P/E - proxy for risk and growth

CFA Level II
#1

See this solution in Qbank. Is it correct, Seems weird?

P/E can be used as a proxy for risk and growth.

#2

Justified P/E is:

a) positively related to growth rates

b) negatively related to required rate of return and risk

Example: P/E of our stock < P/E of benchmark

We could explain this saying:

  1. our stock is undervalued

  2. our stock is properly valued, but the stock has a lower expected growth than the benchmark (lower g > lower P/E)

  3. our stock is properly valued, but the stock has a higher required rate of return (=higher risk) than the benchmark (higher r > lower P/E)

In a nutshell: In order to conclude that our stock is really undervalued, we must ensure that our stock is comparable to the benchmark used, meaning that they have similar expected GROWTH and similar RISK.

#3

Thanks Lucky_27.