Deck 11: Equity Analysis and Valuation

Question 1

A profitable high-tech company would generally have:

A)high price-to-book ratio and high price-to-earnings ratio.
B)high price-to-book ratio and low price-to-earnings ratio.
C)low price-to-book ratio and high price-to-earnings ratio.
D)low price-to-book ratio and low price-to-earnings ratio.

Answer 1

A

Question 2

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

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

Answer 2

B

Question 3

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

-If price-to-book ratio 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

Answer 3

24%.

Question 4

When assessing earnings persistence, it is important to analyze discretionary expenditures. Which of the following is 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 5

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 6

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

Question 7

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

A)All other things being equal, the more cyclical the industry within which a company operates, the lower its quality of earnings.
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 8

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 9

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 10

Dominik Corporation is a fast growing company. They were the first to the market with state-of-the-art voice identification software. Earnings per share for 2005 were $2.08, and book value per share at the beginning of 2005 was $9.55. Dominik does not pay dividends nor is it expected to do so in the foreseeable future. Dominik's cost of equity is 12%.Analysts predict that earnings for 2006 and 2007 will be $3.22 and $3.90, respectively, and that earnings will grow at 19% per year for the following three years (2008-2010). The stock is currently trading at $35 per share, and analysts have set a target price of $50 by the end of 2006.Assuming that the analysts' earnings forecasts for the next five years are correct, and assuming that after the end of the next five years the competition will have driven Dominik's abnormal returns down to zero, what would your target price be for the end of 2006? What will the price-to-book and price-to-earnings ratios be at the end of 2006?

Question 11

You are analyzing a stock. You expect that earnings will grow quickly relative to its current level, but the expected return on common stockholders' equity is low. Assuming price to be constant, what levels of the price-to-earnings ratio (PE) and the price-to-book ratio (PB) would you expect to see? $$\begin{array} { l l l } &\text { PE Ratio } &\text { PB Ratio }\\\text { A) } & \text { Low } & \text { Low } \\\text { B) } & \text { Low } & \text { High } \\\text { C) } & \text { High } & \text { High } \\\text { D) } & \text { High } & \text { Low }\end{array}$$

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

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

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 14

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

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

Question 15

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

A)1.01
B)1.05
C)1.09
D)1.19

Question 16

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 17

A profitable mature company would generally have:

A)high price-to-book ratio and high price-to-earnings ratio.
B)high price-to-book ratio and low price-to-earnings ratio.
C)low price-to-book ratio and high price-to-earnings ratio.
D)low price-to-book ratio and low price-to-earnings ratio.

Question 18

When considering the determinants of the price-to-book ratio (PB) which of the following is correct? I. All other things being equal, the greater a company's return on common stockholders' equity, the greater the PB ratio.II. All other things being equal, the greater a company's cost of equity, the greater the PB ratio.III. If a company's return on common stockholders' equity equals its cost of equity, the PB ratio should equal 1.IV. The greater a company's current earnings the higher the PB ratio.

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

Question 19

Which of the following should be attempted in order to gauge the quality of a company's earnings? I. Assessing an 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 20

A growing company with disappointing profitability would generally have:

A)high price-to-book ratio and high price-to-earnings ratio.
B)high price-to-book ratio and low price-to-earnings ratio.
C)low price-to-book ratio and high price-to-earnings ratio.
D)low price-to-book ratio and low price-to-earnings ratio.

Question 21

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 22

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

-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 23

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

-If price-to-book ratio at the end of 2005 equals 1.00, then PE ratio at end of 2004 equals (pick closest number):

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

Question 24

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 25

A retrenching company with poor prospects would generally have:

A)high price-to-book ratio and high price-to-earnings ratio.
B)high price-to-book ratio and low price-to-earnings ratio.
C)low price-to-book ratio and high price-to-earnings ratio.
D)low price-to-book ratio and low price-to-earnings ratio.

Question 26

Company A and Company B operate in the same industry. Company B has a price-to-book ratio that is much higher than A's. Both companies have price-to-book 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 27

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

Question 28

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

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

Question 29

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

Question 30

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

Question 31

Variability in earning numbers:

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

Question 32

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

Question 33

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 34

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 35

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

Question 36

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

-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 37

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

Question 38

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

-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 39

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

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

Question 40

If a company has a high price-to-book ratio (PB) and low price-to-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 41

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

Question 42

A typical time horizon for measuring earnings power is 5 years.

Question 43

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

Question 44

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

Question 45

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

Question 46

All other things being equal, the price-to-earnings ratio would be expected to increase as the cost of equity capital increases.

Question 47

The more liberal the accounting methods used by a company, the lower the quality of earnings.

Question 48

The higher the dividend payout ratio, the lower the PE ratio of the stock.

Question 49

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

Question 50

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 51

A stock that has a low price-to-earnings ratio and a low price-to-book 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 52

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

Question 53

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 54

Two companies operate in the same industry, but one has a much higher PE ratio than the other. One reason for the difference in PE ratio could be the quality of earnings.

Question 55

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

Question 56

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 57

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

Question 58

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

Question 59

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

Question 60

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

Question 61

Extrapolation is one of the most reliable analytical tools in forecasting earnings.

Question 62

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

Question 63

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

Question 64

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 65

The number of outstanding shares of a company will affect its price-to-earnings ratio.

Question 66

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 it rents, 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 67

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

Question 68

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