I have a confusion with the solution given by CFA regarding the following question.
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Using Exhibits 1 and 2, the stock that would be the best addition to Fund D is:
A.AQU.
B.BRW.
C.CSY.
C is correct. Fund D follows the GARP (growth at a reasonable price) strategy, which seeks out companies with above-average growth that trade at reasonable valuation multiples. Many investors who use GARP rely on the P/E-to-growth (PEG) ratio.
- AQU’s forward P/E is 36 ÷ 3.70 = 9.73, and its PEG ratio is 9.73 ÷ 9.50 = 1.02.
- BRW’s forward P/E is 28 ÷ 2.75 = 10.18, and its PEG is 10.18 ÷ 12.0 = 0.85.
- CSY’s forward P/E is 19 ÷ 1.95 = 9.74, and its PEG is 9.74 ÷ 11.25 = 0.87.
Although lower PEG ratios are preferred and BRW has a slightly lower PEG ratio than CSY, BRW’s EPS growth forecast of 12.00% is below the sector long-term growth forecast of 14.00% whereas CSY’s EPS growth forecast of 11.25% is above the sector long-term growth forecast of 10.00%. Given CSY’s combination of above-average growth and a reasonable valuation multiple, it would be the best addition to Fund D.
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Shouldn’t the PEG ratio be compared with the industry average PEG ratio? In this case AQU’s industry average PEG ratio is 1.42 while CSY’s industry average PEG ratio is 1.08. It seems like AQU is more undervalued than CSY. Thank you.