ART company has come out with a new and improved product. As a result, the marke
ID: 2735119 • Letter: A
Question
ART company has come out with a new and improved product. As a result, the market projects an ROE of 25% for the company, and we know the company will maintain a plowback ratio of 0.20. The company's earnings this year is $3 per share and the current market price is $35. If firms with similar risks in the industry have a PE ratio of 20 with an estimated earnings growth rate of 12%, is ART company overvalued or undervalued based on PEG approach?
The ART company is overvalued because it has a PEG ratio that equals to 1.42
The ART company is undervalued because it has a PEG ratio that equals to 2.22
The ART company is overvalued because it has a PEG ratio that equals to 2.22
The ART company is overvalued because it has a PE ratio that equals to 22.15
The ART company is undervalued because it has a PEG ratio that equals to 1.42
The ART company is undervalued because it has a PE ratio that equals to 11.11
A.The ART company is overvalued because it has a PEG ratio that equals to 1.42
B.The ART company is undervalued because it has a PEG ratio that equals to 2.22
C.The ART company is overvalued because it has a PEG ratio that equals to 2.22
D.The ART company is overvalued because it has a PE ratio that equals to 22.15
E.The ART company is undervalued because it has a PEG ratio that equals to 1.42
F.The ART company is undervalued because it has a PE ratio that equals to 11.11
Explanation / Answer
To compute PEG ratio of ART company:
PEG ratio = PE Ratio / Annual Earning per share Growth
PE Ratio = Market price per share / Earning per share
Step-1 : Market price is $35, Earnings per share is $3, and Growth is computed below
Step-2 : G (growth) = Plowback ratio * Return on equity = 0.20 * 25% = 5%
Step-3 : PEG ratio of ART company = (35/3) / 5 = 2.33
Step-4 : PEG ratio of Industry = (20) / 12 = 1.667
Hence, Option no. 'C' is correct as ART company is overvalued beacuse its PEG ratio is 2.22 (and more than industry standards)
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