value weighted index/PE ratio

CFA Level III Equities
#1

Sch book 3, Pg 169

Q3: A Market-value weighted index is considered the most representative of market conditions, especially when it is adjusted for free float. Some practitioners, however, have suggested moving away from this weighting scheme to one based on fundamentals such as the price-earnings ratio. Explain this reasoning.

Answers: A value-weighted index may overweight overvalued stocks because the overvalue stock will have a higher market cap. By weighted by price-earnings ratio, these practicioners hope to avoid overweighting overvalued stocks. Stocks with high PE ratios would have lower weights in such an index.

I have not quite understood as to why ‘Stocks with high PE ratios would have lower weights in such an index.’

Can someone please help me understand.

Thank you

#2

High PE = over value, they try to give lower weight because “the overvalue stock will have a higher market cap.”

#3

Any explanation that I can come up with is that they will compare market P/E with P/E based on fundamentals and when market P/E is higher than fundamental P/E then the stock will receive lower weight in the index, thus avoiding being overrepresentative. The higher the overvaluation the lower the weight can be (ie. weights in the index will be dynamic).