Alice Joyner, CFA, recently developed growth expectations for Universal Foods (UF) and Low-Carb Delites (LCD). Currently UF and LCD have price-to-earnings (P/E) ratios of 18 and 22 respectively. The market index P/E ratio is 16. Based on growth duration analysis Joyner concluded that P/E ratios of 16 and 24 for UF and LCD are justified. Under these circumstances, which investment strategy is most likely to be profitable? A) Short LCD and buy UF. B) Buy LCD and short UF. C) Buy both LCD and UF. D) Short both LCD and UF.
UF supposed to be at 16 but currently priced at 18 = overvalued = short LCD supposed to be at 24 but is currently priced at 22 = undervalued = long B
black swan - please tell me why? as far as i get it from the CFAI text, the growth duration model just answers the question, how long a growth rate can be sustained by a company. CFAI, p.250, BK4 …" if the implied growth duration is greater than you believe is reasonable, you would advise against buying the stock…"
i see nibs. thanks now it makes sense.
For this one, you can just ignore the growth duration aspect, and focus on the fact that the analyst determined those justified P/E’s. The growth duration comment just refers to the detail that if the analyst calculated a lower P/E they are expecting a shorter period of exceptional growth compared to what the market had factored into the price and vice verse. But all you really need to know to answer this one is what the justified P/Es are calculated as and what the market has the PE at. Like what Nibs said.
thanks for the answer black swan. guess i focussed too much on T (time) in the growth duration analysis rather than looking at the P/E ratios.
Holy f00k, I think I’m done for the day…I got the right answers and then just about picked A) cuz they switched the order of the two stocks in the answer choices. Yeah, def B)
If you have two companies that are otherwise identical…you choose the one with the lower p/e as being undervalued. Here when you compare a company against itself you pick the higher p/e. I’m always confused as how you do comparative valuation with p/e.
Yeah anyone want to add to this. Zim?