Company A trades at a price-to-earnings (P/E) ratio of 35, while Company B in the same industry trades at a P/E of 12. An analyst concludes that Company A is overvalued and Company B is undervalued. Which of the following best identifies a flaw in this reasoning?
AThe P/E ratio is meaningless for comparing companies in the same industry; the price-to-book ratio should always be used instead
BCompany B's lower P/E proves it is riskier, because the market always discounts riskier stocks to lower multiples, making the analyst's conclusion exactly backwards
CA higher P/E can reflect the market pricing in faster expected future earnings growth, so a high P/E alone does not prove overvaluation — the analyst must compare each company's P/E to its own projected growth rate and the industry median before drawing a conclusion
DP/E ratios cannot be compared between two companies unless they have the identical number of shares outstanding
A company reports earnings per share (EPS) of $4.00 and pays an annual dividend of $1.20 per share. What is its dividend payout ratio, and what does this ratio indicate about the company's use of earnings?
A70%, because the payout ratio measures the percentage of earnings the company keeps rather than the percentage it distributes
B30%, meaning the company distributes 30% of its net earnings to shareholders as dividends and retains the remaining 70% for reinvestment, debt repayment, or reserves
C3.33, meaning the company earns 3.33 times as much as it pays in dividends, which is called the dividend coverage ratio, not the payout ratio
DThe payout ratio cannot be calculated without knowing the company's total revenue
An analyst uses a discounted cash flow (DCF) model to value a company. She estimates free cash flows of $10 million per year for the next five years and applies a discount rate of 10%. All else equal, if she raises the discount rate to 15%, what happens to her estimate of the company's intrinsic value and why?
AThe intrinsic value increases, because a higher discount rate reflects higher expected returns and therefore makes the investment more attractive
BThe effect is ambiguous without knowing the terminal value assumption; the discount rate has no impact on the five-year projection itself
CThe intrinsic value stays the same, because the discount rate only affects the timing of cash flows, not their total value over the projection period
DThe intrinsic value decreases, because a higher discount rate reduces the present value of each future cash flow — the same dollar earned in the future is worth less today when discounted at a steeper rate