Chapter 14 - Valuation: Market-Based Approaches

A company is expected to have a value of $142,857 at the start of next period and investors require a 14 percent return on equity capital. Using the assumptions of the price-earnings ratio, what would be the company's earnings for the current year? a. $20,000 b. $14,286 c. $2,800 d. $12,500

a

All of the following are economic factors that will decrease a firm's value-to-book ratio over time EXCEPT: a. decreasing competition that drives the firm's ROCE down b. increasing systematic risk that increases the firm's equity cost of capital over time c. a loss of competitive advantage through changes in technology or other factors d. retaining earnings or issuing equity capital and deploying the capital in activities that generate ROCE levels that are lower than current levels

a

One problem with the price-earnings ratio commonly reported is that: a. it divides share price, which reflects the present value of future earnings by historical earnings. b. it dividends share price, which reflects the present value of book value by historical earnings. c. it does not take into consideration the present value of future earnings. d. it is based on analysts' expectations

a

Residual income is defined as: a. Difference between expected comprehensive income and required earnings by the firm. b. Difference between comprehensive income and retained earnings c. Difference between comprehensive income and the company's book value d. The addition of comprehensive income to net income for the year.

a

The market price of a share of common equity reflects: a. the aggregated expectations of all of the market participants following that particular stock. b. the present value of future residual income c. book value plus the present value of future residual income. d. the correct value for the particular stock.

a

In the value-to-book model growth adds value to shareholders only if the growth is ________________________________________

abnormally profitable abnormally high

The market price of a share of common equity reflects the ____________________________________ of all the market participants following that particular stock.

aggregated expectations

The differences in industry market-to-book ratios may be the result of differences in growth, ROCE relative to Re as well as differences in _______________________________

alternative accounting principles

All of the following are accounting factors that will cause a firm's value-to-book ratio to decrease over time EXCEPT: a. recognizing unrealized gains on assets b. a loss of competitive advantage through changes in technology or other factors c. earning a high ROCE (above the equity cost of capital) on off-balance-sheet R&D assets d. earning a high ROCE (above the equity cost of capital) on off-balance-sheet intangible assets (such as brand equity) over time

b

Companies value-to-book and market-to-book ratios may differ due to accounting reasons. An example of an accounting reason that would create a difference is: a. accelerated methods of depreciation. b. investments in successful research and development programs that are expensed according to conservative accounting principles c. using LIFO versus FIFO for inventory d. high operating leverage

b

Firms with low P/E ratios tend to have a current residual income that is greater than: a. future actual income. b. future residual income. c. past actual income d. past residual income.

b

Under the value-to-book model a firm in stead state equilibrium earning ROCE = Re will: a. create additional shareholder wealth and be valued above book value. b. maintain shareholder wealth and be valued at book value. c. destroy shareholder wealth and be valued below book value. d. be in a no-growth state

b

Wolverwine company's current stock price is $55 per share and the company's trailing earnings per share were $2.10. Given that analysts are forecasting growth of 12% for Wolverwine, what is the company's PEG ratio? a. 21.2 b. 2.18 c. 2.97 d. 1.52

b (55 / 2.10) / (.12 * 100) = 2.18

Assuming that Ska Company's cost of equity capital is 14% and it expects to grow earnings at a rate of 8% per year, we would expect SKa's P/E ratio to be: a. 8 b. 16.7 c. 14 d. 4.5

b 1/(.14-.08) = 16.7

The value-to-book model indicates that a firm in steady state equilibrium earnings ROCE = Re will be valued at ________________________

book value

A company with a PEG ratio of less than one would be interpreted as having a stock price: a. that is underpriced given earnings and expected earnings growth. b. that is low relative to the company's growth prospects c. that is high relative to the company's growth prospects. d. that is overvalued

c

All of the following are accounting factors that can drive a firm's price-earnings ratio in a given period to be higher than that of other firms in the same industry EXCEPT: a. non-recurring expenses or losses in that period. b. a greater degree of accounting conservatism that requires expensing R&D or other intangible asset-generating activities c. a less conservative accounting stance that uses straight-line depreciation rather than accelerated methods d. a greater degree of accounting conservatism regarding accelerated depreciation of PP&E

c

All of the following are economic factors that can cause a firm's price-earnings ratio to be higher than that of other firms in the same industry EXCEPT: a when investors expect that the firm's strategy enables it to generate and sustain greater profitability for a given cost of equity capital b. when the firm earns the same profitability for a given cost of equity capital b. when the firm earns the same profitability but with lower risk and, therefore, a lower cost of equity capital. c. a firm's business model that enables it to generate faster growth in earnings provided the growth creates positive residual ROCE d. a firm's business model that results in slower growth in earnings and this creates negative residual ROCE

c

Under the value-to-book model a firm will be valued below book value when: a. the ROCE is greater than Re b. the ROCE is equal to Re c. the ROCE is less than Re d. the firm's growth rate is above the industry average

c

Valuation using market multiples captures: a. absolute valuation per dollar of book value or per dollar of earnings. b. dollar of book value or dollar of earnings per dollar of common equity. c. relative valuation per dollar of book value or per dollar of earnings. d. intrinsic valuation per dollar of book value or per dollar of earnings.

c

Which of the following ratios give a perspective on risk in the capital structure? a. Book value per share b. Price/earnings ratio c. Degree of financial leverage d. Dividend yield

c

Which of the following ratios usually reflects investor's opinions of the future prospects for the firm? a. Earnings per share b. Dividend yield c. Price/earnings ratio d. Book value per share

c

Economics teaches that, in equilibrium, firms will earn a return equal to the _________________________

cost of capital

A company is expected to generate $175,000 in earnings next period and requires a 20% return on equity capital. Using the assumptions of the price-earnings ratio, what would be the company's value at the beginning of next period? a. $781,250 b. $1,250,000 c. $2,000,000 d. $875,000

d

Book value per share may NOT approximate market value per share because: a. Land may have substantially increased in value. b. Market value reflects future potential earning power. c. Investments may have a market value substantially above the original cost. d. All of these are reasons why book value per share may not approximate market value per share.

d

Strictly speaking, the price-earnings ratio assumes that firm value is the: a future value of a constant stream of expected future earnings, discounted at a constant expected future risk-free rate. b. future value of a constant stream of expected future earnings, discounted at a constant expected future discount rate. c. present value of a constant stream of expected future earnings, discounted at a constant expected future risk-free rate. d. present value of a constant stream of expected future earnings, discounted at a constant expected future discount rate.

d

Trading on the equity is likely to be a good financial strategy for stockholders of companies having: a. Cyclically high and low amounts of reported earnings. b. Steadily declining amounts of reported earnings. c. Volatile fluctuations in reported earnings over short periods of time. d. Steady amounts of reported earnings.

d

Under the value-to-book model new projects will be less profitable only when: a. ROCE equal ROA b. ROCE equal Re c. ROCE is greater than Re d. ROCE is less than Re

d

Which of the following is NOT reason why price-earnings ratios would differ across firms? a. Risk b. Profitability c. Growth d. Operating leverage

d

Which of the following normally does not introduce measurement error into the calculation of P/E ratios? a. differences in firm specific growth rates b. restructuring losses c. transitory gains d. deferred taxes

d

Which of the following would NOT be an example of the use of a multiple when valuing common equity? a. Price-to-operating cash flow b. Price-to-book c. Price-to-earnings d. Multi-period discounted earnings models.

d

The theoretical PE model does NOT work when the growth rate in ______________________________ exceeds the cost of equity capital

earnings

The risk of the firm increases the ________________________________

equity cost of capital

The PE multiple assumes that firm value is the present value of a constant stream of _________________________________, discounted at a expected future discount rate.

expected future earnings

Analysts use the PEG ratio to assess share price relative to earnings and ________________________________________

expected future earnings growth

Firms with low P/E ratios tend to have current residual income that is greater than ________________________________________

future residual income

A company with a PEG ratio of less than one would be interpreted as having a stock price that is low relative to ______________________________

growth prospects

The value-to-book ratio reflects an analyst's expectation of the firm's _______________________ value to book value

intrinsic

Industries with relatively high market-to-book ratios are more likely to have ________________________________________ assets

off-balance-sheet

When a company has a high market to book ratio this could be a result of the company having __________________________________

off-balance-sheet assets

Market multiples capture _______________________ valuation per dollar of book value or per dollar of earnings

relative

To estimate security's risk-neutral value we can use the _________________________________________________ and risk-free rates of return

residual income model

The PEG ratio does NOT take into account differences in ____________________________ and ______________________________ across firms

risk, cost of equity capital

Studies have shown that 50-70% of the variability in PE ratios across firms comes from ________________________ and ________________________

risk, growth

The ____________________________________________ represents the value of the firm, based on book value of equity and forecasts of expected future earnings, in the absence of discounting for risk.

risk-neutral value