Hi, I have a question on Equity, chapter 50, los 50.h, about the P/E comparisons There is an example with Renee’s Bakery, that I have uploaded as a picture here: www.lygeros.org/Pierre/tmp2/Pe.jpg In the answer, after computing the P/E ratio, they deduce that Renee Backery is undervalued. www.lygeros.org/Pierre/tmp2/Pe2.jpg How can they deduce that this firm is undervalued based on P/E ratios comparison with industry average? I don’t understand why Renee’s bakery is undervalued. Thank you.

Have you seen the explanation below the answer? This is from Schweser by the way.

They go on to explain that all other price multiples are lower compared to the industry, except for P/E. Hence the conclusion is not based on P/E, but other multiples. A higher P/E may be the result of depressed earnings due to (quote) “high depreciation, interest expense, or taxes”. Comparing the price multiples over time, there is a downward trend noticeable, which may indicate the stock is currently undervalued relative to its past valuations.

ok, thank you for your reply,

but what I mean, is that, on one side, you have a ratio, the P/E ratio, which is greater than the average:

P/E(Renee Bakery)=15.9 P/E(Industry average)=8.6

hence, you deduce from this that the stock is overvalued,

On the other side, you have 3 other ratios, P/CF, P/B, P/S for which the ratio of the firms are below the average, from which we deduce that the stock is undervalued.

So for me, there seems to be a contradiction, or at least, we cannot decide if it’s overvalued or undervalued.

Hi,

Just like Moonborne stated, the P/E ratio may be the result of situations where the earnings quality may be an issue. For example, it is sensitive to non-recurring earnings or one-time earnings events.

Calculating all the ratios over time it seems as if the P/E ratio is out of whack going from 115.2 in 20X1 to 15.9 in 20X3 while the other ratios (P/CF, P/S, and P/B) are much more even throughout the years. This to me indicates that there are non-recurring or one time events that skews the net income and therefore the P/E ratio. Because of the significant drop from year to year in the P/E it seems to be a very unreliable measure compared to the other 3 ratios and it is therefore ignored for purposes of determining if the company is under or over valued.

It would make sense that if the P/E ratio was not skewed due to non-recurring earnings or one-time events, it would be in line with the other 3 ratios.

I got my understanding of this from the short reading on equity analysis in chapter 28 and so someone may have to confirm/fix my answer!

ok, than you. I understand