Justified Trailing P/E

CFA Level II Equities
#1

CFAI Reading # 35, EoC Q#9

In the above mentioned question how we are getting idea that we need to calculate justified trailing P/E?

#2

The question gives you a market trailing P/E ratio… you need to compare this to the justified trailing P/E (which is based on fundamental data) to determine whether or not it’s undervalued/overvalued/correctly valued.

If market > justified = overvalued

If market < justified = undervalued

#3

Thank you for quick reply:

why we are comparing market trailing P/E with justified trailing P/E? I am not able to understand this logic

#4

You’re comparing what the market has currently priced the stock at per $1 of historical earnings. You want to compare what price per dollar of earnings is justified based on the current dividend, expected growth rate, and required return over the same period of earnings. You don’t want to be comparing, necessarily, the justified forward P/E to the market trailing.

sorry if this isn’t very clear…

#5

Would You Look … thank you!

#6

S2000magician can you add some thing here?

#7

I don’t have the question before me, but the idea behind any of the justified ratios is that they give you an indication of what the actual ratio _ should be _, based on company fundamentals: they’re intrinsic measures. The actual ratio is compared to the corresponding justified ratio to determine whether it is too low or too high; a large difference between the actual ratio and the justified ratio suggests that the stock may be mispriced.

Here, it appears that you’re given the actual trailing P/E, and asked whether the stock is overpriced or underpriced. You compare it to the justified trailing P/E: if the actual is significantly less than the justified, the stock is likely underpriced; if the actual is significantly greater than the justified, the stock is likely overpriced.

#8

S2000magician, thank you for explanation and discussion.

#9

My pleasure.