# Overvalued or undervalued

I think it should be overvalued.

Robert Chan comments to Leslie Singer that Converted Industries’ expected dividend growth rate is 5.0%, dividend payout ratio (g) is 45%, and required return on equity (r) is 10%. Based on a justified trailing P/E ratio compared to the stock’s trailing P/E ratio at market of 9.0, Converted Industries is most likely:

A) overvalued. B) correctly valued. C) undervalued.

Justified trailing P/E = payout ratio * (1 + g) / (r − g). When the expected dividend growth is 5.0%, the justified trailing P/E = 0.45 * (1 + 0.05) / (0.10 − 0.05) = 9.45. This is greater than the market P/E of 9.0.

The Answer should be undervalued bcz Justified trailing P/E means what it should have been, therefore it should have been P/E of 9.45. Interpretation of 9.45 is that, to buy Earning of 1 an investor must pay 9.45 but in the mrkt place an investor is paying only 9 to buy earning of 1 based on stck trailing P/E. So,Stck P/E is undervalued and Stck P/E will reach to what sould be justified P/E.

still not clear. so if A has P/E 10 and market has P/E 5. is A overvalued or undervalued?

thanks

Hahahaha. I get it now. I was confused like you. The question is basically the P/E ratio right now is 9, but the one you calculated is 9.5. This means that the actual P/E for the firm is higher than the market’s perception of the firm. That’s why it’s undervalued. The P/E should be 9.5 and not 9. The market is undervaluing the stock.

You’re thought process is right, but they way you read the question was similar to how I read it.

You thought that this company’s P/E is 9.5 and the industry’s is 9. If you read carefully it’s not that.

wow. thank you so much

the market is pricing at 9 times earnings (trailing).

and based on your Justified PE analysis…the price should be 9.45 times earnings.

Remember in this way that Justified P/E is like your Intrinsic value ( I do not know whether it is mentioned anywhere or not ) and Stock Trailing P/E is the actual trailing P/E of stock so if Stock Trailing P/E is above Justified P/E, we expect the Stock trailing P/E to fall to the level of Justified P/E next period bcz what happens is that the stock intrinsic value is the true value of the stock in an efficient markt. If there is any mispricing means deviation from Intrinsic Value, it will be bought and sold accordingly. The reason beihid buying and selling of stock based on mispricing is that the stock should trade on its intinsic value. Justified P/E is like the same. If Justified P/E is 9.45, it means Stock should trade at P/E of 9.45, any thing less than 9.45 means stock is undervalued. How the P/E is derived is as important as intrpreting the P/E. For interpreting the P/E of 9.45 we view the P/E in this way [§=9.45] / [(E)=1] this shows that we must pay price of 9.45 to buy a stock which will return us an earning of 1. Now if Stock Trailing P/E is 9 i.e [§=9.00] / [(E)=1], this means that we are paying the price of 9 to buy the stock which will return us an earning of 1. This is clear evident that we should have paid price of 9.45 to get the earnings of 1 but we paid 9.00 to get earning of 1 and we also know that stock will reach to the justified P/E of 9.45 and we are paying less ( i.e 9 instead of 9.45 ) to buy same unit of earning. so, the stock is undervalued. This is what I understood and i hope, this may help you to build good understanding.