Categorization of Companies X and Y: CFA Level 1 Exam

C

Based on the information provided, we can categorize the two companies as follows:

Company X:

• Company X consistently earns a higher rate of return on assets than its cost of capital. This indicates that the company is generating positive returns on its investments.
• However, the stock price of Company X is substantially greater than its fair value. This suggests that the stock may be overvalued in the market.

Based on these characteristics, Company X can be categorized as a growth company. The consistent higher rate of return on assets indicates that the company is growing its earnings effectively. However, the overvaluation of the stock price suggests that investors may have high expectations for the company's future growth, resulting in an inflated stock price.

Company Y:

• Company Y's earnings have been pulled down by the recent economic slowdown. This implies that the company's financial performance has been negatively impacted by the overall economic conditions.
• Despite the negative returns on the overall market, the stock price of Company Y has remained stable. This suggests that the market perceives the stock to be relatively resistant to economic downturns.

Based on these characteristics, Company Y can be categorized as a defensive stock. The stable stock price during a period of negative returns on the overall market indicates that investors view the stock as a safe haven or less susceptible to economic downturns. This perception could be due to factors such as the nature of the company's business, stable cash flows, or a strong market position.

Given these categorizations, the correct statement is:

C. Company X is a growth company, and Stock Y is a defensive stock.