CFA Level 1 - Equity Investments Session 14 - Reading 52

CFA Level 1 - Equity Investments Session 14 - Reading 52 (Notes, Practice Questions, Sample Questions) 1. If an analyst estimates the intrinsic value for a security that is different from its market value, the analyst should most likely take an investment position based on this difference if: A)many analysts independently evaluate the security. B)the security lacks a liquid market and trades infrequently. C)the model used is not highly sensitive to its input values. {Explanation: In general, an analyst can be more confident about an estimate of intrinsic value if the model used is not highly sensitive to changes in its inputs. If a large number of analysts follow a security, its market value is more likely to be a reliable estimate of its intrinsic value. A security that does not trade frequently or in a liquid market may remain mispriced for an extended time, and thus may not result in a profit within the investment horizon even if the analyst’s estimate of intrinsic value is correct} 2. An equity valuation model that values a firm based on the market value of its outstanding debt and equity securities, relative to a firm fundamental, is a(n): A)enterprise value model. {Explanation: An enterprise value model relates a firm’s enterprise value (the market value of its outstanding equity and debt securities minus its cash and marketable securities holdings) to its EBITDA, operating earnings, or revenue} B)asset-based model. C)market multiple model. 3. Witronix is a rapidly growing U.S. company that has increased free cash flow to equity and dividends at an average rate of 25% per year for the last four years. The present value model that is most appropriate for estimating the value of this company is a: A)multistage dividend discount model. {Explanation: A multistage model is the most appropriate model because the company is growing dividends at a higher rate than can be sustained in the long run. Though the company may be able to grow dividends at a higher-than-sustainable 25% annual rate for a finite period, at some point dividend growth will have to slow to a lower, more sustainable rate. The Gordon growth model is appropriate to use for mature companies that have a history of increasing their dividend at a steady and sustainable rate. A single stage free cash flow to equity model is similar to the Gordon growth model, but values future free cash flow to equity rather than dividends} B)Gordon growth model. C)single stage free cash flow to equity model. 4. A valuation model based on the cash flows that a firm will have available to pay dividends in the future is best characterized as a(n): A)free cash flow to equity model. {Explanation: Free cash flow to equity represents a firm’s capacity to pay future dividends. A free cash flow to equity model estimates the firm’s FCFE for future periods and values the stock as the present value of the firm’s future FCFE per share} B)free cash flow to the firm model. C)infinite period dividend discount model. 5. The yield on a company’s 7.5%, $50 par preferred stock is 6%. The value of the preferred stock is closest to: A)$12.50. B)$50.00. C)$62.50. {Explanation: The preferred dividend is 0.075($50) = $3.75. The value of the preferred = $3.75 / 0.06 = $62.50} 6. Use the following data to analyze a stock's price earnings ratio (P/E ratio): The stock's beta is 1.2. The dividend payout ratio is 60%. The stock's expected growth rate is 7%. The risk free rate is 6% and the expected rate of return on the market is 13%. Using the dividend discount model, the expected P/E ratio of the stock is closest to: A)5.4. B)8.1. {Explanation: k = ER = Rf + Beta(RM − Rf) = 0.06 + (1.2)(0.13 − 0.06) = 0.144 Dividend payout ratio = 0.60 P/E = div payout / (k − g) = 0.6 / (0.144 − 0.07) = 8.1} C)10.0. 7. A stock has a required rate of return of 15%, a constant growth rate of 10%, and a dividend payout ratio of 45%. The stock’s price-earnings ratio should be: A)9.0 times. {Explanation: P/E = D/E1/ (k - g) D/E1 = Dividend Payout Ratio = 0.45 k = 0.15 g = 0.10 P/E = 0.45 / (0.15 - 0.10) = 0.45 / 0.05 = 9} B)4.5 times. C)3.0 times. 8. The current price of XYZ, Inc., is $40 per share with 1,000 shares of equity outstanding. Sales are $4,000 and the book value of the firm is $10,000. What is the price/sales ratio of XYZ, Inc.? A)10.000. {Explanation: The price/sales ratio is (price per share)/(sales per share) = (40)/(4,000/1,000) = 10.0. Alternatively, the price/sales ratio may be thought of as the market value of the company divided by its sales, or (40 × 1,000)/4,000, or 10.0 again} B)0.010. C)4.000. 9. Given the following information, compute price/book value. Book value of assets = $550,000 Total sales = $200,000 Net income = $20,000 Dividend payout ratio = 30% Operating cash flow = $40,000 Price per share = $100 Shares outstanding = 1000 Book value of liabilities = $500,000 A)5.5X. B)2.0X. {Explanation: Book value of equity = $550,000 - $500,000 = $50,000 Market value of equity = ($100)(1000) = $100,000 Price/Book = $100,000/$50,000 = 2.0X} C)2.5X. 10. General, Inc., has net income of $650,000 and one million shares outstanding. The profit margin is 6 percent and General, Inc., is selling for $30.00. The price/sales ratio is equal to: A)0.65. B)10.83. C)2.77. {Explanation: 6% profit margin = $650,000/x; x (sales) = $10,833,333. Sales per share = $10.83 M/1,000,000 = $10.83 per share. P/Sales = $30.00/$10.83 = 2.77} 11. An analyst studying Albion Industries determines that the average EV/EBITDA ratio for Albion’s industry is 10. The analyst obtains the following information from Albion’s financial statements: EBITDA = £11,000,000 Market value of debt = £30,000,000 Cash = £1,000,000 Based on the industry’s average enterprise value multiple, what is the equity value of Albion Industries? A)£110,000,000. B)£80,000,000. C)£81,000,000. {Explanation: Enterprise value = Average EV/EBITDA × company EBITDA = 10 × £11,000,000 = £110,000,000 Enterprise value = Equity value + debt − cash Equity value = Enterprise value − debt + cash = £110,000,000 − £30,000,000 + £1,000,000 = £81,000,000} 12. Gwangwa Gold, a South African gold producer, has as its primary asset a mine which is shown on the balance sheet with a value of R100 million. An analyst estimates the market value of this mine to be 90% of book value. The company’s balance sheet shows other assets of R20 million and liabilities of R40 million, and the analyst feels that the book value of these items reflects their market values. Using the asset-based valuation approach, what should the analyst estimate the value of the company to be? A)R80 million. B)R70 million.{Explanation: Market value of assets = 0.9(R100 million) + R20 million = R110 million Market value of liabilities = R40 million Estimated net value of company = R110 million − R40 million = R70 million} C)R110 million. 13. Regarding the estimates required in the constant growth dividend discount model, which of the following statements is most accurate? A)Dividend forecasts are less reliable than estimates of other inputs. B)The variables "k" and "g" are easy to forecast. C)The model is most influenced by the estimates of "k" and "g."{Explanation: The relationship between "k" and "g" is critical - small changes in the difference between these two variables results in large value fluctuations} 14. Which of the following is NOT an advantage of using price-to-book value (PBV) multiples in stock valuation? A)Book value is often positive, even when earnings are negative. B)PBV ratios can be compared across similar firms if accounting standards are consistent. C)Book values are very meaningful for firms in service industries.{Explanation: Book values are NOT very meaningful for firms in service industries} 15. One advantage of price/sales (P/S) multiples over price to earnings (P/E) and price-to-book value (PBV) multiples is that: A)P/S can be used for distressed firms.{Explanation: Unlike the PBV and P/E multiples, which can become negative and not meaningful, the price/sales multiple is meaningful even for distressed firms (that may have negative earnings or book value)} B)P/S is easier to calculate. C)Regression shows a strong relationship between stock prices and sales. 16. Which of the following is least likely an advantage of using price/sales (P/S) multiple? A)P/S multiples are more reliable because sales data cannot be distorted by management. {Explanation: Accounting data on sales is used to calculate the P/S multiple. The P/S multiple is thought to be more reliable because sales figures are not as easy to manipulate as the earnings and book value, both of which are significantly affected by accounting conventions. However, it is not true that "sales data cannot be distorted by management" because aggressive revenue recognition practices can influence reported sales} B)P/S multiples provide a meaningful framework for evaluating distressed firms. C)P/S multiples are not as volatile as P/E multiples and hence may be more reliable in valuation analysis. 17. An argument against using the price to cash flow (P/CF) valuation approach is that: A)non-cash revenue and net changes in working capital are ignored when using earnings per share (EPS) plus non-cash charges as an estimate. {Explanation: Items affecting actual cash flow from operations are ignored when the EPS plus non-cash charges estimate is used. For example, non-cash revenue and net changes in working capital are ignored. Both remaining responses are arguments in favor of using the price to cash flow approach} B)cash flows are not as easy to manipulate or distort as EPS and book value. C)price to cash flow ratios are not as volatile as price-to-earnings (P/E) multiples. 18. An argument against using the price-to-earnings (P/E) valuation approach is that: A)earnings can be negative. {Explanation: Negative earnings render the P/E ratio useless. Both remaining factors increase the usefulness of the P/E approach} B)research shows that P/E differences are significantly related to long-run average stock returns. C)earnings power is the primary determinant of investment value. 19. Which of the following is a disadvantage of using the price-to-book value (PBV) ratio? A)Book value may not mean much for manufacturing firms with significant fixed costs. B)Firms with negative earnings cannot be evaluated with the PBV ratios. C)Book values are affected by accounting standards, which may vary across firms and countries. {Explanation: The disadvantages of using PBV ratios are: 1.Book values are affected by accounting standards, which may vary across firms and countries. 2.Book value may not mean much for service firms without significant fixed costs. 3.Book value of equity can be made negative by a series of negative earnings, which limits the usefulness of the variable} 20. One advantage to using the price/book value (P/B) ratio over using the price/earnings (P/E) ratio is that P/B can be used when: A)stock markets are volatile. B)earnings or cash flows are negative. {Explanation: When earnings are negative, P/E ratios cannot be used but P/B ratios can be used. The firm's rate of growth and the volatility of markets do not suggest advantages of using P/B ratios rather than P/E ratios} C)the firm is in a slow growth phase.