CFA CFA Level 2 Justified P/B ratio results interpretation

Justified P/B ratio results interpretation

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      Hello everybody,

      I just answered wrong to a question on the Qbank on Schweser, and i really don’t understand why it’s wrong so here it is:

      Question 44 – #127293
      Leslie Singer comments to Robert Chan that Dreamtime Industries’ expected dividend growth rate is 5.0%, ROE is 14%, and required return on equity (r) is 10%. Based on a justified P/B ratio compared to a P/B ratio (based on market price per share) of 1.60, Dreamtime Industries is most likely:

      A) overvalued.
      B) correctly valued.
      C) undervalued.
      Your answer: A was incorrect. The correct answer was C) undervalued.
      Justified P/B = (ROE − g) / (r − g). When the expected dividend growth is 5.0%, the justified P/B = (0.14 − 0.05) / (0.10 − 0.05) = 1.80. This is greater than the market P/B of 1.60.

      For me if the Price to whatever is greater than the benchmark, it’s overvalued (big price = too expensive).

      Where i am wrong?

    • Up

      @Lord_Thomas, let me try something. The problem says the market price is such that P/B is 1.6x. According to “our” valuation model, price (justified) is calculated to be 1.8x “book” (from the ROE-g/r-g formula). So the market is saying 1.6x while we really believe it is 1.8x, so the stock is undervalued and we should buy it. Hope this helps.

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