Question on Valuation Multiples

CFA Level II Equities
#1

Hi folks,

Need some help here. I attach the background data

image
image876×536 102 KB

The question is:

Based on the information in the figure, which of the following statements least
likely supports a recommendation of Home Decor over Lester’s?
A. Home Decor’s P/B ratio relative to the industry.
B. Home Decor’s P/B ratio relative to Lester’s P/B ratio.
C. Home Decor’s historical P/B ratios.

I calculated Home Décor’s P/B relative to:

  • Industry: 0.914
  • Lester: 0.766
  • Historical: 0.383

Given that Home Decor’s P/B discount to the industry P/B is the lowest, why is (A) wrong?

The correct answer given is (C).

Thanks in advance!

#2

When you compare P/B ratios you also need to consider ROE.

Home Decor has same roe with industry average but with lower p/b ratio, which means it has the same probability level but with lower market price. Thus, you should long Home Decor.

Home Decor’s historical P/B ratios are too high. It means that Home Decor’s market price is probably unreasonably overpriced.

#3

Thanks @Okachiang

But if Home Decor’s historical P/B ratios are persistently higher than the industry average, couldn’t we say that the market values Home Decor at a premium for certain reasons? And that therefore if Home Decor now trades at a discount to its historical average, it is undervalued?

#4

That’s why we need to combine with ROE to make a conclusion.

#5

Thanks @Okachiang

I see what you mean. In this case, the historical valuation premium that Home Decor commanded is not justifiable given that its ROE is similar to the industry ROE.

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