As a stock portfolio manager, you spend most of your day searching for stocks that ap- pear to be undervalued. In the last few days, you have received information about two stocks that you are assessing-Olympic stock and Kenner stock. Many stock analysts be- lieve that Olympic stock and Kenner stock are undervalued because their price-earnings ratios are lower than the industry average. Olympic, Inc. has a PE ratio of 6, versus an industry PE ratio of 8. Its stock price declined recently in response to an announcement that its quarterly earnings would be lower than expected due to expenses from recent restructuring. The restructuring is expected to improve Olympic's future performance, but its earnings will take a large onetime hit this quarter.
Kenner Company has a PE ratio of 9, versus a PE ratio of 11 in its industry. Its earn- ings have been decent in recent years, but it has not kept up with new technology and may lose market share to competitors in the future.
Questions
1. Should you still consider purchasing Olympic stock in light of the analysts' argu- ments about why it may be undervalued?
2. Should you still consider purchasing Kenner stock in light of the analysts' arguments about why it may be undervalued?
3. Some stock analysts have just predicted that the prices of most stocks will fall because interest rates are expected to rise, which would cause investors to use higher required rates of return when valuing stocks. The analysts used this logic to suggest that the present value of future cash flows would decline if interest rates rise. The expected in- crease in interest rates is due to expectations of a stronger economy, which will result in an increased demand for loanable funds by corporations and individuals. Do you believe that stock prices will decline if the economy strengthens and interest rates rise?