Assume That You Have Been Asked to Evaluate the P/E

Essay

Assume that you have been asked to evaluate the P/E ratios of five prospective acquisition candidates.You have the following information:
$\begin{array} { l c l c c } \text { company } & \text { P/E ratio } & \text { beta } & \text { growth rate } & \text { payout ratio } \\\hline\mathrm {A}& 10 & 1.0 & 5 \% & 0.9 \\\mathrm {B} & 8 & 1.25 & 8 \% & 0.8 \\\mathrm { C } & 9 & 1.25 & 10 \% & 0.6 \\\mathrm { D } & 6 & 1.5 & 11 \% & 0.4 \\\mathrm { E } & 5 & 2.0 & 12 \% & 0.45\end{array}$

a. If the riskless rate is 7% and the above statistics will hold through infinity, which of the companies are overvalued and which are undervalued?
b. Now assume that you are using a regression methodology to estimate the relationship between P/E ratios and these variables. Using a cross-sectional sample, you obtain the following equation: P/E = 2 + 0.3 x growth rate + 5 x payout ratio - 1 x beta. Using this equation, which of the companies are overvalued and which are undervalued?