CFA Level 1: Equity Valuation Concepts (Session 14 - Reading 60 - LOS g)

CFA Level 1 - Equity Session 14 - Reading 60 Equity Valuation: Concepts and Basic Tools LOS g (Notes, Practice Questions, Sample Questions) 1. Which of the following is a disadvantage of using price-to-sales (P/S) multiples in stock valuations? A) It is difficult to capture the effects of changes in pricing policies using P/S ratios. B) P/S multiples are more volatile than price-to-earnings (P/E) multiples. C) The use of P/S multiples can miss problems associated with cost control. {Explanation — Due to the stability of using sales relative to earnings in the P/S multiple, an analyst may miss problems of troubled firms concerning its cost control. P/S multiples are actually less volatile than P/E ratios, which is an advantage in using the P/S multiple. Also, P/S ratios provide a useful framework for evaluating effects of pricing changes on firm value} 2. Which of the following is least likely a reason the price to cash flow (P/CF) model has grown in popularity? A) CFs are generally more difficult to manipulate than earnings. B) CFs are used extensively in valuation models. C) CFs are more easily estimated than future dividends. {Explanation — CFs are not easier to estimate than dividends} 3. The price to book value ratio (P/BV) is a helpful valuation technique when examining firms: A) with older assets compared to those with newer assets. B) with the same stock prices. C) that hold primarily liquid assets. {Explanation — P/BV analysis works best for firms that hold primarily liquid assets} 4. Which of the following statements regarding price multiples is most accurate? A) A disadvantage of the price/book value ratio is that it is not an appropriate measure for firms that primarily hold liquid assets. B) An advantage of the price/sales ratio is that it is meaningful even for distressed firms. {Explanation — The P/S ratio is meaningful even for distressed firms, since sales revenue is always positive. This is not the case for the P/E and P/BV ratios, which can be negative. In the P/BV ratio book value is an appropriate measure of net asset value for firms that primarily hold liquid assets. Analysts use several different definitions of cash flow (CFO, adjusted CFO, FCFE, EBITDA, etc.) to calculate P/CF ratios. When earnings are negative, the P/E ratio is meaningless} C) A rationale for using the price/cash flow ratio is that there is only one clear definition of cash flow. 5. One advantage of using price-to-book value (PBV) multiples for stock valuation is that: A) it is a stable and simple benchmark for comparison to the market price. {Explanation — Book value provides a relatively stable measure of value that can be compared to the market price. For investors who mistrust the discounted cash flow estimates of value, it provides a much simpler benchmark for comparison. Book value may or may not be closer to the market value. A firm may have negative book value if it shows accounting losses consistently} B) most of the time it is close to the market value. C) book value of a firm can never be negative. 6. Of the following types of firm, which is most suitable for P/B ratio analysis? A) A firm with accounting standards consistent to other firms. {Explanation — Assuming consistent accounting standards across firms, P/B ratios can reveal signs of misvaluation across firms} B) A firm with accounting standards different from other firms. C) A service industry firm without significant fixed assets.