Deck 11: Equity Analysis and Valuation

Question 1

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 value be at the end of 2005 (pick closest number)?

A) 1.0
B) 1.05
C) 1.09
D) 1.19

Answer 1

D

Question 2

A profitable high-tech company would generally have

A) High price/book and high price/earnings
B) High price/book and low price/earnings
C) Low price/book and high price/earnings
D) Low price/book and low price/earnings

Answer 2

A

Question 3

ABC Corporation and DEF Corporation operate in the same industry. ABC has a P/E ratio that is 50% higher than DEF Corporation. Which of the following account for some of the difference in the observed P/E 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

A) I, II, III and IV
B) I, III and IV
C) I and III
D) II, III and IV

Answer 3

B

Question 4

If a company has a 100% dividend payout ratio and expected growth in earnings is zero. Cost of capital is 9%. Its P/E ratio would be expected to be:

A) 8.33
B) 9.33
C) 10
D) 11.11

Question 5

Which of the following would not be considered a component of business risk?

A) Financial leverage
B) Variability of demand
C) Variability of price of inputs to production
D) Changing regulatory requirements

Question 6

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

A) The more cyclical the industry within which a company operates the lower its quality of earnings, all other things equal
B) The smoother the earnings stream of a company, the greater the quality of the earnings
C) Quality of earnings is independent of business risk
D) Quality of earnings is largely beyond management's control

Question 7

When considering the determinants of the price to book value ratio (P/BV) which of the following statements are correct?
I) The greater a company's return on common stockholders' equity the greater the P/BV ratio, all other things being equal
II) The greater a company's cost of equity the greater the P/BV ratio, all other things being equal
III) The greater a company's return on common stockholders' equity equals a company's cost of equity the P/BV ratio should equal 1.0
IV) The greater a company's current earnings the higher the P/BV ratio

A) I, III and IV
B) I and III
C) II and IV
D) I and II

Question 8

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

A) Changes in accounting assumptions
B) Timing revenue recognition
C) Write-downs of operating assets
D) Reporting fictitious transactions

Question 9

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

A) I, II, III and IV
B) I, II and IV
C) II, III and IV
D) I, III and IV

Question 10

Alexas Corporation reports the following:
$\begin{array}{|l|l|}\hline&\mathbf{2 0 0 5}\\\hline \text { Earnings per share } & \$ 1.80 \\\hline \text { Dividends per share } & \$ 0.72\\\hline \text { Book Value per share-end of year } & \$8.62\\\hline\end{array}$

-If Price to book value 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:

A) 15%
B) 21%
C) 24%
D) Not determinable

Question 11

A growing company with disappointing profitability would generally have

A) High price/book and high price/earnings
B) High price/book and low price/earnings
C) Low price/book and high price/earnings
D) Low price/book and low price/earnings

Question 12

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

A) Changing accounting estimates
B) Offsetting one-time gains and losses
C) Changing accounting principles
D) Changing auditors

Question 13

You are analyzing a stock. You expect that earnings will grow quickly relative to their current level, but the expected return on common stockholders' equity is low. What levels of the price earnings ratio (P/E) and price to book value ratio (P/BV) would you expect to see (relative to industry average)? $$\begin{array} { | c | c | c | } \hline & \text { P/E Ratio } & \text { P/BV Ratio } \\\hline \text { A) } & \text { Low } & \text { Low } \\\hline \text { B) } & \text { Low } & \text { High } \\\hline \text { C) } & \text { High } & \text { High } \\\hline \text { D) } & \text { High } & \text { Low } \\\hline\end{array}$$

A) Option A
B) Option B
C) Option C
D) Option D

Question 14

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

A) Estimating the level of earnings
B) Separation of recurring and nonrecurring components
C) Recognizing potential earnings management
D) Recognizing potential income smoothing

Question 15

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

A) Stability of the earnings
B) Magnitude of the earnings
C) Predictability of the earnings
D) The earnings' trend

Question 16

Pitfalls when forecasting earnings include failure to consider
I) capital adequacy
II) capacity constraints
III) anticipated return on equity
IV) new management

A) I and III
B) II and IV
C) I, III and IV
D) I, II and III

Question 17

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

A) I, II, III and IV
B) I, II and III
C) I, III and IV
D) I and III

Question 18

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

A) Changing price levels
B) Extraordinary items
C) Usual operating costs
D) Accounting methods used

Question 19

When assessing earnings persistence it is important to analyze discretionary expenditures. Which of the following statements are 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

A) I, II and III
B) I, III and IV
C) II, III and IV
D) I and III

Question 20

A profitable mature company would generally have

A) High price/book and high price/earnings
B) High price/book and low price/earnings
C) Low price/book and high price/earnings
D) Low price/book and low price/earnings

Question 21

A retrenching company with poor prospects would generally have

A) High price/book and high price/earnings
B) High price/book and low price/earnings
C) Low price/book and high price/earnings
D) Low price/book and low price/earnings

Question 22

Alexas Corporation reports the following:
$\begin{array}{|l|l|}\hline&\mathbf{2 0 0 5}\\\hline \text { Earnings per share } & \$ 1.80 \\\hline \text { Dividends per share } & \$ 0.72\\\hline \text { Book Value per share-end of year } & \$8.62\\\hline\end{array}$

-If Price to book value at the end of 2005 equals 1.00, then P/E ratio at end of 2003 equals (pick closest number):

A) 8.38
B) 4.78
C) 4.19
D) Not determinable

Question 23

When examining quarterly results of a company in a seasonal business it is useful

A) to compare to the preceding quarter
B) to match the company's results against economic statistics
C) to compare to the same period in the prior year
D) to analyze using a percentage income statement

Question 24

Which of the following statements concerning interim financial reports is incorrect?

A) Accrual accounting is used for revenue and expense recognition
B) Extraordinary items are reported in annual but not interim financial reports
C) LIFO liquidation is not reported for interim purposes, unless decline in inventory is expected to be permanent
D) Income taxes are accrued using effective tax rate expected for the annual period

Question 25

If a company has a high price to book ratio (PB) and low price-earnings (PE) ratio, this suggests that:

A) Earnings are expected to grow slowly or decline relative to current level, with low expected return on common stockholders' equity (ROCE)
B) Earnings are expected to grow quickly relative to current level, but with low expected ROCE
C) Earnings are expected to grow slowly or decline relative to current level, but with high expected ROCE
D) Earnings are expected to grow quickly relative to current level, with high expected ROCE

Question 26

Business risk:

A) Is independent of actions by management
B) Does not affect the systematic risk of a company
C) Refers to financial leverage
D) Is a component of the overall risk of a company

Question 27

Adjusting earnings includes assigning earnings components from the recast income statements to periods they likely belong.

Question 28

Which of the following should be considered when examining a software development company's earnings persistence?
I) Changes in accounting estimates
II) Amount spent on software development
III) Gains from sale of marketable securities
IV) Managerial compensation

A) All of the above
B) I, II and III
C) I, II and IV
D) I, III and IV

Question 29

Which of the following statements is most correct?

A) If two companies have the same ROE and the same risk they must have the same residual income (abnormal earnings) for the year
B) If two companies have the same net book value and the same residual income this year, then their stock prices must be the same
C) If two companies have the same ROE and the same stock price their earnings must be the same for the year
D) If two companies have the same ROE, net book value, and cost of capital then their residual income must be the same for the year

Question 30

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

A) Managerial compensation
B) Changes in accounting principle
C) Cyclicality of business
D) Seasonality of business
True / False Questions

Question 31

Hupta Corporation
$$\begin{array} { | l | r | } \hline & \mathbf { 2 0 0 5 } \\\hline \text { Net income } & \$ 6,000 \\\hline \text { Dividends } & \$ 2,000 \\\hline \text { Total assets-12/31/05 } & \$ 50,000 \\\hline \text { Total liabilities-12/31/05 } & \$ 20,000 \\\\\hline \text { Number of shares outstanding } & 1,000 \\\hline \text { Cost of equity } & 10 \% \\\hline\end{array}$$

-Net income is expected to increase by 10% for the next year, and dividend payout ratio is expected to remain constant. After 2006, residual earnings are expected to decrease to zero. Using the earnings-based valuation method what is the value per share of Hupta stock as of 12/31/05?

A) $33.60
B) $33.27
C) $32.73
D) $30.00

Question 32

Which of the following will affect observed price earnings ratio (lagged ratio):
I) Quality of earnings
II) Business risk
III) Risk free rate of interest
IV) Expected growth

A) All of the above
B) II, III and IV
C) II and IV
D) I, II and IV

Question 33

Which of the following will affect observed price to book ratio
I) Expected ROCE
II) Business risk
III) Risk free rate of interest
IV) Expected growth

A) All of the above
B) II, III and IV
C) II and IV
D) I, II and IV

Question 34

To produce a reliable forecast of earnings, an analyst must first separate the persistent components of earnings from the nonrecurring components.

Question 35

Company A and Company B operate in the same industry. Company B has a price to book value that is much higher than A's. Both companies have price to book value ratios greater than one. Which of the following could explain this difference, all else equal?

A) A uses less conservative accounting methods
B) A has lower expected future dividend payout ratio
C) A has higher expected growth
D) A has many more shares outstanding

Question 36

Variability in earning numbers:

A) Is desirable as it increases variance of earnings and hence value of stock options
B) Increases if a company increases its operating leverage
C) Increases if a company decreases its financial leverage
D) Is independent of operating leverage

Question 37

Analysts' expected earnings for Alexas for next two years are:
2006: $2.00
2007: $2.23
Cost of equity is 15%. Return on equity is expected to equal cost of equity from 2008 onwards. Dividend payout ratio is expected to remain the same for 2006 and 2007. Price per share at the end of 2005 would be closest to:

A) $9.45
B) $9.81
C) $9.89
D) Not determinable

Question 38

Interim financial reports

A) Are not required by SEC
B) Are as reliable as annual reports
C) Require allocation of certain discretionary costs across interim periods
D) Normally use FIFO inventory reporting, regardless of method used for annual reports

Question 39

Two companies, A and B, have the same ROEs but Company A has a higher residual income. Which of the following would explain this, all else equal?

A) Company A is riskier than Company B
B) Company A has higher expected future growth
C) Company A has greater net book value
D) Company A has lower ROA

Question 40

Hupta Corporation
$$\begin{array} { | l | r | } \hline & \mathbf { 2 0 0 5 } \\\hline \text { Net income } & \$ 6,000 \\\hline \text { Dividends } & \$ 2,000 \\\hline \text { Total assets-12/31/05 } & \$ 50,000 \\\hline \text { Total liabilities-12/31/05 } & \$ 20,000 \\\\\hline \text { Number of shares outstanding } & 1,000 \\\hline \text { Cost of equity } & 10 \% \\\hline\end{array}$$

-Using the dividend discount model, assuming dividends grow at 10% in 2006 and at 5% thereafter, what is the value per share of Hupta at 12/31/05?

A) $48.20
B) $44.00
C) $40.18
D) $40.00

Question 41

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

Question 42

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.

Question 43

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.

Question 44

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.

Question 45

Atypical horizon for measuring earnings power is 5 years.

Question 46

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.

Question 47

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

Question 48

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

Question 49

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.

Question 50

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

Question 51

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

Question 52

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

Question 53

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

Question 54

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.

Question 55

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

Question 56

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

Question 57

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.

Question 58

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

Question 59

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

Question 60

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

Question 61

If a company has a low price to book value and a high price earnings ratio this is an indicator that the stock is most likely under-priced.

Question 62

The SEC has issued "safe harbor" rules to encourage forecasts by registrants, but it has had limited success.

Question 63

Problem Six: Adjusting Financial Statements
You are examining the financial statements of ABC Corporation for Year 2. ABC Corporation manufactures widgets and has a unionized workforce. You are trying to assess the earnings persistence of the company. To aid you in this endeavor you are adjusting earnings for non-recurring, non-sustainable items.
Below is a list of items you believe might affect earnings persistence. Indicate why the item may affect earnings persistence and how each item might affect net income.
Company has:
1. LIFO Liquidation of $3M
2. Decreased the discount rate used to determine post-retirement health benefits
3. Accumulated Depreciation as a percentage of gross depreciable assets is ninety percent
4. Labor unions went on strike for one month during the year

Question 64

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.

Question 65

Problem Seven: Earnings Persistence/Future Earnings
Consider each of the scenarios below independently.
1. Luxury Limos is in the business of renting limousines in New York City. It has a fleet of 200 limos. It owns the limousines that they rent, and keeps them on average for five years. In Year 3, Luxury Limos showed a loss on the sale of limos of $5,000. In Years 1 and 2 it recorded a loss on sale of $2,000 and $1,000, respectively. Should the gains and losses on the sale of limos be ignored when determining earnings persistence or not?
2. Turnaround Corporation has just hired new top management. In the new management's first year they take a huge restructuring charge (looks as though they are taking a "big bath"). Included in the restructuring charge are:
● Recognition of a contingent liability for probable environmental clean-up
● Write-down of assets (which amounted to a 50% write-down of all assets)
● A charge for a future upgrade of its computer system
For each of the items included in the restructuring charge, and considering management's possible motivation for taking a "big bath", identify how these items might affect future recorded income.

Question 66

If a company has a price to book value ratio that is less than one this implies that future expected return on equity is less than required return on equity.

Question 67

Two companies operate in the same industry but one has a much higher price/earnings (P/E) ratio than the other. One reason for the difference in P/E ratio could be the quality of earnings.

Question 68

Extrapolation is one of the more useful analytical tools.
Essay Questions

Question 69

The number of shares authorized a company has will affect its earnings per share ratio.

Question 70

You are given the following information for Young Company. As of year 1, the company's book value is $80,000 and its cost of capital is 15%.
Dividends for year 6 and beyond are expected to remain at year 5 level.

Question 71

a. What is meant by "earnings" persistence?
b. Why might an analyst be interested in examining the earnings persistence of a company?
c. How might managerial incentives affect the analysis of earnings persistence?

Question 72

The number of shares outstanding a company has will affect its earnings per share and price/earnings ratio.

Question 73

Problem Three: Analyzing Earnings
Earnings are extremely important to a publicly traded company and the creditors and investors of that company. However, looking at earnings without regard to the quality of those earnings is hazardous to the health of creditors and investors.
a. Why is the determination of earnings quality and persistence important?
b. Explain recasting of the income statement and give three examples of items that are recasted.
c. Explain adjusting of the income statement and give three examples of items that are recasted.