Question

You are researching the valuation of the stock of a company in the food - processing industry. Suppose you intend to use the mean value of the forward P/ Es for the food - processing industry stocks as the benchmark value of the multiple. This mean P/ E is 18.0. The forward or expected EPS for the next year for the stock you are studying is $ 2.00. You calculate 18.0 $ 2.00 $ 36, which you take to be the intrinsic value of the stock based only on the information given here. Comparing $ 36 with the stock ’ s current market price of $ 30, you conclude the stock is undervalued.

A. Give two reasons why your conclusion that the stock is undervalued may be in error.

B. What additional information about the stock and the peer group would support your original conclusion?

Answer 1

A.

Why your conclusion that the stock is undervalued may be in error.

1) The forward EPS may not be relevant if earnings are highly volatile so that next year's earnings are not forecastable with any degree of accuracy

2) The company whose stock is analyzed might have a different business model and financials as compared to the peers. Hence the mean P/E would not aptly reflect the mean or expected P/E for the stock and cannot be used as a bench-mark.

3) Management discretion distorts reported earnings. Hence this factor can lead to an error

B.

Additional information about the stock and the peer group would support your original conclusion

1) If the historical long-time volatility of the stock as the food-processing industry is low, then the conclusion may be supported

2) The company of whose stock is analyzed has a business model and financial ( Balance sheet size etc) pretty comparable to the peers in the food-processing industry whose mean value of the forward P/ Es is used.