Chartered Financial Analyst (CFA) Practice Exam Level 2

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What does the Justified Trailing P/E formula represent?

  1. Valuation of growth stocks at maturity

  2. Valuation method for assessing dividends only

  3. A valuation formula linking dividend growth to earnings

  4. A formula for evaluating stock price trends

The correct answer is: A valuation formula linking dividend growth to earnings

The Justified Trailing P/E formula serves as a valuation approach that connects a company's dividend growth rate to its earnings growth. Specifically, it is derived from the Gordon Growth Model, which posits that a stock's value is based on the present value of its future dividend payments that are expected to grow at a constant rate. Essentially, the Justified Trailing P/E takes into account both current earnings and the anticipated growth rate of those earnings, effectively establishing a linkage between earnings, dividends, and growth. By using this formula, investors can gain insight into whether a stock is overvalued or undervalued based on its growth prospects relative to its price. This formula is particularly useful for assessing companies that consistently pay dividends, as it acknowledges the relationship between earnings and dividend payouts. Hence, it helps investors to identify the fair value of stocks in a manner that aligns with fundamental growth expectations. The other options do not quite capture the essence of the Justified Trailing P/E. While growth stocks can be evaluated concerning their maturity, the Justified Trailing P/E isn't limited to just that phase. The reference to a valuation method solely for assessing dividends overlooks the crucial connection to earnings growth. Lastly, while stock price trends are a factor