CFA Level II ExamEquity InvestmentsEasy
An investment manager is comparing two companies, Company X and Company Y, using price multiples. Company X has a P/E ratio of 15x, while Company Y has a P/E ratio of 20x. Both companies operate in the same industry and have similar risk profiles. Which of the following statements is most likely correct regarding the comparison of Company X and Company Y based solely on their P/E ratios?
- ACompany Y has higher expected growth than Company X.
- BCompany X has lower expected growth than Company Y.
- CCompany Y is overvalued relative to Company X.
- DCompany X is undervalued relative to Company Y.
Show answer & explanationAnswer & explanation
Correct answer: A. Company Y has higher expected growth than Company X.
A higher P/E ratio generally implies that investors expect higher future earnings growth. If two companies in the same industry have similar risk, the one with the higher P/E is typically expected to grow faster. Therefore, Company Y with a P/E of 20x is likely expected to have higher growth than Company X with a P/E of 15x.
Why the other options are wrong
- B. This is the opposite of what a higher P/E typically suggests in a relative comparison.
- C. Similarly, we cannot definitively say Company Y is overvalued. Its higher P/E could be justified by higher expected growth.
- D. Without knowing if the P/E of 15x is fair, we cannot definitively say Company X is undervalued. It could simply have lower growth prospects.
Price-to-Earnings (P/E) Ratio
A valuation multiple that measures a company's current share price relative to its per-share earnings. It indicates how much investors are willing to pay for each dollar of earnings.
- Calculated as Share Price / Earnings Per Share (EPS).
- Higher P/E often implies higher growth expectations or lower risk.
- Used for relative valuation within the same industry.
Memory trick: P/E's high, growth is nigh.