Question 1

A profitable high-tech company would generally have:

Accepted Answer

A profitable high-tech company typically has both a high price-to-book ratio and a high price-to-earnings ratio. This is because investors are willing to pay more for each dollar of earnings and book value, anticipating future growth.

Question 2

Which of the following is not included in the definition of earnings persistence?

Accepted Answer

The magnitude of earnings is not included in the definition of earnings persistence. Earnings persistence refers to the predictability or stability of earnings over time, as well as the trend of the earnings. Magnitude, or the absolute level of earnings, is not a factor in determining persistence.

Question 3

Alexas Corporation reports the following:
 $$\begin{array} { l l } 
& \mathbf { 2 0 0 5 } \
\text { Earnings per share } & \$ 1.80 \
\text { Dividends per share } & \$ 0.72 \
\text { Book value per share- at the end of the } &\$ 8.62\
\text { year } & 
\end{array}$$
-If price-to-book ratio at the end of 2005 equals 1.00, and return on beginning of year equity is expected to remain constant, then cost of equity (to nearest percent) equals:

Accepted Answer

The cost of equity is given by the formula:Cost of equity = (Dividend per share / Beginning book value per share) + Return on equityWe are given that the price-to-book ratio at the end of 2005 equals 1.00, which means that the beginning book value per share is equal to the ending book value per share. Therefore, we can use the ending book value per share as the beginning book value per share.We are also given that the return on beginning of year equity is expected to remain constant. Therefore, we can use the earnings per share as the return on beginning of year equity.Substituting these values into the formula, we get:Cost of equity = (0.72 / 8.62) + 1.80 = 0.24 = 24%Therefore, the cost of equity is 24%.

Question 4

When assessing earnings persistence, it is important to analyze discretionary expenditures. Which of the following is correct?

I. Research and development is generally considered a discretionary expenditure.
II. Decreased discretionary expenditures should always be taken as a positive indicator that the company is getting costs under control.
III. Advertising expenditures can be considered discretionary expenditures, which often have implications for future sales.
IV. Absolute levels of discretionary expenditures are more important than the level of expenditures relative to sales.

Accepted Answer

I and III are correct because research and development (R&D) and advertising expenditures are considered discretionary, meaning companies can adjust these expenses based on their financial situation. These expenditures can have implications for future sales and innovation, making them important for assessing earnings persistence. II is incorrect because decreased discretionary expenditures are not always positive; they could signal a company is cutting back on investment in future growth. IV is incorrect because the level of discretionary expenditures relative to sales is often more telling than absolute levels, as it provides context regarding the company's investment in growth relative to its size.

Question 5

Which of the following is not a form of earnings management?

Accepted Answer

Reporting fictitious transactions is not a form of earnings management; it is considered fraudulent accounting. Earnings management involves legal yet potentially misleading accounting methods to present financial statements in a more favorable light, without crossing into the realm of outright fraud.

Question 6

ABC Corporation and DEF Corporation operate in the same industry. ABC has a PE ratio that is 50% higher than DEF Corporation. Which of the following accounts for some of the difference in the observed PE ratios?

I. ABC uses more conservative accounting principles.
II. ABC has a higher cost of equity capital.
III. ABC has higher expected future growth.
IV. DEF uses FIFO and ABC uses LIFO.

Accepted Answer

The answer of ABC Corporation and DEF Corporation operate in...

Question 7

Which of the following statements concerning quality of earnings is correct?

Accepted Answer

Cyclical industries tend to have more volatile earnings, which can lower the perceived quality of earnings due to less predictability and stability.

Question 8

Which of the following can affect earnings quality?

I. Management's choice of accounting principle
II. Management's choice of dividend policy
III. Management's estimates
IV. Management's discretionary expenditures

Accepted Answer

Earnings quality can be affected by management's choice of accounting principles, estimates, and discretionary expenditures. Dividend policy affects the distribution of earnings rather than the quality of the earnings themselves.

Question 9

Pitfalls when forecasting earnings include failure to consider:

I. capital adequacy.
II. capacity constraints.
III. anticipated return on equity.
IV. new management.

Accepted Answer

Failure to consider capital adequacy, capacity constraints, and anticipated return on equity can all affect earnings forecasts. While new management can also be a factor, it is not necessarily always a pitfall and therefore not included in the best choice of answer.

Question 10

Dominik Corporation is a fast growing company. They were the first to the market with state-of-the-art voice identification software. Earnings per share for 2005 were $2.08, and book value per share at the beginning of 2005 was $9.55. Dominik does not pay dividends nor is it expected to do so in the foreseeable future. Dominik's cost of equity is 12%.

Analysts predict that earnings for 2006 and 2007 will be $3.22 and $3.90, respectively, and that earnings will grow at 19% per year for the following three years (2008-2010). The stock is currently trading at $35 per share, and analysts have set a target price of $50 by the end of 2006.

Assuming that the analysts' earnings forecasts for the next five years are correct, and assuming that after the end of the next five years the competition will have driven Dominik's abnormal returns down to zero, what would your target price be for the end of 2006? What will the price-to-book and price-to-earnings ratios be at the end of 2006?

Accepted Answer

The answer of Dominik Corporation is a fast growing company....

Question 11

You are analyzing a stock. You expect that earnings will grow quickly relative to its current level, but the expected return on common stockholders' equity is low. Assuming price to be constant, what levels of the price-to-earnings ratio (PE) and the price-to-book ratio (PB) would you expect to see? $$\begin{array} { l l l } 
&\text { PE Ratio } &\text { PB Ratio }\
\text { A) } & \text { Low } & \text { Low } \
\text { B) } & \text { Low } & \text { High } \
\text { C) } & \text { High } & \text { High } \
\text { D) } & \text { High } & \text { Low }
\end{array}$$

Accepted Answer

The PE ratio is low because the expected return on equity is low. The PB ratio is also low because the price is constant and earnings are expected to grow quickly.

Question 12

Which of the following is not a typical form of earnings management?

Accepted Answer

Changing auditors is not a typical form of earnings management as it does not directly impact the financial statements or the reporting of earnings. The other choices listed (changing accounting estimates, offsetting one-time gains and losses, and changing accounting principles) are all common methods used by companies to manipulate their reported earnings.

Question 13

Which of the following factors is least likely to affect earnings persistence?

Accepted Answer

Usual operating costs are a regular part of business operations and are expected to continue in the future, thus they are less likely to affect earnings persistence compared to extraordinary items, changing price levels, or accounting methods, which can introduce variability or one-time effects.

Question 14

Which of the following is not a factor in producing earnings forecasts?

Accepted Answer

Estimating the level of dividends is not a factor in producing earnings forecasts. Earnings forecasts typically focus on the expected level of earnings, which may or may not be reflected in dividend payouts.

Question 15

Fristy Corporation has a book value of equity of $5,000 at the beginning of 2005, and net income of $1,000 for year ended 2005. It pays no dividends, and its cost of equity capital is 10%. It expects return on beginning of year equity to remain constant for 2006 and 2007 and decrease to 10% thereafter. What should its price-to-book ratio be at the end of 2005 (pick closest number)?

Accepted Answer

The price-to-book ratio at the end of 2005 can be calculated using the Gordon Growth Model, which in this case simplifies to the formula for a perpetuity since the return on equity (ROE) is expected to equal the cost of equity (10%) from 2008 onwards. The net income for 2005 is $1,000, which is also the expected net income for 2006 and 2007 since the return on equity is constant and there are no dividends paid. The book value at the beginning of 2005 is $5,000, and it increases by the net income each year due to no dividends being paid. Therefore, the book value at the end of 2005 is $6,000 ($5,000 + $1,000). The expected net income for 2008, when the ROE equals the cost of equity, would be 10% of the book value at the end of 2007, which is $6,000 + $1,000 (2006 net income) + $1,000 (2007 net income) = $8,000. Thus, the expected net income for 2008 is $800 (10% of $8,000). Using the Gordon Growth Model with a growth rate of 0 (since ROE equals the cost of equity from 2008 onwards), the value at the end of 2007 is the expected net income for 2008 divided by the cost of equity, or $800 / 0.10 = $8,000. The price-to-book ratio at the end of 2005 is then the value at the end of 2007 ($8,000) divided by the book value at the end of 2005 ($6,000), which equals approximately 1.33. However, since this option is not available, it seems there was a mistake in the calculation or interpretation of the choices provided. The correct approach involves understanding the relationship between ROE, cost of equity, and the perpetuity value of future earnings, but the final step or the interpretation of the options may need reconsideration based on the provided choices.

Question 16

Management of earnings has been a newsworthy subject, above and beyond the business press. Analysts are forced to devote time and attention to ferreting out the real numbers, when the clues are available. Explain four kinds of earnings management, giving examples.

Accepted Answer

The answer of Management of earnings has been a newsworthy...

Question 17

A profitable mature company would generally have:

Accepted Answer

The answer of A profitable mature company would generally have:
...

Question 18

When considering the determinants of the price-to-book ratio (PB) which of the following is correct?

I. All other things being equal, the greater a company's return on common stockholders' equity, the greater the PB ratio.
II. All other things being equal, the greater a company's cost of equity, the greater the PB ratio.
III. If a company's return on common stockholders' equity equals its cost of equity, the PB ratio should equal 1.
IV. The greater a company's current earnings the higher the PB ratio.

Accepted Answer

I. All other things being equal, the greater a company's return on common stockholders' equity, the greater the PB ratio. This is correct as PB ratio measures the market value of a share as a multiple of its book value per share, and a higher return on equity indicates that the company is making more money per dollar invested by shareholders, which could lead to a higher market value.
II. All other things being equal, the greater a company's cost of equity, the greater the PB ratio. This statement is incorrect as the cost of equity is a discount rate used to calculate the present value of future cash flows, but it does not directly impact the market valuation of a company's shares.
III. If a company's return on common stockholders' equity equals its cost of equity, the PB ratio should equal 1. This statement is correct as the PB ratio is essentially the market's expectation of the future growth opportunities and profitability of a company, and if the return on equity is equal to the cost of equity, it implies that the market expects the company to be stable and grow at a rate that is not higher or lower than its cost of equity.
IV. The greater a company's current earnings the higher the PB ratio. This statement is incorrect as the PB ratio is based on the book value of a company and not its current earnings.

Question 19

Which of the following should be attempted in order to gauge the quality of a company's earnings?

I. Assessing an adequacy of discretionary expenditures
II. Assessing degree of conservatism in reporting assets
III. Assessing degree of conservatism in reporting liabilities
IV. Assessing degree of conservatism in application of accounting principles

Accepted Answer

All four options are relevant to gauging the quality of a company's earnings. Assessing discretionary expenditures can reveal if a company is artificially inflating its earnings by cutting necessary expenses. Evaluating the conservatism in reporting assets, liabilities, and the application of accounting principles helps in understanding if the company is overstating its financial health.

Question 20

A growing company with disappointing profitability would generally have:

Accepted Answer

The answer of A growing company with disappointing profitability would...

Quiz 11: Equity Analysis and Valuation