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CFA Level I · CFA Level I Exam · Relative Value Equity Valuation Approaches

An analyst values a Brazilian bank and a German bank using P/E. Brazilian nominal interest rates and expected inflation are much higher than German ones. Holding other factors equal, the Brazilian bank's justified P/E is most likely:

The Brazilian bank's justified P/E is most likely lower. Higher nominal interest rates and country risk raise the required return on equity, and with other factors held equal a higher discount rate reduces the justified earnings multiple. Higher inflation does not offset this.

  1. Ahigher, because inflation raises nominal earnings growth
  2. Blower, because the required return on equity is higherCorrect
  3. Cthe same, because P/E is unaffected by country factors

Explanation

Higher nominal rates and country risk raise the required return on equity. A higher required return, with growth held equal, lowers the justified P/E. The growth claim in option A ignores that the discount rate rises by at least as much.

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