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Enhanced Systems, Inc., (ESI) has a leading price to sales (P/S) of 0.18 while the median leading P/S of a peer group of companies within the industry is 0.10. Based on the method of comparables, an analyst would most likely conclude that ESI should be:

A) bought on margin as an undervalued stock.

B) sold or sold short as an overvalued stock.

C) bought as an undervalued stock.

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The price per dollar of sales is considerably higher than that for the median of the peer group, which implies that it may well be overvalued.

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Enhanced Systems, Inc., (ESI) has a leading price to book value (P/B) of four while the median P/B of a peer group of companies within the industry is six. Based on the method of comparables, an analyst would most likely conclude that ESI should be:

A) viewed as a properly valued stock.

B) bought as an undervalued stock.

C) sold as an overvalued stock.

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The price per dollar of book value is considerably lower than that for the median of the peer group, which implies that it may well be undervalued

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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 a 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.

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

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

B) Many stocks in the benchmark group are mispriced.

C) Large stocks have an outsized effect on the benchmark data.

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Capitalization weights are not an issue unless the benchmark is a cap-weighted index. Jenkins is using a basket of stocks in the same industry, which can be assumed to be a simple arithmetic 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. (Study Session 12, LOS 44.k)

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If she wants to compare Canadian software companies to U.S. software companies, it would be most appropriate for Jenkins to value the companies using the:

A) price/sales ratio.

B) enterprise value/EBITDA ratio.

C) price/book ratio.

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Accounting issues are not relevant to this discussion. As such, we must consider the other characteristics of the market to choose the best method. The P/E ratio is limited in value because many of the companies do not make money. The P/S ratio doesn’t work well when the companies have different cost structures, and the measure does not reflect differences in profit margins. EBITDA is less likely to be negative than earnings, but it will fall prey to differences in cost structure just as the P/E and P/S ratios will. Like EBITDA, book value is often positive even when profits are negative. The price/book ratio is best for valuing companies with small amounts of fixed assets, like software makers. In addition, the fact that most of the companies are small eliminates one of the P/B ratio’s weaknesses that it can be misleading when compared firms have significantly different asset sizes. (Study Session 12, LOS 44.k)

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Which valuation ratio is least appropriate for comparing Massive and Mouse?

A) Price/book because Massive is larger than Mouse.

B) Enterprise value/EBITDA because Massive and Mouse have very different debt levels.

C) Price/cash flow because cash flows for small companies can be extremely volatile.

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The P/B ratio’s can be misleading when used to compare companies with vastly different asset bases. A large semiconductor company is likely to have lots of fixed assets, while a tiny software company may have very few assets. The P/CF ratio tends to be more stable than the P/E ratio. The P/E ratio is useless for considering companies that lose money, but that does not mean the measure has no value when earnings are positive. The EV/EBITDA ratio is effective at comparing stocks with different degrees of financial leverage. (Study Session 12, LOS 44.k)

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Mouse & Associates is cheaper than Massive Tech as measured by:

A) the price/sales ratio and the dividend yield.

B) the price/sales ratio and the price/earnings ratio.

C) the earnings yield but not the price/book.

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To calculate the P/E, divide the market capitalization by the earnings. Lower is cheaper.
To calculate the P/B, divide the market capitalization by the equity. Lower is cheaper.
To calculate the P/S, determine sales by dividing the earnings by the net margin. Then divide the market capitalization by the sales. Lower is cheaper.
To calculate the earnings yield, divide the earnings by the market capitalization. Higher is cheaper.
To calculate the dividend yield, divide the dividends by the price. Higher is cheaper.

	Massive Tech	Mouse & Associates
P/E	30.23	26.67
P/B	10.83	15.27
P/S	3.63	5.87
Earnings yield	3.31%	3.75%
Dividend yield	4.62%	0.17%

(Study Session 12, LOS 44.d)

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The price/cash flow ratio of Massive Tech, where cash flow is defined as earnings plus noncash charges, is closest to:

A) 9.65.

B) 7.89.

C) 16.67.

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Cash flow = net income plus depreciation plus amortization = ($4,300 + 3,500 + 5,675) = $13,475 million.
P/CF = market capitalization/cash flow = ($130,000/13,475) = 9.65. (Study Session 12, LOS 44.d)

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If Jenkins wants to compare foreign stocks to U.S. stocks and is concerned about differences in accounting, she should start with the:

A) price/book ratio.

B) dividend yield.

C) price/FCFE ratio.

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Of all the price ratios, the price/free cash flow to equity ratio is the least affected by international accounting differences. However, the dividend yield is not affected by such accounting differences at all, and represents a good starting point. Residual-income models and price/book ratios are very sensitive to accounting issues. (Study Session 12, LOS 44.p)

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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.

A) Firm C.

B) Firm B.

C) Firm A.

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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.

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Consider the statement: "Unlike many valuation metrics that incorporate dividend discounting, the PEG ratio may be used to value firms with zero expected dividend growth prospects." Is this statement correct?

A) Yes, because the expected dividend growth rate is cancelled out in the computation of the PEG ratio.

B) Yes, because the computation of the PEG ratio does not use the rate of expected dividend growth.

C) No, because the PEG ratio is undefined for zero-growth companies.

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The PEG ratio measures the tradeoff between P/E and expected earnings growth (g). The formula for the PEG ratio is: PEG = (P/E) / g. Firms with zero expected earnings growth will have an infinite (or undefined) PEG ratio due to division by zero.

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Two security analysts, Ramon Long and Sri Beujeau, disagree about certain aspects of the PEG ratio. Long argues that: "unlike typical valuation metrics that incorporate dividend discounting, the PEG ratio is unique because it generates meaningful results for firms with negative expected earnings-growth." Is Long correct?

A) Yes, because the expected earnings-growth rate is cancelled out in the computation of the PEG ratio.

B) No, because the PEG ratio generates meaningless results for negative earnings-growth companies.

C) Yes, because the computation of the PEG ratio does not use the rate of expected earnings growth.

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The PEG ratio is: PEG = (P/E) / earnings growth. As such, firms with negative expected earnings growth will have a negative PEG ratio, which is meaningless.

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The definition of a PEG ratio is price to earnings (P/E):

A) divided by the expected earnings growth rate.

B) divided by the average growth rate of the peer group.

C) divided by average historical earnings growth rate.

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The PEG ratio is P/E divided by the expected earnings growth rate.

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Which of the following statements regarding the P/E to growth (PEG) valuation approach is least accurate? The P/E to growth (PEG) valuation approach assumes that:

A) there are no risk differences among stocks.

B) there is a linear relationship between price to earnings (P/E) and growth.

C) stocks with higher PEGs are more attractive than stocks with lower PEGs.

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The PEG valuation approach implicitly assumes there is a linear relationship between price to earnings (P/E) and growth, even though there is not a "real world" linear relationship. The analyst must be cautious when using the PEG ratio for valuation or comparison purposes especially if the growth rate is very small or very large. If earnings or the growth rate is negative the PEG ratio is meaningless. The PEG ratio does not adjust for varying levels of risk among stocks and views stocks with lower PEG ratios to be more attractive than stocks with higher PEG ratios.

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The relative valuation model known as the PEG ratio is equal to:

A) earnings per share growth rate / price-to-earnings.

B) P/E × earnings.

C) price-to-earnings (P/E) / earnings per share (EPS) growth rate.

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The PEG ratio is equal to the price-to-earnings ratio divided by the EPS growth rate.

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Good Sports, Inc., (GSI) has a leading price-to-earnings (P/E) ratio of 12.75 and a 5-year consensus growth rate forecast of 8.5%. What is the firm’s P/E to growth (PEG) ratio?

A) 150.00.

B) 1.50.

C) 0.67.

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The firm’s PEG is 12.75 / 8.50 = 1.50.