CHAPTER 17
PE RATIOS AND EARNINGS GROWTH
LEARNING OBJECTIVES
1.
How expected earnings growth affects price/earnings ratios.
2.
Why we distinguish between supernormal and long-term growth rates.
3.
How to use the price/earnings to growth ratio to adjust for supernormal growth differences.
TRUE/FALSE QUESTIONS
1.
When the PE ratio is used in a multiples-based valuation, earnings is the value driver.
(easy, L.O. 1, Section 1, true)
2.
One of the most influential factors on the PE ratio is stock market volatility.
(moderate, L.O. 1, Section 1, false)
3.
The analyst must assume that earnings and cash flow are equal to isolate the effect of expected earnings
growth on the PE ratio.
(moderate, L.O. 1, Section 1, true)
4.
There are only a finite number of variations in earnings growth patterns.
(moderate, L.O. 2, Section 1, false)
5.
Failures to closely match on expected earnings growth or adjust for the effects of differences in expected
earnings growth on the PE ratio in some way will result in a potentially large valuation error.
(moderate, L.O. 2, Section 1, true)
6.
It can be graphically shown that the PE ratio changes little with varying degrees of supernormal earnings
growth expectations.
(difficult, L.O. 2, Section 1, false)
7.
If a company being valued that has an 20% expected supernormal growth rate is compared with a firm
that has a 30% expected supernormal growth rate, a significant valuation error will occur.
(difficult, L.O. 2, Section 1, true)
8.
Because the supernormal growth rate affects the PE ratio, the analyst must control for it in any PE
analysis.
(moderate, L.O. 3, Section 2, true)
9.
One way analysts attempt to achieve comparability is to match on industry; however, there can be a wide
range of growth expectations across firms within the same industry.
(moderate, L.O. 3, Section 2, true)
10.
A firm that invests heavily in research and development may have lower current earnings but will likely
have higher earnings growth expectations.
(moderate, L.O. 3, Section 2, true)
11.
With the simple PE approach, the analyst does not estimate growth rates of the two firms because it is
explicitly assumed that the two firms’ growth rates are the same.
(moderate, L.O. 3, Section 2, false)
12.
The PEG ratio will be useful for valuing otherwise comparable firms with different sustainable growth
rates as long as it is roughly constant across the different values of supernormal growth.
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