Question

Stock A has PIE:15   stock B has PIE : 35

A) which stock is better

B) what does this difference tell us about there stocks

C) which stock would perform be tter in the bull market

Answer 1

Let us first review the facts of the case

P/E of A= 15

P/E of B = 35

Now we need to understand what are the factors that determine a firms P/E ratio

The factors are

1) Growth Potential - Higher growth firms tend to have a higher P/E

2) Cost of capital - Firms with higher cost of capital will have lower P/E

3) Dividend payout ratio - Firms with higher dividend payout ratios will have a higher P/E

A) Which stock is better ?

It is difficult to ascertain which stock is better, without knowing what the P/E ratio of the peer set is. Assuming that the P/E of the peer set is 30, then we can say that at first look, B is overvalued but A is significantly undervalued. Although we will have to do a deeper analysis to determine is company A deserves to be undervalued.

But on first glance, it appears to be that Stock B is better, as the market is giving it a higher valuation multiple

B) What is the difference in the stocks ?

As discussed above, there could be three primary differences

1) Company B could have a higher growth potential compared to Company A, which is why it has a higher PE multiple

2) Company B has a lower cost of capital, as it could have some leverage on its books, compared to company A, which has a higher cost of capital since it is funded only by Equity

3) Company B could have higher dividends vs company A, and hence Equity shareholders give it a higher multiple

C) which will perform better in a bull run

Stock B, will perform better in a bull market run as it has a higher growth potential and the market allocates a high valuation multiple to it