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Question: You are researching the valuation of the stock of a company in the food-processing indus- try. su...

you are researching the valuation of the stock of a company in the food-processing indus- try. suppose you intend to use the mean value of the forward P/es for the food-process- ing 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): Two reasons why your conclusion that the stock is undervalued may be in error are:

(i): The peer group stocks themselves can be overvalued causing their P/E to be high. Thus basing the stock price of the company on mean P/E may be faulty if the peer group stocks are overvalued.

(ii) The PEG ratio i.e. Price/Earnings to Growth ratio is not considered here and so there is a fair chance that the stock is not undervalued.

(b): The additional information about the stock and the peer group that will support my original conclusion will be the information with regards to the EPS growth rate of the stock and that of the peer group.