BV
IV. P/E cannot be used for unprofitable companies. E/P can be used, however.
prabhur08 I'm not sure about III. Price should go up when earnings go up (and down when earnings come down). On the other hand, book value stays constant but price can go up or down! So P/E should be relatively more stable than P/BV.
Agreed earnings fluctuate more than book value but we are talking P/E and P/BV and not earnings and book value in isolation.
davidt876 wrong again prabhur. BV goes up or down with retained earnings (and therefore indirectly earnings). make a loss and your BV goes down - as well as your price.

just think about the fact that P/E can vary exponentially up to infinity. Say a stock's price is $10, and EPS is normally $1. P/E = 10. But this year the economy squeezes the firm' profits and EPS falls to $0.01. Now P/E = 1,000.

Now if you ever find a stock with a P/B of 1,000... run..
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