Question

You are researching the valuation of the stock of a company in the food-processing indus­try. Suppose you intend to use the mean value of the forward P/Es for the food-process­ing industry stocks as the benchmark value of the multiple. This mean P/E is 18.0. The forward or expected EPS for the next year for the stock you are studying is $2.00. You calculate 18.0 × $2.00 = $36, which you take to be the intrinsic value of the stock based only on the information given here. Comparing $36 with the stock’s current market price of $30, you conclude the stock is undervalued.

A.) Give two reasons why your conclusion that the stock is undervalued may be in error.

B.) What additional information about the stock and the peer group would support your original conclusion

Answer 1

A) Firstly, It depends on the interest rates.

$36 is the forward value of the stock. The current value is $30.

Now lets say the interest rate is 15%. the intrinsic value would be $36/1.15 = $31.30

This would imply that the current market price is over valued.

Secondly, Forward price of $36 is dependent on the expectation that EPS next year would be $2. What if the EPS is $1. If that is true the current market price is over-valued.

B) If the SD of forward P/E in the peer group is very small then it would support my conclusion as i can take forward P/E for this stock as industry mean as well.