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CFA Level I · CFA Level I Exam · Introduction to Equity Valuation

An analyst compares the price-to-earnings ratio of a listed software company with the median ratio of its industry peers and concludes the stock is undervalued because its ratio is lower. Which of the following is the most likely weakness of this conclusion?

The most likely weakness is that peer multiples can reflect mispricing across the whole industry. Relative valuation shows only value compared with comparables, so a lower P/E than overpriced peers may still not indicate undervaluation relative to intrinsic value.

  1. APeer multiples can themselves reflect mispricing across the whole industryCorrect
  2. BRelative valuation requires a discount rate estimate for each period
  3. CThe approach ignores the market prices of the comparable companies

Explanation

Relative valuation only indicates value compared with peers. If the whole peer group is overvalued or undervalued, the conclusion is flawed. It does not need a discount rate and it relies directly on market prices.

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