CHAPTER IV

COMPANY ANALYSIS
4.1 Introduction
Technical analysis emphasis on evaluation of firms’ financial status based on price movement and change in a
volume of security over a given period of time. In contrary fundamental analysis focuses on firm’s financial
performance such as operating performance, financial position, cash flows, and market value. In the olden time
investment dealt with financial performance and the modern investment theory concentrates with a risk and
return. Here in this chapter the point of attention will be dealing with the operating and financial performance of
firms.
In modern investment analysis, the risk for a stock is related to its beta coefficient. Beta reflects the relative
systematic risk for a stock, or the risk that can not be diversified away.
Last step EIC is individual company analysis
Goal: Estimate share’s intrinsic Value
Constant growth version of dividend discount model
Intrinsic Value = P0= D1__
K –g
Earnings multiple could also be used
Po = estimated EPS x justified P/E ratio
Stock is under or (over) valued if intrinsic value is larger (smaller) than current market price
Focus on earnings and P/E ratio
 Dividend paid from earnings
 Close correlation between earnings and stock price changes
4.1.1 Income statement
It is a measure of how a firm is profitable. Perhaps the very important financial statement that aligns with the
profit maximization/wealth maximization goal of a firm. The constituent of income statement
Investments in capital markets primarily involve transactions in shares, bonds, debentures, and other financial
products issued by companies. The decision to invest in these securities is thus linked to the evaluation of these
companies, their earnings, and potential for future growth. In this chapter we look at one of the most important
tools used for this purpose, Valuation. The fundamental valuation of any asset (and companies are indeed assets
into which we invest) is an examination of future returns, in other words, the cash flows expected from the
asset. The ‘value’ of the asset is then simply what these cash flows are worth today, i.e., their present discounted
value. Valuation is all about how well we predict these cash flows, their growth in future, taking into account
future risks involved.
2. The Analysis of Financial Statements
A company’s financial statements provide the most accurate information to its management and shareholders
about its operations, efficiency in the allocation of its capital and its earnings profile. Three basic accounting

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statements form the backbone of financial analysis of a company: the income statement (profit & loss), the
balance sheet, and the statement of cash flows. Let us quickly summarize each of these.
2.2.1 Income Statement (Profit & Loss)
A profit & loss statement provides an account of the total revenue generated by a firm during a period (usually a
financial year or a quarter), the expenses involved and the money earned. In its simplest form, revenue
generation or sales accrues from selling the products manufactured, or services rendered by the company.
Operating expenses include the costs of these goods and services and the costs incurred during the manufacture.
Beyond operating expenses are interest costs based on the debt profile of the company. Taxes payable to the
Government are then debited to provide the Profit After Tax (PAT) or the net income to the shareholders of the
company.
Actual P&L statements of companies are usually much more complicated than this, with so called ‘other
income’ (income from non-core activities), ‘negative’ interest expenses (from cash reserves with the company),
preferred dividends, and non-recurring, exceptional income or expenses.
Sales or revenues EBT
- Product costs - Taxes__
Gross profit Net Income available to owners
- Period Costs__ - Dividends
EBIT Addition to Retain Earnings
- Interest____ EPS and DPS
EBT
The Balance Sheet
Assets owned by a company are financed either by equity or debt and the balance sheet of a company is a
snapshot of this capital structure of the firm at a point in time; the sources and applications of funds of the
company.
A company owns fixed assets (machinery, and other infrastructure), current assets (manufacturing goods in
progress, money it expects to receive from business partners— receivables, inventory etc.), cash and other
financial investments. In addition to these three, a company could also own other assets which carry value, but
are not directly marketable, like patents, trademarks, and ‘goodwill’—value not linked to assets, but realized
from acquisitions.
These assets are financed either by the company’s equity (investments by shareholders) or by debt. The
illustrative example shown below is the balance sheet of a large Pharmaceutical company.
Cash Flow Statement
The cash flow statement is the most important among the three financial statements, particularly from a
valuations perspective. As the name implies, such a statement is used to track the cash flows in the company
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over a period. Cash flows are tracked across operating, investing, and financing activities. Cash flows from
operations include net income generation adjusted for changes in working capital (like inventories, receivables
and payables), and non-core accruals (like depreciation, etc). A firm’s investment activities comprise fixed, and
current assets (capital and operating expenditure), sometimes into other firms (like an acquisition), and
generally represent negative cash flows. Cash flows in financing activities are the net result of the firm’s
borrowing, and payments during the period. The sum total of cash flows from these three heads represents the
net change in cash balances of the firm over the period.
Cash generation from operating activities of the firm, when adjusted for its capital expenditure represent the
‘free cash’ available to it, for potential investment activities, acquiring other firms or businesses, or distribution
among its shareholders. As we will see in later topics, free cash flows are the key to calculating the so-called
intrinsic value of an asset in any discounted valuation model.
Financial Ratios (Return, Operating and, Profitability Ratios)
Financial ratios are meaningful links between different entries of financial statements, as by themselves the
financial entries offer little to examine a company. In addition to providing information about the financial
health and prospects of a company, financial ratios also allow a company to be viewed, in a relative sense, in
comparison with its own historical performance, others in its sector of the economy, or between any two
companies in general. In this section we examine a few such ratios, grouped into categories that allow
comparison of size, solvency, operating performance, growth profile and risks. The list below is by no means
exhaustive, and merely serves to illustrate a few of the important ones.
Measures of Profitability RoA, RoE
Return on Assets (RoA) in its simplest form denotes the firm’s ability to generate profits given its assets :
RoA = (Net Income + Interest Expenses)*(1- Tax Rate)/Average Total Assets
Return on Equity (RoE) is the return to the equity investor:
RoE = Net Income / Shareholder Funds
Sometimes this ratio is also calculated as RoAE, to account for recent capital rising by the firm
Return on Average Equity = Net Income / Average Shareholder Funds
Return on Total Capital = Net Income + Gross Interest Expense / Average total capital
Measures of Liquidity
Short-term liquidity is imperative for a company to remain solvent. The ratios below get increasingly
conservative in terms of the demands on a firm to meet near-term payables.
Current ratio = Current Assets / Current Liabilities
Quick Ratio = (Cash + Marketable Securities + Receivables) / Current Liabilities
Acid test ratio = (Cash + Marketable Securities) / Current Liabilities
Cash Ratio = (Cash + Marketable Securities) / Current Liabilities
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Capital Structure and Solvency Ratios
Total debt to total capital = (Current Liabilities + Long-term Liabilities) / (Equity + Total Liabilities)
Long-term Debt-Equity = Long-term Liabilities / Equity
Operating Performance
Gross Profit Margin = Gross Profit / Net Sales
Operating Profit Margin = Operating Income / Net Sales
Net Profit Margin = Net Income / Net Sales
Asset Utilization
These ratios look at the effectiveness of a firm to utilize its assets, especially its fixed assets. A high turnover
implies optimal use of assets. In addition to the two below there are others like Sales to inventories, and Sales to
Working capital.
Total Asset Turnover = Net Sales /Average Total Assets
Fixed Asset Turnover = Net Sales/Average Net Fixed Assets
There are many other categories, like the ‘common size’ ratios, which serve to present the company in terms of
one of its own denominators, like Net Sales, or the market capitalization; and others that specifically look at the
risk aspect of things (business, financial, and liquidity). We shall take a look at another two categories, the
market measures, and valuation ratios, after the discussion on valuations.
We shall take a look at another two categories, the market measures, and valuation ratios, after the discussion
on valuations.
The valuation of common stocks
So far we examined a few of the major valuation methods for fixed income-generating assets. Using financial
statements and ratios, we now examine some of the concepts relating to share valuations and to be more
specific, we will deal with valuation of common stocks. Common shareholders are the owners of the firm, and
as such are the final stakeholders in its growth, and risks; they appoint the management to run its day-to-day
affairs and the Board of Directors to oversee the management’s activities. The cash flows (return) to common
shareholders from the company are generally in the form of current and future dividends distributed from the
profits of the firm. Alternatively, an investor can always sell her holdings in the market (secondary market), get
the prevailing market price, and realize capital appreciation if the returns are positive.
We now examine the valuation of common shares in some detail. As mentioned above, the valuation of any
asset is based on the present value of its future cash flows. Such a methodology provides what is called the
‘intrinsic’ value of the asset—a common stock in our case. The problem of valuing the stock then translates into
one of predicting the future free cash flow profile of the company, and then using the appropriate discount
factor to measure what they are worth today. The appropriately named discounted-cash flow technique is also

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referred to as absolute valuation, particularly when compared to another widely-followed approach in valuation,
called relative valuation.
Relative valuation looks at pricing assets on the basis of the pricing of other, similar assets— instead of pricing
them independently—the core assumption being that assets with similar earnings and growth profile, and facing
the same risks ought to be priced comparably. Two stocks in the same sector of the economy could thus be
compared, and the same sector (and its stocks) across countries. The discussion on relative valuation follows
that of absolute or intrinsic valuation.
Absolute (Intrinsic) Valuation
Intrinsic value or the fundamental value refers to the value of a security, which is intrinsic to or contained in the
security itself. It is defined as the present value of all expected cash flows to the company. The estimation of
intrinsic value is what we would be dealing with in details in this chapter.
Discounted Cash Flows
The discounted cash flow method values the share based on the expected dividends from the shares. The price
of a share according to the discounted cash flow method is calculated as under:

( ( 1+r )t )
∞
Divt
P0 ¿ ∑
t=1

It is the intrinsic value of the firm. For a project having current cash expenditure with future cash in flow with a
predetermined life the degree of acceptability of the project will be the difference of the present value of the
future cash in flow discounted at an appropriate rate should exceed the current outlay.
Eg Assume a project has a current cash outlay of birr 120,000 with an estimated life of 5 years providing an
equal cash inflow of br. 35,000 at the end of each year. If the appropriate discount rate is 12%, determine the
acceptability of the project
Solution
PVoa= 35,000[1- 1/(1.12)5]/0.12 =br. 126,167
Since the present value of future cash inflow is greater than the out flow by br. 6, 167(126,167 – 120,000), the
project is acceptable
Approaches to Equity Valuation
Because of the complexity and importance of valuing common stock, various techniques for accomplishing this
task have been devised over time. These techniques fall into one of two general approaches:
(1) the discounted cash flow valuation techniques, where the value of the stock is estimated based upon the
present value of some measure of cash flow, including dividends, operating cash flow, and free cash flow; and
(2) The relative valuation techniques, where the value of a stock is estimated based upon its current price
relative to variables considered to be significant to valuation, such as earnings, cash flow, book value, or sales.
1. Discounted Cash Flow Techniques (absolute valuation model)
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• Present Value of Dividends (DDM)
• Present Value of Operating Free Cash Flow
• Present Value of Free Cash Flow to Equity
2. Relative Valuation Techniques
• Price/Earnings Ratio (P/E)
• Price/Cash Flow Ratio (P/CF)
• Price/Book Value Ratio (P/BV)
• Price/Sales Ratio (P/S)
An important point is that both of these approaches and all of these valuation techniques have several common
factors.
First, all of them are significantly affected by the investor’s required rate of return on the stock because this rate
becomes the discount rate or is a major component of the discount rate.
Second, all valuation approaches are affected by the estimated growth rate of the variable used in the valuation
technique for example, dividends, earnings, cash flow, or sales. Both of these critical variables must be
estimated. As a result, different analysts using the same valuation techniques will derive different estimates of
value for a stock because they have different estimates for these critical variable inputs. The following
discussion of equity valuation techniques considers the specific models and the theoretical and practical
strengths and weaknesses of each of them. Notably, the authors’ intent is to present these two approaches as
complementary, not competitive, approaches—that is, you should learn and use both of them.

Why and When to Use the Discounted Cash Flow Valuation Approach
These discounted cash flow valuation techniques are obvious choices for valuation because they are the epitome
of how we describe value—that is, the present value of expected cash flows. The major difference between the
alternative techniques is how one specifies cash flow—that is, the measure of cash flow used.
The cleanest and most straightforward measure of cash flow is dividends because these are clearly cash flows
that go directly to the investor, which implies that you should use the cost of equity as the discount rate.
However, this dividend technique is difficult to apply to firms that do not pay dividends during periods of high
growth, or that currently pay very limited dividends because they have high rate of return investment
alternatives available.
The second specification of cash flow is the operating free cash flow, which is generally described as cash flows
after direct costs (cost of goods and S, G & A expenses) and before any payments to capital suppliers. Because
we are dealing with the cash flows available for all capital suppliers, the discount rate employed is the firm’s
weighted average cost of capital (WACC).

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This is a very useful model when comparing firms with diverse capital structures because you determine the
value of the total firm and then subtract the value of the firm’s debt obligations to arrive at a value for the firm’s
equity. The third cash flow measure is free cash flow to equity, which is a measure of cash flows available to
the equity holder after payments to debt holders and after allowing for expenditures to maintain the firm’s asset
base. Because these are cash flows available to equity owners, the appropriate discount rate is the firm’s cost of
equity. Beyond being theoretically correct, these models allow a substantial amount of flexibility in terms of
changes in sales and expenses that implies changing growth rates over time. Once you understand how to
compute each measure of cash flow, you can estimate cash flow for each year by constructing a pro forma
statement for each year or you can estimate overall growth rates for the alternative cash flow values as we will
demonstrate with the DDM. A potential difficulty with these cash flow techniques is that they are very
dependent on the two significant inputs—(1) the growth rates of cash flows (both the rate of growth and the
duration of growth) and (2) the estimate of the discount rate. As we will show in several instances, small change
in either of these values can have a significant impact on the estimated value. This is a critical realization when
using any theoretical model: Everyone knows and uses the same model, but it is the inputs that are critical—
GIGO: garbage in, garbage out!

Present Value of Operating Free Cash Flows

In this chapter, you are deriving the value of the total firm because you are discounting the operating free cash
flows prior to the payment of interest to the debt holders but after deducting funds needed to maintain the firm’s
asset base (capital expenditures). Also, because you are discounting the total firm’s operating free cash flow,
you would use the firm’s weighted average cost of capital (WACC) as your discount rate. Therefore, once you
estimate the value of the total firm, you subtract the value of debt, assuming your goal is to estimate the value of
the firm’s equity. The total value of the firm is equal to:

RELATIVE VALUATION TECHNIQUES

In contrast to the various discounted cash flow techniques that attempt to estimate a specific value for a stock
based on its estimated growth rates and its discount rate, the relative valuation techniques implicitly contend
that it is possible to determine the value of an economic entity (i.e., the market, an industry, or a company) by
comparing it to similar entities on the basis of several relative ratios that compare its stock price to relevant
variables that affect a stock’s value, such as earnings, cash flow, book value, and sales. Therefore, in this
section, we discuss the following relative valuation ratios: (1) price/earnings (P/E), (2) price/cash flow (P/CF),
(3) price/book value (P/BV), and price/sales (P/S). We begin with the P/E ratio, also referred to as the earnings
multiplier model, because it is the most popular relative valuation ratio. In addition, we will show that the P/E
ratio can be directly related to the DDM in a manner that indicates the variables that affect the P/E ratio
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1. Earnings Multiplier Model As noted, many investors prefer to estimate the value of common stock using an
earnings multiplier model. The reasoning for this approach recalls the basic concept that the value of any
investment is the present value of future returns. In the case of common stocks, the returns that investors
are entitled to receive are the net earnings of the firm. Therefore, one way investors can estimate value is by
determining how many dollars they are willing to pay for a dollar of expected earnings (typically
represented by the estimated earnings during the following 12month period). For example, if investors are
willing to pay 10 times expected earnings, they would value a stock they expect to earn $2 a share during
the following year at $20. You can compute the prevailing earnings multiplier, also referred to as the
price/earnings
(P/E) ratio, as follows Earnings Multiplier Price / Earnings Ratio=

Current Market Price______

Expected 12-Month Earnings
This computation of the current earnings multiplier (P/ ratio) indicates the prevailing attitude of investors
toward a stock’s value. Investors must decide if they agree with the prevailing P/E ratio (that is, is the earnings
multiplier too high or too low?) based upon how it compares to the P/E ratio for the aggregate market, for the
firm’s industry, and for similar firms and stocks. To answer this question, we must consider what influences the
earnings multiplier (P/E ratio) over time. For example, over time the aggregate stock market P/E ratio, as
represented by the S&P Industrials Index has varied from about 6 times earnings to about 30 times earnings.
The infinite period dividend discount model can be used to indicate the variables that should determine the
value of the P/E ratio as follows:
P=D/k-g If we divide both sides of the equation by E1(expected earnings during the next 12 months), the result
is Pi/Ei = Dt/Et
K-G Thus, the P/E ratio is determined by 1. The expected dividend payout ratio (dividends divided by earnings)
2. The estimated required rate of return on the stock (k)
3. The expected growth rate of dividends for the stock (g)
Required Rate of Return (k) =risk free rate of return + inflation +risk premium Growth rate (g) = (Retention
Rate) × (Return on Equity) =RR×ROE Payout ratio=100%-blow back (retention) ratio E.g. if pay out40% of
earnings as dividends and ROE= 20%, what is g?
Retention rate (RR) =100%- payout ratio=100%-40%=60%
g=RR x ROE= .60*.20 = 12%
As an example, if we assume a stock has an expected dividend payout of 50 percent, a required rate of return of
12 percent, and an expected growth rate for dividends of 8 percent, this would imply the following: D/E = 0.05,
k = 0.12, g = 0.08 P/E = 0.05/ (0.12-0.08) =12.5

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 Again, a small difference in either k or g or both will have a large impact on the earnings multiplier. The
spread between k and g is the main determinant of the size of the P/E ratio. Although the dividend payout ratio
has an impact, we are generally referring to a firm’s long run target payout, which is typically rather stable with
little effect on year-to-year changes in the P/E ratio (earnings multiplier).
After estimating the earnings multiple, you would apply it to your estimate of earnings for the next year (E1) to
arrive at an estimated value. In turn, E1 is based on the earnings for the current Year (E0) and your expected
growth rate of earnings. Using these two estimates, you would compute an estimated value of the stock and
compare this estimated value to its market price.
Consider the following estimates for an example firm:
D/E=0.50
k=0.12
g=0.09
E0= $2.00 Using these estimates, you would compute earnings multiple of:
P/E= 0.05/90.12-0.09)=0.05/0.03=17.7
Given current earnings (E0) of $2.00 and a g of 9 percent, you would expect E1 to be $2.18.
Therefore, you would estimate the value (price) of the stock as V=16.7 ×$2.18 ==$36.4
This estimated value of the stock to its current market price to decide whether you should invest in it. This
estimate of value is referred to as a “two-step process” because it requires you to estimate future earnings (E1)
and a P/E ratio based on expectations of k and g
2. The Price/Cash Flow Ratio The growth in popularity of this relative valuation ratio can be traced to concern
over the propensity of some firms to manipulate earnings per share, whereas cash flow values are generally less
prone to manipulation. Also, as noted, cash flow values are important in fundamental valuation (when
computing the present value of cash flow), and they are critical when doing credit analysis where “cash is king.”
The price to cash flow ratio is computed as follows:
P/CFj ==P/(CFjt+1)
Where: P/CFj =the price/cash flow ratio for firm j
Pt =the price of the stock in period t
CFt+1=the expected cash flow per share for firm j
Regarding what variables affect this valuation ratio, the factors are similar to the P/Eratio. Specifically, the
main variables should be: (1) the expected growth rate of the cash flow variable used, and (2) the risk of the
stock as indicated by the uncertainty or variability of the cash flow series over time. The specific cash flow
measure used is typically EBITDA, but the measure will vary depending upon the nature of the company and
industry and which cash flow specification (for example, operating cash flow or free cash flow) is the best

9
measure of performance for this industry. An appropriate ratio can also be affected by the firm’s capital
structure
3. The Price/Book Value Ratio
The price/book value (P/BV) ratio has been widely used for many years by analysts in the banking industry as a
measure of relative value. The book value of a bank is typically considered as good indicator of intrinsic value
because most bank assets, such as bonds and commercial loans, have a value equal to book value. This ratio
gained in popularity and credibility as a relative valuation technique for all types of firms based upon a study by
Fama and French that indicated a significant inverse relationship between P/BV ratios and excess rates of return
for a cross section of stocks.
The P/BV ratio is specified as follows
P/Bj =Pt/BVt+1
Where
P/BVj =the price/book value ratio for firm j
Pt =the price of the stock in period t
BVt+1=the estimated end-of-year book value per share for firm j
As with other relative valuation ratios, it is important to match the current price with the future book value that
is expected to prevail at the end of the year. The difficulty is that this future book value is not generally
available. One can derive an estimate of the end-of-year book value based upon the historical growth rate for
the series or use the growth rate implied by the sustainable growth formula :g=(ROE) (Retention Rate).
Regarding what factors determine the size of the P/BV ratio, it is a function of ROE relative to the firm’s cost
of equity since the ratio would be one if they were equal—that is, if the firm earned its required return on assets.
In contrast, if the ROE is much larger, it is a growth company and investors are willing to pay a premium over
book value for the stock.
4. The Price/Sales Ratio
The price/sales (P/S) ratio has a volatile history. It was a favorite of Phillip Fisher, a well-known money
manager in the late 1950s, his son, and others. Recently, the P/S ratio has been suggested as useful by Martin
Leibowitz, a widely admired stock and bond portfolio manager. These advocates consider this ratio meaningful
and useful for two reasons.
First, they believe that strong and consistent sales growth is a requirement for a growth company. Although they
note the importance of an above-average profit margin, they contend that the growth process must begin with
sales.
Second, given all the data in the balance sheet and income statement, sales information is subject to less
manipulation than any other data item.
The specific P/S ratio is:
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P/sj= Pt/st+1 Where:
P/Sj =the price to sales ratio for firm j
Pt =the price of the stock in period t
St+1=the expected sales per share for firm j
Again, it is important to match the current stock price with the firm’s expected sales per share, which may be
difficult to derive for a large cross section of stocks. Two caveats are relevant to the price to sales ratio. First,
this particular relative valuation ratio varies dramatically by industry. For example, the sales per share for retail
firms, such as Kroger or Wal-Mart, are typically much higher than sales per share for computer or microchip
firms. The second consideration is the profit margin on sales. The point is, retail food stores have high sales per
share, which will cause a low P/S ratio, which is considered good until one realizes that these firms have low
net profit margins. Therefore, your relative valuation analysis using the P/S ratio should be between firms in the
same or similar industries.
Implementing the Relative Valuation Technique As noted, the relative valuation technique considers several
valuation ratios—such as P/E, P/BV—to derive a value for a stock. To properly implement this technique, it is
essential to compare the various ratios but also to recognize that the analysis needs to go beyond simply
comparing the ratios—it is necessary to understand what factors affect each of the valuation ratios and,
therefore, know why they should differ. The first step is to compare the valuation ratio (e.g., the P/E ratio) for a
company to the comparable ratio for the market, for the stock’s industry, and to other stocks in the industry to
determine how it compares—that is, is it similar to these other P/Es, or is it consistently at a premium or
discount? Beyond knowing the overall relationship to the market, industry, and competitors, the real analysis is
involved in understanding why the ratio has this relationship or why it should not have this relationship and the
implications of this mismatch. Specifically, the second step is to explain the relationship. To do this, you need
to understand what factors determine the specific valuation ratio and then compare these factors for the stock
versus the same factors for the market, industry, and other stocks.

To illustrate this process, consider the following example wherein you want to value the stock of a
pharmaceutical company and, to help in this process, you decide to employ the P/E as a relative valuation
technique. Assume that you compare the P/E ratios for this firm over time (e.g. the last 15 years) to similar
ratios for the S&P Industrials, the pharmaceutical industry, and competitors. The results of this comparison
indicate that the company P/E ratios are consistently
above all the other sets. The obvious question leads you into the second part of the analysis whether the
fundamental factors that affect the P/E ratio (i.e., the firm’s growth rate and required rate of return) justify the
higher P/E.A positive scenario would be that the firm had a historical and expected growth rate that was
substantially above all the comparable and a lower required rate of return. This would indicate that the higher
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P/E ratio is justified; the only question that needs to be considered is, how much higher should the P/E ratio be?
Alternatively, the negative scenario would be if the company’s expected growth rate was equal to or lower than
the industry and competitors while the required k was higher than for the industry and competitors. This would
signal a stock that is apparently overpriced based on the fundamental factors that determine

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