Answers - Reading 19 Equity Valuation, Applications and Processes

Question #1 of 39 Question ID: 1472774 A valuation of a firm based on the current market price of its assets - liabilities is referred to as the firm's: A) operating value. B) going-concern value. C) liquidation value. Explanation The liquidation value is based on the assumption that the firm will cease to operate and all of its assets will be sold to repay liabilities. (Module 19.1, LOS 19.b) Question #2 of 39 Question ID: 1472801 The value of a conglomerate derived using a sum-of-the-parts valuation would least accurately be called the: A) liquidation value. B) breakup value. C) private market value. Explanation Sum-of-the-parts valuation totals the estimated values of each of the company's business divisions as independent going concerns. The value derived using a sum-of-the-parts valuation is also sometimes called the private market value or the breakup value, even when such a restructuring is not necessarily expected. (Module 19.1, LOS 19.g) Question #3 of 39 Question ID: 1472783 An analyst performing an asset valuation to detect investor's expectations about the future value of the variables that affect a stock's price is most likely using the valuation for: A) projecting the value of corporate actions. B) generating a fairness opinion. C) reading the market. Explanation Asset valuation has many uses including stock selection, reading the market, projecting the value of corporate actions, issuing fairness opinions, and valuing private businesses. Reading the market entails detecting investor's expectations about the future value of the variables that affect a stock's price. (Module 19.1, LOS 19.d) Question #4 of 39 Question ID: 1472776 A valuation of a firm based on the assumption that the firm will continue to operate is referred to as its: A) status quo value. B) going-concern value. C) operating value. Explanation The going-concern value is based on the assumption that the firm will continue to operate and the firm's value is the present value of its future dividends. (Module 19.1, LOS 19.b) Question #5 of 39 Question ID: 1472791 Which of the following least accurately represents one of the primary steps of the equity valuation process described by Pinto, Henry, Robinson, and Stowe? A) Selecting a valuation model. B) Decision making. C) Assessing corporate governance. Explanation The valuation process described by Pinto, Henry, Robinson, and Stowe consists of 5 steps: 1. Understanding the business. 2. Forecasting company performance. 3. Selecting a valuation model. 4. Complete a valuation. 5. Decision making. Corporate governance is important, but is not one of the primary steps. (Module 19.1, LOS 19.e) Question #6 of 39 Question ID: 1472786 Notes to financial statements contain: A) a description of the firm’s financial condition and future prospects. B) important information about the firm's accounting practices and basis of presentation. C) discussion of the firm's accounting practices and basis of presentation. Explanation A number of important disclosures regarding a firm's accounting practices and the basis on which income and expense are recognized are contained in the footnotes to the financial statements. An overview by management of the company's past, present, and future can be found in the Management discussion and analysis (MD&A) section of a financial statement. (Module 19.1, LOS 19.e) Question #7 of 39 Which of the following is least likely a use of equity valuation? A) Issuing fairness opinions. B) Assessing corporate governance. C) Projecting the value of corporate actions. Explanation Question ID: 1472782 Equity valuation has many uses including stock selection, reading the market, projecting the value of corporate actions, issuing fairness opinions, and valuing private businesses. Equity valuation is not specifically related to corporate governance. (Module 19.1, LOS 19.d) Question #8 of 39 Question ID: 1472797 Which of the following two ratios are likely to be used for determining value as a function of company peer benchmarks? A) Price-to-earnings and price-to-book. B) Price-to-sales and debt/equity. C) Return on equity and net profit margin. Explanation Relative valuation looks at market-based ratios of comparable companies in the industry. Price-to-sales, price-to-book, price-to-earnings, and price-to-cash flow are examples of ratios used in relative valuation analysis. (Module 19.1, LOS 19.f) Question #9 of 39 Question ID: 1472788 Overestimating the growth rate of a firm in using a valuation model would result in a value that is likely to be: A) too low. B) too high. C) can't tell from this information. Explanation Using an estimate for a firm's growth rate that is too high would overstate the amount of future returns, resulting in a present value that is too high. (Module 19.1, LOS 19.e) Question #10 of 39 Question ID: 1472778 Q Quest o : 8 Liquidation value is the: A) market value of the total assets less the market value of the total liabilities. B) present value of future cash flow less the possible liquidation cost. C) cash generated by terminating a business, selling its assets, and repaying liabilities. Explanation Liquidation value is the cash generated by terminating a business, selling all of its assets, and repaying liabilities. (Module 19.1, LOS 19.b) Question #11 of 39 Question ID: 1472772 A wise analyst will examine a valuation to determine: A) how well it will be received by the firm's management. B) ways to enhance a client's valuation. C) its sensitivity to changes in expectations. Explanation The results of valuation models can be very sensitive to changes in the expectations incorporated in the model. Analysis of a valuation's sensitivity to the expectations and a review of the confidence the analyst has in the expectations may lead to the use of a valuation range rather than a pin-point value. (Module 19.1, LOS 19.a) Question #12 of 39 Which of the following is NOT a use of asset valuation? A) Estimating inflation rates. B) Projecting the value of corporate actions. C) Issuing fairness opinions. Explanation Question ID: 1472780 Asset valuation has many uses including stock selection, reading the market, projecting the value of corporate actions, issuing fairness opinions, and valuing private businesses. Asset valuation is not used to project inflation rates. (Module 19.1, LOS 19.d) Question #13 of 39 Question ID: 1472789 When an analyst scrutinizes a firm's financial statements to try to discern how accurately the reported information reflects economic reality, and to evaluate the sustainability of the company's performance, the process is most likely to be referred to as a: A) quality of earnings analysis. B) reasonable assurance analysis. C) comprehensive basis of accounting analysis. Explanation The accuracy and level of detail disclosed in financial reports is referred to as the quality of earnings. When we say "quality of earnings analysis" we are generally referring to scrutinizing all a firm's financial statements (including the balance sheet) to try to determine not only the sustainability of the companies' performance but also how accurately the financial statements reflect economic reality. (Module 19.1, LOS 19.e) Question #14 of 39 Question ID: 1472770 Valuation models for equities contain estimates of required returns and: A) known future cash flows. B) expected future cash flows. C) an assumed continuation of past cash flows. Explanation Valuation models used for equities require the analyst to estimate the required return applicable to the investment and to develop an expectation of future cash flows. While cash flows for fixed-income investments are stated, no such definition is available for equities. (Module 19.1, LOS 19.a) Question #15 of 39 Question ID: 1472779 For an analyst valuing public equities, the relevant concept of value is most likely to be: A) fair market value. B) intrinsic value. C) orderly liquidation value. Explanation For an analyst valuing public equities, the most relevant definition of value is generally intrinsic value. A value based on a going-concern assumption, rather than a liquidation assumption, is the appropriate choice for a company that will continue to produce and sell goods. Fair market value is the most relevant definition of value to use in an agreement between the owners of a private business regarding the price at which the owners can sell their ownership interest. (Module 19.1, LOS 19.c) Question #16 of 39 Question ID: 1472781 Minority shareholders often do not have control of the price at which the firm will be sold or merged with another firm. In order to safeguard their interests, minority shareholders will often seek an analyst's opinion of the value of the firm. This opinion is referred to as a: A) fairness opinion. B) minority opinion. C) second opinion. Explanation Minority shareholders are often dependent upon an analyst's opinion about the fairness of a price to be received. Hence the term fairness opinion. (Module 19.1, LOS 19.d) Question #17 of 39 Question ID: 1472799 A valuation of a firm based on the comparison of the firm with the market value of other firms is known as a: A) peer group valuation. B) comparison valuation. C) relative valuation. Explanation A relative valuation is a valuation based on comparing the firm to other firms with similar characteristics. Market multiples are commonly used as the basis of relative valuations. (Module 19.1, LOS 19.f) Question #18 of 39 Question ID: 1472803 An ownership perspective can be important for an analyst determining the value of a share position. A controlling interest suggests the most appropriate model is a: A) time series model. B) dividend discount model. C) cash flow model. Explanation A controlling interest suggests a cash flow model may be most appropriate since the controlling interest would allow the purchaser to set dividend policy. (Module 19.1, LOS 19.h) Question #19 of 39 Question ID: 1472773 How can we account for different valuations for the same firm from several analysts even if they use the same required returns? A) The analysts may be biased with personal opinions about management. B) Valuation models contain random errors. C) Valuations are based on the analyst's expectations. Explanation Valuation is based on expectations of future cash flows rather than known values. Each analyst will build expectations of cash flows from the fundamental data and from other factors, internal and external, that the analyst believes will affect the firm's performance. (Module 19.1, LOS 19.a) Question #20 of 39 Question ID: 1472792 Disclosures of accounting practices and basis are most likely to be made in which part of a firm's financial reports? A) The audit report. B) Footnotes. C) Management's discussion and analysis (MD&A). Explanation A number of important disclosures regarding a firm's accounting practices and the basis on which income and expense are recognized are contained in the footnotes to the financial statements. (Module 19.1, LOS 19.e) Question #21 of 39 Question ID: 1472804 One justification for using multiple models to estimate firm value is: the ability to examine differences in estimated values can reveal how a model’s A) assumptions and the perspective of the analysis are affecting the estimated values. B) the ability to learn from each successive model and to make improvements. C) the ability to streamline and economize the development process through repeated use of the same generic baseline. Explanation One thing to remember with respect to choice of a valuation model is that the analyst does not have to consider only one. Using multiple models and examining differences in estimated values can reveal how a model's assumptions and the perspective of the analysis are affecting the estimated values. (Module 19.1, LOS 19.h) Question #22 of 39 Question ID: 1472785 What are three factors that would make a firm's accounting earnings less of a gauge of future economic performance? Late filings, unusually: A) B) C) low amounts of loans to company insiders, and short tenure of senior management. high amounts of loans to company insiders, and long tenure of senior management. high amounts of loans to company insiders, and short tenure of senior management. Explanation Quality of earnings looks at the relationship between accounting earnings and economic profit potential of the firm. An analyst is concerned about anything that would render accounting earnings less useful as a gauge of the firm's future expected economic earnings. Warning signals include late filings, unusually high amounts of loans to company insiders, and short tenure of senior management. (Module 19.1, LOS 19.e) Question #23 of 39 Question ID: 1472800 A valuation of a firm based on the intrinsic value of the firm's investment characteristics is known as an: A) asset based valuation. B) absolute valuation. C) absolution valuation. Explanation An absolute valuation approach attempts to determine the value of the firm based on its specific characteristics without regard to the market prices of other firms. (Module 19.1, LOS 19.f) Question #24 of 39 Question ID: 1472784 An analyst is most likely to review the footnotes to a firm's financial statements to find information about the firm's: A) accounting practices. B) operation. C) cash flow activities. Explanation A number of important disclosures regarding a firm's accounting practices and the basis on which income and expense are recognized are contained in the footnotes to the financial statements. The profit and loss statement provides information on the operation of the firm. The statement of cash flows is the best source of data on a company's cash flow activities such as operating, investing and financing. (Module 19.1, LOS 19.e) Question #25 of 39 Question ID: 1472802 Important considerations for choosing an appropriate approach for valuing a given company are least likely to include: A) Is the model consistent with the investor's IPS? B) Is the model suitable given the purpose of the analysis? C) Is the model appropriate based on the quality and availability of input data? Explanation Important considerations when choosing a valuation model include: Does the model fit the characteristics of the company? Is the model suitable given the purpose of the analysis? Is the model appropriate based on the quality and availability of input data? (Module 19.1, LOS 19.h) Anna Heller, CFA, is a financial journalist and editor working for Money in the Morning, an online daily journal aimed at the investment industry. She is currently reviewing three articles, which staff writers have submitted to her for imminent publication. Heller has a few concerns with the articles, which she notes down as follows. Article One—The Modern Equity Valuation Process Introductory Paragraph: "The Grossman-Stiglitz paradox states that if security prices are informationally efficient there would be no reward to collecting and analyzing information. If this is the case no investor would collect and analyze information and the market price could not reflect intrinsic value. Further works have shown the easier intrinsic value is to estimate the bigger the potential divergence between price and value will be." Illustrative Example: "Assume an analyst had performed a valuation exercise on security HTWO and come up with the following results: Analyst Derived Intrinsic Value $25.20 Market Price $23.85 Clearly, the analyst has identified a potentially undervalued security. However, attaining a positive risk adjusted return is only possible if the analyst's intrinsic value is correct. If he or she has incorrectly calculated the intrinsic value, then the potential for positive risk adjusted returns may be reduced or eliminated." Heller is enthusiastic about including this example, but would like to extend it. She will instruct the staff writer to detail the valuation error and the actual mispricing if the analyst had calculated an intrinsic value, which was $1.20 higher than the actual intrinsic value. Article Two—I'm Going to Tell You My Concerns Linpan Inc. Discussion: "The blanket government ban of its new product line leads to a problem in deciding on an appropriate valuation for Linpan Inc. If the business is not a viable one then any kind of valuation based on free cash flow growth, or perhaps even more outrageously, dividend growth, is pointless. Assuming that the business voluntarily winds down over the next year, as I believe it should, and gradually sells off its assets, I would suggest that the value of the security should be no more than the cash the asset sales would bring in net of the firm's liabilities." Heller wants to the writer to name this suggested valuation method. Toys to You Inc. Discussion: "A brief review of the somewhat fanciful chairman's statement, and a comparison of a summary income statement of Toys to You Inc. (TTY) compared to a direct competitor demonstrates the problems with TTY's generic strategy: Figure 1 Income Statement (extracts) TTY Inc. Competitor Revenue 7.9 12.3 Net income 1.1 1.9 Chairman's Statement (extract) "I believe the future of Toys to You is a bright one, despite the difficulties encountered over a turbulent last 18 months. Our continued commitment to producing traditional toys which match our competitors on quality and price will ensure our loyal customer base is maintained, while our cutting edge production technology will maintain our industry leading cost base and deliver superb returns to our investors." Heller would like to add a conclusion regarding the problems with TTY's strategy. Question #26 - 30 of 39 Question ID: 1480227 Why is the introductory paragraph in Article One incorrect? A) B) C) Most analysts believe that at some point intrinsic and market value will converge. The harder intrinsic value is to estimate the greater the potential divergence of market and intrinsic value. Markets cannot be constantly informationally efficient as this would mean that intrinsic and market price would always be identical. Explanation Intrinsic value is the valuation of an asset by someone who has a perfect understanding of the asset or the firm. Intrinsic value is therefore the theoretical value the stock would take if it were perfectly valued and stock price contained all relevant information. The harder it is to establish the intrinsic value the bigger the potential divergence between market price and intrinsic value. (Module 19.1, LOS 19.a) Question #27 - 30 of 39 Question ID: 1480228 Using Heller's suggestion of an analyst intrinsic value which is $1.20 too high in the illustrative example for Article One, calculate the valuation error and the actual mispricing: Valuation error Actual mispricing A) $1.20 $0.15 B) $1.35 $0.15 C) $0.15 $1.20 Explanation Valuation error = IVanalyst – IVactual = 1.20 Actual mispricing = IVactual – price = (25.20 – 1.20) – 23.85 = 0.15 (Module 19.1, LOS 19.a) Question #28 - 30 of 39 Question ID: 1480229 In response to Heller's point regarding the Linpan discussion in Article Two, which of the following correctly identifies the suggested valuation method? A) Going Concern Valuation. B) Liquidation Value. C) Orderly Liquidation Value. Explanation The proceeds raised by selling assets over a longer period of time are likely to be larger than those raised in a rapid forced "fire sale." Hence, the term Orderly Liquidation Value is often used to differentiate from a forced liquidation value. (Module 19.1, LOS 19.b) Question #29 - 30 of 39 Question ID: 1480230 In the Toys to You Inc. (TTY) discussion in Article Two, which of the following would be the most appropriate conclusion for the writer to add? TTY is attempting a strategy of product differentiation by committing to high A) quality products but appears to be failing as revenues are lower than its competitors. TTY is attempting a strategy of cost leadership by keeping prices equal to or B) lower than its competitors but appears to be failing as margins are lower than its competitor’s. C) TTY is attempting a strategy of cost leadership by producing with the lowest cost base but appears to be failing as margins are lower than its competitor’s. Explanation Product differentiation involves adding product features or services that increase the attractiveness of the firm's product. There is no suggestion that TTY is attempting to do this. Cost leadership is a bid to produce at the lowest cost, a strategy that is evident from the chairperson's statement. However, it has resulted in a margin of only 13.9% compared to the competitor's 15.4%. (Module 19.1, LOS 19.e) Question #30 - 30 of 39 Question ID: 1480231 Which of the following would not be an example of one of Michael Porter's 5 competitive forces applicable to Toys to You? A) A new chain of toy stores, Games & Goodies, has opened up in key Toys to You territories. B) C) Toys to You’s biggest supplier have ‘due to unforeseen market conditions’ added a 15% premium to key product lines. Due to cash flow issues Toys to You have been forced to halve the marketing and advertising budget compared to the previous financial year. Explanation Porter's Five Forces include risk of new entrants (A), supplier power (B), customer power, established rivals, and the risk of substitute offerings. Marketing and advertising budgetary constraints are not relevant. (Module 19.1, LOS 19.e) Question #31 of 39 Question ID: 1472787 Which of the following would cause an analyst to have concern about a firm's quality of earnings? A) The gain on the sale of a plant was included in operating earnings. B) The firm took a write off for a recently impaired asset. C) A firm books sales when orders are shipped. Explanation The inclusion of gains from the sale of assets as operating income would cause the analyst to question the quality of the firm's earnings. (Module 19.1, LOS 19.e) Question #32 of 39 Question ID: 1472771 The goal of asset valuation, based on the expected future cash flows of an asset, is to establish an asset's: A) relative value. B) market value. C) intrinsic value. Explanation Asset valuation based on the expected future cash flows is utilized to estimate an asset's intrinsic value, or the value derived from the asset's investment characteristics. (Module 19.1, LOS 19.a) Question #33 of 39 Question ID: 1472798 A valuation of a firm based on a review of other firms' price to earnings, price to sales, and price to return on investment ratios is an example of a: A) relative valuation. B) fundamental valuation. C) broad-based valuation. Explanation An approach using market multiples to establish the value of the subject firm in relation to similar firms is an example of a relative valuation approach. (Module 19.1, LOS 19.f) Question #34 of 39 Question ID: 1472777 The present value of expected future cash flows is the firm's: A) going-concern value. B) terminal value. C) liquidation value. Explanation Going-concern value is the present worth of expected future cash flows generated by a business. (Module 19.1, LOS 19.b) Question #35 of 39 Question ID: 1472790 Financial Analyst Davey Jarvis, CFA, is evaluating Laura's Chocolates, Inc., which processes nut-based toffee for world-wide distribution. Which of the following steps is Jarvis most likely to take as part of the top-down valuation process? A) Learn / understand the business. B) Perform momentum-based technical analysis. C) Evaluate price performance on an ongoing basis. Explanation The valuation process consists of 5 steps: 1. Understanding the business. 2. Forecasting company performance. 3. Selecting a valuation model. 4. Complete the valuation. 5. Decision making. (Module 19.1, LOS 19.e) Joe Dentice has an opportunity to buy 5% of Gold Star Oil, Inc., a closely held oil company. He wants to value the company so as to make a decision on a fair price to pay for the investment. Question #36 - 38 of 39 Question ID: 1472794 Consider the steps in the top down valuation approach as it is applicable for Gold Star. Dentice should forecast the growth of: A) Gold Star, the growth of the oil industry, and then the growth of the overall economy. B) the overall economy, growth of the industry, and the growth rate of Gold Star. C) each firm in the oil industry, the growth rate of the oil industry, and the growth rate of the economy. Explanation The top down model for valuation would begin with analysis of the overall economy and the expectation of the growth rate in the economy. Further, the impact of the expected growth rate of the economy on the oil industry needs to be ascertained. The second component is the analysis of the oil industry in which Gold Star operates. That involves the determination of the competitive forces in the industry and the future threats and opportunities faced by the industry. It also determines the variables that determine the future profitability of the entire oil industry. The analyst then forms future expectations of these variables given the expectations about the overall economy. The expectations of variables determining the growth and profitability of the oil industry are then used to determine the expectations of the overall growth of Gold Star. In the company analysis, the analyst reviews the quality of earnings, financial ratios, management and intangibles to ascertain the growth prospects for the company. The analyst then selects an appropriate model to value the company. Assumptions used in the valuation must be clearly spelled out and updated to reflect new information. (Module 19.1, LOS 19.e) Question #37 - 38 of 39 Question ID: 1472795 Which of the following models would be most suitable to value Gold Star? A) Liquidation value. B) Absolute valuation. C) Relative valuation. Explanation Absolute valuation models or intrinsic value models such as the dividend growth rate model and the free cash flow model value a company independent of peer valuation. The valuation is based on the present value of cash-flows for the specific company. Relative valuation models such as P/E ratio compare the earnings multiple to that of similar companies to make a judgment about the valuation. If the P/E ratio is higher than peer company P/E ratio, it is said to be overvalued. Conversely, if the P/E ratio is lower than peer company P/E ratio, it is said to be undervalued. Caution should be taken to make sure that peer companies are indeed comparable. For the valuation of Gold Star, absolute valuation would be suitable since it is closely held and hence market valuation is not available. (Module 19.1, LOS 19.e) Question #38 - 38 of 39 Question ID: 1472796 Which discounts must be taken into account while valuing the investment opportunity? Joe should take into account the: A) marketability, liquidity, and majority discounts in the valuation. B) marketability, liquidity, and minority discounts in the valuation. C) marketability, liquidity, and control premium in the valuation. Explanation Since Gold Star is closely held, the investment is not easily marketable. Closely linked is the fact that the investment cannot be easily liquidated and the cost of selling the investment needs to be discounted from the value. Finally, since only 5% of the stock is being invested in, the control of the operations of the company still remains with the majority shareholders. This lack of control needs to be quantified and discounted from Gold Star's valuation. (Module 19.1, LOS 19.e) Question #39 of 39 Question ID: 1472775 A comparison between a firm's going-concern valuation and its liquidation value will show that the going-concern value will always be: A) less than the liquidation value. B) greater than the liquidation value. C) equal to the present value of the expected continued operation of the firm. Explanation It is not possible to state the relationship between the going-concern value and the liquidation value without examining the prospects for the firm and the current value of the assets. The going-concern value is equal to the present value of the expected dividends arising from continued operation. (Module 19.1, LOS 19.b)