Question #25
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: 9
Status: Correct
Correct Answer: A
Question
For which of the following firms is the Price/Earnings to Growth (PEG) ratio most appropriate for identifying undervalued or overvalued equities? Firm A: Expected dividend growth = 6%; Cost of equity = 12%; price-to-earnings (P/E) = 12. Firm B: Expected dividend growth = −6%; Cost of equity = 12%; price-to-earnings (P/E) = 12. Firm C: Expected dividend growth = 1%; Cost of equity = 12%; price-to-earnings (P/E) = 12.
Answer Choices:
A. C) Firm
B. Firm
C. Firm C
Explanation
The formula for the PEG ratio is: PEG = (P/E) / g. It measures the tradeoff between P/E and
expected dividend growth (g). For traditional growth firms, PEG ratios fall between 1 and 2.
The general rule is that PEG ratios above 2 are indicative of overvalued firms (expensive),
and PEG ratios below 1 are indicative of firms that are undervalued (cheap).
Firm A:
PEG = 2, indicating a stock that is appropriately priced.
Firm B:
The PEG ratio of firms with negative expected dividend growth is negative,
which is meaningless. For Firm B, PEG = -2.
Firm C:
Firms with very low expected dividend growth are likely to have PEG ratios
that unrealistically indicate overvalued stocks. For Firm C, PEG = 12.