when it is estimated that P/E will fall

CFA Level II
#1

when it is estimated that P/E for the next year will fall from its current value - do we underweight or overweight the stock???

#2

Hmmm…P/E can fall in two ways. 1. Price falls. If that happens obviously we would want to underweight 2. Earnings increase. That would seem to lead to overweight. Is this conceptual or do you have an answer?

#3

I think I put underweight for this… Assuming they were not talking about forward p/e (Po/E1) I took it as the est. P/E = P1/E1 Which is this case would mean that the stock will be worth less relative to the future earnings… Could be very wrong if they implied estimated P/E to mean forward P/E

#4

this is from an exam the answer says underweighting is more appropriate and no reference to P or E…

#5

this sounds like a bad question from schweser very debatable depending on the investor’s style, if they believe the lower PE is underpricing the stock, etc.

#6

I guess one way of looking at it would be that if we know that P/E is gonna fall, so the stock is overvalued right now and thus we would need to underweight it.

#7

True… OR… If the price stays the same but earnings increase (implying a decrease in the P/E multiple), and the firm doesnt pay dividends… Then the cash flows associated with the investment will be zero. In this case you would not want to overweight the holdings.

#8

but we don’t know all this from the question, do we?

#9

Cash flow shouldn’t matter chadtap. If the earnings are higher than firm value is higher whether they pay dividends or not. If the firm never paid a dividend and then liquidated there would be more to liquidate.

#10

mwvt9 Wrote: ------------------------------------------------------- > Cash flow shouldn’t matter chadtap. If the > earnings are higher than firm value is higher > whether they pay dividends or not. If the firm > never paid a dividend and then liquidated there > would be more to liquidate. true true… I was just thinking about it from a 1 year holding period where there was zero cash flows and the price remained constant. In this case the investment would have yielded nothing even though the BV was high… Its a bad worded question to begin with…

#11

P/E goes down = price for a dollar of earnings goes down = earnings will be cheaper in the future. If something is cheaper in the future, why but it now? So underweight it. That’s my logic anyways.