Chartered Financial Analyst (CFA) Practice Exam Level 2

In the Method of Comparables, what indicates that a firm is overvalued?

1. Firm multiple equals benchmark

2. Firm multiple is significantly lower than the benchmark

3. Firm multiple is higher than the benchmark

4. Firm multiple equals industry average

The correct answer is: Firm multiple is higher than the benchmark

In the Method of Comparables, evaluating a firm’s valuation typically involves comparing its valuation multiples, such as price-to-earnings (P/E) or enterprise value-to-EBITDA (EV/EBITDA), to those of similar firms in the industry or to an established benchmark. When the firm multiple is higher than the benchmark, it suggests that the firm may be overvalued. This implication arises because a higher multiple indicates that investors are willing to pay more for each unit of earnings or cash flow relative to peers. This excess willingness to pay, without a corresponding increase in intrinsic value or growth potential, can signal inflated expectations. Investors might be pricing in excessive optimism about future performance, which may not be justified when comparing with similar companies. Thus, a firm multiple exceeding the benchmark could indicate that the market has overestimated the firm's growth prospects, leading to potential overvaluation. Investors might then look for opportunities to sell the stock or exercise caution in their investments based on this assessment.