Page 18 - FINAL CFA II SLIDES JUNE 2019 DAY 8

The Fed and Yardeni Models READING 31: MARKET-BASED VALUATION: PRICE AND
ENTERPRISE VALUE MULTIPLES
States that overall market is overvalued (undervalued) when the earnings yield on
the S&P 500 Index is lower (higher) than the yield on 10-year U.S. Treasury bonds. MODULE 31.4: EV AND OTHER ASPECTS

where:
CEY = current earnings yield of the market
CEY = CBY − k × LTEG + ε i CBY = current Moody’s A-rated corporate bond yield
LTEG = five-year consensus earnings growth rate
k = constant assigned by the market to earnings growth (about 0.20 in recent years).

Taking reciprocals of the Yardeni model (and ignoring the error term), we get:

Says P/E ratio is negatively related to interest rates and positively related to growth.

LOS 31.k: Calculate and interpret the P/E-to-growth ratio (PEG) and explain its use in relative valuation.
P/E per unit of expected growth.
It “standardizes” the P/E ratio for stocks with different expected growth rates.
Lower PEGs = more attractive, than stocks with higher PEGs, assuming that risk is similar.
EXAMPLE: Calculating and using the PEG ratio: MR has a leading P/E of 28.75 and a 5-year consensus growth rate forecast
of 14.5%. The median PEG for a group of companies comparable in risk to Med-Ready is 2.34. Calculate the firm’s PEG and
explain whether the stock appears to be correctly valued, overvalued, or undervalued.

Answer: MR is undervalued –hence attractive! But make certain that peer group PEG is also based on
PEG is 28.75 / 14.5 = 1.98. leading P/Es and that comparable firms are similar in risk.

Drawbacks of PEG ratio:
• The relationship between P/E and g is not linear, which makes comparisons difficult.
• Does not account for risk.
• Does not reflect the duration of the high-growth period for a multistage valuation model, especially if the analyst uses a short-
term high-growth forecast.