Question 1

The price/earnings ratio would be expected to increase as the cost of equity capital increases, all other things equal.

Accepted Answer

The price/earnings ratio (P/E ratio) is calculated by dividing the market price of a stock by its earnings per share (EPS). The cost of equity capital refers to the return required by the investors for their investment in equity shares. If the cost of equity capital increases, it means that the investors require a higher return on their investment. This would result in a decrease in the P/E ratio, all other things equal, as investors would be willing to pay less for a given level of earnings. Hence, the statement is false.

Question 2

A stock that has a low price/earnings ratio and a low price/book value ratio is an indicator of a stock that is expected to have slow or negative growth in earnings and a low return on common stockholders' equity.

Accepted Answer

A low price/earnings ratio and a low price/book value ratio indicate that the stock is undervalued and has the potential for growth.

Question 3

The price-to-book value of a company can be shown to be a function of future expected return on common stockholders' equity and risk of equity capital.

Accepted Answer

The price-to-book value of a company is influenced by many factors, including its future expected return on common stockholders' equity and the risk associated with its equity capital. The relationship between these two factors can impact the market's perception of the company's value and, ultimately, its price-to-book ratio.

Question 4

A stock that has a high price/earnings ratio and a high price/book value ratio is an indicator of a stock that is definitely overvalued.

Accepted Answer

A high P/E and P/B ratio may suggest overvaluation, but it is not definitive as these ratios must be considered alongside other factors like growth potential, industry norms, and market conditions.

Question 5

Atypical horizon for measuring earnings power is 5 years.

Accepted Answer

The atypical horizon for measuring earnings power is typically considered to be 5 years, as it allows for a reasonable projection of future earnings while also accounting for potential changes in the business and industry over time. However, some investors may use shorter or longer horizons depending on their individual investment strategies and goals.

Question 6

Although growth is often touted as one of the key drivers of the value of a stock, no amount of growth will increase the value of a company if its return to providers of capital is less than the cost of that capital.

Accepted Answer

This statement is true. The value of a company is ultimately determined by its ability to generate returns for its investors that exceed the cost of the capital invested in the company. Growth is important, but if it is not profitable growth, it will not increase the value of a company.

Question 7

The SEC requires monthly financial reports to be filed (Form 10-M).

Accepted Answer

The SEC requires quarterly financial reports to be filed (Form 10-Q) rather than monthly reports.

Question 8

The value of common stockholders' equity can be estimated as the present value of future abnormal earnings discounted at the cost of equity.

Accepted Answer

The estimation of the value of common stockholders' equity using the present value of future abnormal earnings discounted at the cost of equity is a widely accepted approach in valuation theory. It implies that the future earnings generated by the company will exceed the expected earnings, which represents the residual returns that the equity shareholders can expect to receive after payment of all necessary expenses.

Question 9

Although interim financial reports are normally prepared using the same accounting methods as the annual financial reports they are generally less reliable, in part because of the increased use of estimates in the interim periods.

Accepted Answer

Interim financial reports are prepared for less time and are based on estimations which make them less reliable than annual financial reports.

Question 10

Quality of earnings is generally lower the more liberal the accounting methods used by a company.

Accepted Answer

Quality of earnings refers to the level of earnings that is deemed sustainable over the long term. If a company uses liberal accounting methods, it may report higher earnings in the short term, but these earnings may not be sustainable and may be prone to manipulation. This lowers the quality of earnings as they are not a true representation of the company's actual financial health. Therefore, the more liberal the accounting methods used by a company, the lower the quality of its earnings.

Question 11

Earnings management uses acceptable accounting reporting principles for purposes of reporting specific results.

Accepted Answer

Earnings management involves the manipulation of financial records within the boundaries of generally accepted accounting principles (GAAP) to present desired financial results.

Question 12

Adjustments to income statement numbers should be done following the estimation of the earnings persistence.

Accepted Answer

Adjustments to income statement numbers should be done before estimating the earnings persistence, to ensure that the earnings figure used in the analysis is as accurate and representative of the underlying economic reality as possible.

Question 13

The quality of earnings is a measure of the difference between this year's earnings and last year's earnings.

Accepted Answer

The quality of earnings refers to the degree to which a company's reported earnings accurately reflect its true financial performance. It is not directly related to the difference between this year's earnings and last year's earnings.

Question 14

If a company's return on equity is lower than its cost of equity capital, then the higher the dividend payout ratio the higher the P/E of the stock.

Accepted Answer

If a company's return on equity is lower than its cost of equity capital, then it is destroying value for shareholders. In this case, the higher the dividend payout ratio, the lower the P/E of the stock, as investors will be less willing to pay a premium for a company that is not generating a sufficient return on its investments.

Question 15

Interim financial reports are generally prepared using the same accounting methods as used for the annual financial reports.

Accepted Answer

Interim financial reports are usually prepared using the same accounting principles and methods as those used for annual reports to ensure consistency and comparability of financial information.

Question 16

Quality of earnings is said to be high if analysts' earnings forecasts have a small standard deviation.

Accepted Answer

Quality of earnings refers to the degree to which earnings are free from distortion and provide a reliable indication of the company's financial performance. It is not directly related to the standard deviation of analysts' earnings forecasts, which measures consensus or variability in expectations among analysts.

Question 17

If a company has a return on equity that is lower than its cost of equity capital it could be said to be destroying value.

Accepted Answer

A company's return on equity should ideally be higher than its cost of equity capital, otherwise it is not generating enough profit to compensate for the cost of capital invested by shareholders. This can be seen as value destruction, as shareholders are not earning a sufficient return on their investment.

Question 18

The quality of earnings is affected by the volatility of a company's sales.

Accepted Answer

The quality of earnings is impacted by the stability of a company's sales. If a company experiences large fluctuations or irregularities in their sales, it can impact their earnings and create uncertainty for investors. On the other hand, a company with stable and predictable sales is likely to have higher quality earnings.

Question 19

The SEC requires only quarterly financial reports to be filed (Form 10-Q).

Accepted Answer

In addition to quarterly financial reports (Form 10-Q), the SEC also requires annual financial reports (Form 10-K) to be filed by public companies.

Question 20

When assessing earnings persistence is important to determine if there has been any earnings management.

Accepted Answer

Earnings management can affect the persistence of earnings, so it is important to consider whether it has occurred when assessing this measure. Earnings management refers to the deliberate practice of manipulating financial results to meet or exceed expectations, and can impact the accuracy and reliability of reported earnings over time.

Quiz 11: Equity Analysis and Valuation