Question #5 - Reading 22 Market-Based Valuation - Price and Enterprise Value Multiples

Reading: Reading 22 Market-Based Valuation - Price and Enterprise Value Multiples

PDF File: Reading 22 Market-Based Valuation - Price and Enterprise Value Multiples.pdf

Page: 3

Status: Incorrect

Correct Answer: B

Your Answer: B

Shared Context

of 140 An analyst has gathered the following fundamental data: Firm A Firm B Firm C Firm D Payout Ratio 75% Required Rate of Return 12% 12% 12% 12% Return on Equity (ROE) 20% 15% 30% 14% Price/Book Value (PBV) Ratio 3.00 0.70 3.50 What is the PBV ratio for Firm A? A) 1.25. B) 0.71. C) 2.14. Carol Jenkins, CFA, works as a stock analyst for Cape Cod Partners, a money-management firm that handles private accounts for high net worth clients. Jenkins' assignment is to find attractively valued stocks for client portfolios. Jenkins believes that recent weakness in the technology sector presents an attractive opportunity. She is looking at Massive Tech, the market leader in chipsets for laptop computers, and Mouse & Associates, a tiny software developer specializing in data-storage programs. Jenkins is considering the companies' relative values in a number of ways. Statistics for Massive and Mouse are provided below: Massive Tech Mouse & Associates Stock price $65 $12 Trailing earnings $4,300 $3.15 Market capitalization $130,000 $84 Assets $16,250 $7.0 Equity $12,000 $5.5 Operating margin 49% 54% Net margin 12% 22% Depreciation $3,500 $6 Amortization $5,675 $1.5 Fixed investment plus borrowing $4,200 $0.3 Dividends $3 $0.02 Shares outstanding 2,000 7 * All figures except stock price, dividends, and percentages are in millions. In most cases, Jenkins values her stocks relative to an equally-weighted basket of stocks in the same industry in order to avoid significant fundamental differences between companies of different types. However, her picks made based on price/earnings ratios are not doing well against the market. She fears the stocks she selects are not as cheap as she originally thought, relative to her benchmark. Jenkins also wants to improve Cape Cod's selection of software stocks. To widen the field beyond the companies she currently follows, Jenkins wants to include Canadian software stocks in Cape Cod's research universe. Differences in accounting methodologies are not a concern, but Jenkins is still concerned about the difficulty of valuing the different stocks. Jenkins has assembled the following data about Canadian software companies: Most are very small. Most carry little debt, but about 20% are heavily leveraged. These companies are more likely to be unprofitable compared to U.S. companies. Few pay dividends, as is the case in the U.S. Many of the companies are government-subsidized, which leads to drastic differences in the level of operating expenses.

Question

Which of the following explanations is least likely to explain why Jenkins' stock picks underperform?

Answer Choices:

A. Large stocks have an outsized effect on the benchmark data

B. She is using the mean rather than the median valuation as a benchmark

C. Many stocks in the benchmark group are mispriced

Explanation

Capitalization weights are not an issue unless the benchmark is a cap-weighted index. Jenkins is using an equally-weighted basket of stocks in the same industry (or simple average). Average valuations reflect outliers; medians do not. P/Es can get very high, but can never fall below zero. As such, the outliers are going to trend high, and the median is likely to be considerably lower than the mean. A stock that looks cheap relative to the mean may look expensive relative to the median. Stocks of different sizes often have different average or median valuations. Mispricing of stocks in the benchmark is always a risk.

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