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Series 7 practice questionhardEquity Securities — Common Stock — Scenario

An investor is deciding between Company A with a P/E ratio of 35 and Company B with a P/E ratio of 12, both in the same industry. Which conclusion is MOST appropriate?

  1. ACompany A is always the better investment because it has higher earnings
  2. BCompany B is undervalued and should be purchased immediately
  3. CInvestors are willing to pay more per dollar of earnings for Company A, possibly due to higher expected growth, but the P/E ratio alone does not determine which is a better investment✓ Correct answer
  4. DCompany A's stock price will decline because its P/E is too high
Explanation

Why C — Investors are willing to pay more per dollar of earnings for Company A, possibly due to higher expected growth, but the P/E ratio alone does not determine which is a better investment

A higher P/E ratio indicates that investors are paying more for each dollar of current earnings, typically reflecting higher growth expectations. However, a high P/E does not automatically make a stock overvalued, nor does a low P/E make one undervalued. P/E ratios must be evaluated in context of growth prospects, industry norms, risk factors, and other fundamental analysis metrics.

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