Deck 14: Valuation: Market-Based Approaches

Question 1

Under the value-to-book model a firm in steady state equilibrium earning ROCE = RE will:

A) create additional shareholder wealth and be valued above book value.
B) maintain shareholder wealth and be valued at book value.
C) destroy shareholder wealth and be valued below book value.
D) be in a no-growth state.

Answer 1

B

Question 2

Residual income is defined as:

A) Difference between expected comprehensive income and required earnings by the firm
B) Difference between comprehensive income and retained earnings
C) Difference between comprehensive income and the company's book value
D) The addition of comprehensive income to net income for the year

Answer 2

A

Question 3

The market price of a share of common equity reflects:

A) the aggregated expectations of all of the market participants following that particular stock.
B) the present value of future residual income.
C) book value plus the present value of future residual income.
D) the correct value for the particular stock.

Answer 3

A

Question 4

A company is expected to have a value of $142,857 at the start of next period and investors require a 14 percent return on equity capital.Using the assumptions of the price-earnings ratio,what would be the company's earnings for the current year?

A) $20,000
B) $14,286
C) $2,800
D) $12,500

Question 5

Which of the following would not be an example of the use of a multiple when valuing common equity?

A) Price-to-operating cash flow
B) Price-to-book.
C) Price-to-earnings.
D) Multi-period discounted earnings models.

Question 6

Strictly speaking,the price-earnings ratio assumes that firm value is the:

A) future value of a constant stream of expected future earnings, discounted at a constant expected future risk-free rate.
B) future value of a constant stream of expected future earnings, discounted at a constant expected future discount rate.
C) present value of a constant stream of expected future earnings, discounted at a constant expected future risk-free rate.
D) present value of a constant stream of expected future earnings, discounted at a constant expected future discount rate.

Question 7

One problem with the price-earnings ratio commonly reported is that:

A) it divides share price, which reflects the present value of future earnings by historical earnings.
B) it divides share price, which reflects the present value of book value by historical earnings.
C) it does not take into consideration the present value of future earnings.
D) it is based on analysts' expectations.

Question 8

Under the value-to-book model a firm will be valued below book value when:

A) the ROCE is greater than RE
B) the ROCE is equal to RE
C) the ROCE is less than RE
D) the firm's growth rate is above the industry average

Question 9

Under the value-to-book model new projects will be less profitable only when:

A) ROCE equals ROA
B) ROCE equals RE
C) ROCE is greater than RE
D) ROCE is less than RE

Question 10

Which of the following normally does not introduce measurement error into the calculation of P/E ratios?

A) differences in firm specific growth rates
B) restructuring losses
C) transitory gains
D) deferred taxes

Question 11

Valuation using market multiples captures:

A) absolute valuation per dollar of book value or per dollar of earnings.
B) dollar of book value or dollar of earnings per dollar of common equity.
C) relative valuation per dollar of book value or per dollar of earnings.
D) intrinsic valuation per dollar of book value or per dollar of earnings.

Question 12

Trading on the equity is likely to be a good financial strategy for stockholders of companies having:

A) Cyclically high and low amounts of reported earnings.
B) Steadily declining amounts of reported earnings.
C) Volatile fluctuations in reported earnings over short periods of time.
D) Steady amounts of reported earnings.

Question 13

Wolverwine Company's current stock price is $55 per share and the company's trailing earnings per share were $2.10.Given that analysts are forecasting growth of 12% for Wolverwine,what is the company's PEG ratio?

A) 21.2
B) 2.18
C) 2.97
D) 1.52

Question 14

Which of the following is not a reason why price-earnings ratios would differ across firms?

A) Risk
B) Profitability
C) Growth
D) Operating leverage

Question 15

Which of the following ratios usually reflects investor's opinions of the future prospects for the firm?

A) Earnings per share
B) Dividend yield
C) Price/earnings ratio
D) Book value per share

Question 16

Firms with low P/E ratios tend to have current residual income that is greater than:

A) future actual income.
B) future residual income.
C) past actual income.
D) past residual income.

Question 17

Companies value-to-book and market-to-book ratios may differ due to accounting reasons.An example of an accounting reason that would create a difference is:

A) accelerated methods of depreciation.
B) investments in successful research and development programs that are expensed according to conservative accounting principles.
C) using LIFO versus FIFO for inventory.
D) high operating leverage.

Question 18

A company is expected to generate $175,000 in earnings next period and requires a 20% return on equity capital.Using the assumptions of the price-earnings ratio,what would be the company's value at the beginning of next period?

A) $781,250
B) $1,250,000
C) $2,000,000
D) $875,000

Question 19

Assuming that Ska Company's cost of equity capital is 14% and it expects to grow earnings at a rate of 8% per year,we would expect Ska's P/E ratio to be:

A) 8
B) 16.7
C) 14
D) 4.5

Question 20

A company with a PEG ratio of less than one would be interpreted as having a stock price:

A) that is underpriced given earnings and expected earnings growth.
B) that is low relative to the company's growth prospects.
C) that is high relative to the company's growth prospects.
D) that is overvalued.

Question 21

In the value-to-book model growth adds value to shareholders only if the growth is ________________________________________.

Question 22

The risk of the firm increases the _____________________________________________.

Question 23

Economics teaches that,in equilibrium,firms will earn a return equal to the ______________________________.

Question 24

All of the following are accounting factors that can drive a firm's price-earnings ratio in a given period to be higher than that of other firms in the same industry except:

A) non-recurring expenses or losses in that period
B) a greater degree of accounting conservatism that requires expensing R&D or other intangible asset-generating activities
C) a less conservative accounting stance that uses straight-line depreciation rather than accelerated methods
D) a greater degree of accounting conservatism regarding accelerated depreciation of PP&E

Question 25

Book value per share may not approximate market value per share because:

A) Land may have substantially increased in value.
B) Market value reflects future potential earning power.
C) Investments may have a market value substantially above the original cost.
D) All of these are reasons why book value per share may not approximate market value per share.

Question 26

To estimate security's risk-neutral value we can use the _____________________________________________ and risk-free rates of return.

Question 27

Market multiples capture ____________________ valuation per dollar of book value or per dollar of earnings.

Question 28

The PE multiple assumes that firm value is the present value of a constant stream of _____________________________________________,discounted at a constant expected future discount rate.

Question 29

The differences in industry market-to-book ratios may be the result of differences in growth,ROCE relative to RE,as well as differences in _______________________________________________________.

Question 30

The ______________________________ represents the value of the firm,based on book value of equity and forecasts of expected future earnings,in the absence of discounting for risk.

Question 31

Industries with relatively high market-to-book ratios are more likely to have ___________________________________ assets.

Question 32

The value-to-book ratio reflects an analyst's expectation of the firm's ____________________ value to book value.

Question 33

All of the following are economic factors that can cause a firm's price-earnings ratio to be higher than that of other firms in the same industry except:

A) when investors expect that the firm's strategy enables it to generate and sustain greater profitability for a given cost of equity capital
B) when the firm earns the same profitability but with lower risk and, therefore, a lower cost of equity capital
C) a firm's business model that enables it to generate faster growth in earnings provided the growth creates positive residual ROCE
D) a firm's business model that results in slower growth in earnings and this creates negative residual ROCE

Question 34

The theoretical PE model does not work when the growth rate in ____________________ exceeds the cost of equity capital.

Question 35

Which of the following ratios give a perspective on risk in the capital structure?

A) Book value per share
B) Price/earnings ratio
C) Degree of financial leverage
D) Dividend yield

Question 36

All of the following are economic factors that will decrease a firm's value-to-book ratio over time except:

A) decreasing competition that drives the firm's ROCE down
B) increasing systematic risk that increases the firm's equity cost of capital over time
C) a loss of competitive advantage through changes in technology or other factors
D) retaining earnings or issuing equity capital and deploying the capital in activities that generate ROCE levels that are lower than current levels

Question 37

All of the following are accounting factors that will cause a firm's value-to-book ratio to decrease over time except:

A) recognizing unrealized gains on assets
B) a loss of competitive advantage through changes in technology or other factors
C) earning a high ROCE (above the equity cost of capital) on off-balance-sheet R&D assets
D) earning a high ROCE (above the equity cost of capital) on off-balance-sheet intangible assets (such as brand equity) over time

Question 38

Analysts use the PEG ratio to assess share price relative to earnings and _________________________________________________________________.

Question 39

The value-to-book model indicates that a firm in steady state equilibrium earnings ROCE=RE will be valued at _________________________.

Question 40

The market price of a share of common equity reflects the _____________________________________________ of all of the market participants following that particular stock.

Question 41

In research examining market efficiency,Bernard and Thomas examined quarterly earnings announcements.Discuss how Bernard and Thomas test the issue of market efficiency and the results of their research.

Question 42

When a company has a high market to book ratio this could be a result of the company having __________________________________________________.

Question 43

If the market price of a share of stock is based on the expectations of all of the market participants and the trading volume in that stock,what would happen if the company's reputation were damaged by a scandal or defective product that caused personal injury or death?

Question 44

A company with a PEG ratio of less than one would be interpreted as having a stock price that is low relative to ______________________________.

Question 45

Explain the analysts' role in making the capital markets efficient.

Question 46

Assume an analyst is evaluating a firm with $1,000 of book value of common equity and a cost of equity capital equal to 12 percent.Assume that the analyst forecasts that the firm will earn ROCE of 18 percent until year 2015,when the firm will start earning ROCE equal to 12 percent.The company pays no dividends and will not engage in any stock transactions.Use this information to complete the following table and calculate the firm's value-to-book ratio.

Question 47

What information can a PEG ratio provide about a company's stock price? What does a PEG ratio greater than one mean? Less than one?

Question 48

Studies have shown that 50-70% of the variability in PE ratios across firms comes from ________ and _______.

Question 49

a.Compute the price-earnings ratio under the following sets of assumptions:

b.Assess the sensitivity of the price-earnings ratio to changes in the cost of equity capital and changes in the growth rate.

Question 50

The PEG ratio does not take into account differences in ____________________ and ________________________________________ across firms.

Question 51

A firm's value-to-book and market-to-book ratios may differ from one for a number of reasons.Discuss how a successful,internally funded research and development program would create a situation where the value-to-book and market-to-book ratios differ from one another.

Question 52

What is the value of reverse engineering stock prices? How does the process work?

Question 53

Investors have invested $30,000 in common equity in a company.The investors expect that the company will reinvest all income back into projects.The company is forecasted to earn $7,000 the first year,$6,000 the second year,$5,750 the third year,and $6,442 each year after the third year.The company's current stock price is $18 per share.Assuming that the company has 4,300 shares outstanding and the risk-free rate of interest is 7%,calculate the price differential for this company.

Question 54

The use of P/E ratios in valuation can result in measurement bias.What two items can result in measurement error and why?

Question 55

Firms with low P/E ratios tend to have current residual income that is greater than _____________________________________________.

Question 56

Assume a zero-growth rate for earnings and dividends in each situation below.Also assume that all earnings are paid out as dividends and that the earnings-based valuation model is being used.
Situation 1: Das Company's earnings are expected to be $9 per share and its stock price is $36.What is the required rate of return on the firm's equity?
Situation 2: South Company's earnings are expected to be $6 per share and its required rate of return on equity is 26%.What is the current price of the stock?
Situation 3: Jones Company's current stock price is $60 and its required rate of return on equity is 15%.What is the firm's expected earnings?

Question 57

What is a price differential and how is it computed? What information does a price differential provide to an analyst?

Question 58

Discuss how risk and profitability factors cause differences in price-earnings ratios across firms.Explain the difference between abnormal and normal earnings.

Question 59

Assume an analyst is evaluating a firm with $1,000 of book value of common equity and a cost of equity capital equal to 8 percent.Assume that the analyst forecasts that the firm will earn ROCE of 14 percent until year 2016,when the firm will start earning ROCE equal to 8 percent.The company pays no dividends and will not engage in any stock transactions.Use this information to complete the following table and calculate the firm's value-to-book ratio.

Question 60

Why is book value often meaningless? What improvements to financial statements would make it more meaningful?

Question 61

Use the following information to answer the requirements:

Required:
a.Use a risk-adjusted cost of capital of 15% to calculate each firm's implied share price and earning multiples.What are the implicit share prices and earnings multiples for the two firms different?
b.Repeat requirement a.,but use a risk-adjusted cost of capital of 8% instead.