CFA 2018 quest bank 05 market based valuation p nterprise value multiples

Market-Based Valuation: Price and Enterprise Value MultiplesAn argument for using the price-to-earnings P/E valuation approach is that: management discretion increases the reliability of

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Market-Based Valuation: Price and Enterprise Value Multiples

An argument for using the price-to-earnings (P/E) valuation approach is that:

management discretion increases the reliability of the ratio

earnings can be negative

earnings power is the primary determinant of investment value

Explanation

Earnings power is the primary determinant of investment value Both remaining factors reduce the usefulness of the P/E approach

An analyst has gathered the following data about Jackson, Inc.:

Payout ratio = 60%

Expected growth rate in dividends = 6.7%

Required rate of return = 12.5%

What will be the appropriate price-to-book value (PBV) ratio for Jackson, based on fundamentals?

Yes, because the expected dividend growth rate is cancelled out in the

computation of the PEG ratio

Yes, because the computation of the PEG ratio does not use the rate of expected

dividend growth

No, because the PEG ratio is undefined for zero-growth companies

Explanation

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Question #4 of 140 Question ID: 463330

Two security analysts, Ramon Long and Sri Beujeau, disagree about certain aspects of the PEG ratio Long argues that:

"unlike typical valuation metrics that incorporate dividend discounting, the PEG ratio is unique because it generates meaningfulresults for firms with negative expected earnings-growth." Is Long correct?

Yes, because the expected earnings-growth rate is cancelled out in the

computation of the PEG ratio

No, because the PEG ratio generates meaningless results for negative

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sold short as an overvalued stock

sold as an overvalued stock

Explanation

The price per dollar of earnings is considerably lower than that for the median of the peer group, which implies that it may well be

undervalued

Earnings before interest, taxes, depreciation, and amortization (EBITDA) is best suited as a measure of:

total company value

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Bill Whelan and Chad Delft are arguing about the relative merits of valuation metrics

Whelan: "My ratio is less volatile than most, and it works particularly well when I look at stocks in cyclical industries."

Delft: "The problem with your ratio is that it doesn't reflect differences in the cost structures of companies in different

industries I like to use a metric that strips out all the fluff that distorts true company performance."

Whelan: "People can't even agree how to calculate your ratio."

Which valuation metric do the analysts most likely prefer?

Price/book EV/EBITDA

Price/cash flow Price/book

Price/sales Price/cash flow

Explanation

The price/sales ratio is not very volatile, and it is of particular value when dealing with cyclical companies The price/cash flowratio considers the stock price relative to cash flows, ignoring the noncash gains and losses that can skew earnings A majorweakness of the price/cash flow ratio is the fact that there are different ways of calculating it, making comparisons difficult attimes

Margin and Sales Trade-off for CVR, Inc and Home, Inc., for Next Year

Firm Strategy Retention Rate Profit Margin

Sales/BookValue (SBV) ofEquityCVR, Inc High Margin / Low Volume 20% 8% 1.25

CVR, Inc Low Margin / High Volume 20% 2% 4.00

Low Margin / High Volume 40% 1% 20.0

Note: CVR, Inc., has a book value of equity of $80 and a required rate of return of 10% Home, Inc., has a book value of equity of $100and a required rate of return of 11%

If Home, Inc., has a required return for shareholders of 11%, what is its appropriate leading price-to-sales (P / S ) multiple if the firmundertakes the low margin/high volume strategy?

0.20

o 1

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g = Retention Rate × Profit Margin × SBV of equity = 0.40 × 0.01 × 20.0 = 0.08.

If profit margin is based on the expected earnings next period,

P/S = (profit margin × payout ratio) / (r − g) = (0.01 × 0.60) / (0.11 − 0.08) = 0.20

The warranted or intrinsic price multiple is called the:

multiple implied by historical growth

justified price multiple

multiple implied by the market price

Explanation

A justified price multiple is the warranted or intrinsic price multiple It is the estimated fair value of that multiple

Margin and Sales Trade-off for CVR, Inc and Home, Inc., for Next Year

Firm Strategy Retention Rate Profit Margin Sales/Book

Value of EquityCVR, Inc High Margin / Low Volume 20% 8% 1.25

CVR, Inc Low Margin / High Volume 20% 2% 4.00

Low Margin / High Volume 40% 1% 20.0

(Note: CVR, Inc., has a book value of equity of $80 and a required rate of return of 10% Home, Inc., has a book value of equity of $100and a required rate of return of 11%.)

If CVR, Inc., has a required return for shareholders of 10%, what is its appropriate leading price-to-sales (P/S) multiple if the firm

undertakes the high margin/low volume strategy?

0.80

1.46

0.20

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g = Retention Rate × Profit Margin × Sales/book value of equity = 0.20 × 0.08 × 1.25 = 0.02

If profit margin is based on the expected earnings next period,

Leading P/S = (profit margin × payout ratio) / (r − g) = (0.08 × 0.80) / (0.10 − 0.02) = 0.80

An analyst gathers the following information for ABC Industries:

Market Value of Debt $110 million

Market Value of Equity $90 million

Book Value of Debt $100 million

Book Value of Equity $50 million

EV uses market values for debt and equity (110 + 90) / 75 = 2.67

The Farmer Co has a payout ratio of 70% and a return on equity (ROE) of 14% What will be the appropriate price-to-book value (PBV)based on fundamentals if the expected growth rate in dividends is 4.2% and the required rate of return is 11%?

Which of the following statements about cyclical firms is least accurate?

The problems encountered when using the price-to-earnings (P/E) multiples of cyclical

firms can be completely eliminated by using average or normalized earnings

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Cyclical firms have volatile earnings, and their price-to-earnings (P/E) multiple is not very

useful for valuation

The price-to-earnings (P/E) multiple of a cyclical firm normally peaks at the depths of

recession and bottoms out at the peak of economic boom

Explanation

The P/E multiples for cyclical firms are not very useful for valuation Earnings will follow the economy, and prices will reflect expectationsabout the future Thus, most of the time, the P/E multiple of a cyclical firm will peak at the depths of recession and bottom out at thepeak of an economic boom This problem can be minimized to some extent by using average or normalized earnings but will not beeliminated completely

Proprietary Technologies, Inc., (PTI) has a leading price-to-earnings (P/E) ratio of 38 while the median leading P/E of a peer group ofcompanies within the industry is 28 Based on the method of comparables, an analyst would most likely conclude that PTI should be:bought as an undervalued stock

viewed as a properly valued stock

sold or sold short as an overvalued stock

Barnes said numerous academic studies have shown that low P/E stocks tend to outperform those with high P/Es She uses the P/Eratio as the basis of most of her valuation analysis "I prefer to use the justified P/E ratio because it is inversely related to therequired rate of return."

Lincoln warned against using P/E ratios to evaluate technology stocks He suggests using price-to-book (P/B) ratios instead, becausethey are useful for explaining long-term stock returns "Book value is a good measure of value for companies with a lot of liquidassets, and it is easier to calculate than the P/E because you rarely have to adjust book value."

Bosley prefers the price/sales (P/S) ratio and the earnings yield "The P/S ratio is particularly useful for valuing companies in cyclicalindustries because it isn't affected by sharp changes in profitability caused by economic cycles."

Marks acknowledges that the P/E ratio is a useful valuation measurement However, she prefers using the price/free-cash-flow ratio

"Free cash flow (FCF) is more difficult to manipulate than earnings, and it has proven value as a predictor of stock returns."

Powell has provided Barnes with a group of small-cap stocks to analyze The stocks come from a variety of different sectors and havewidely different financial structures and growth profiles She has been asked to determine which of these stocks represent attractive

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values She is considering four possible methods for the job:

The PEG ratio, because it corrects for risk if the stocks have similar expected returns

Comparing P/E ratios to the average stock in the S&P 500 Index, because the benchmark should serve as a good proxy for theaverage small-cap stock valuation

Comparing P/E ratios to the median stock in the S&P 500 Index, because outliers can skew the average P/E upward

The P/S ratio, because it works well for companies in different stages of the business cycle

Which analyst's quote is least accurate?

The company is likely to be unprofitable

P/E ratios for medical-technology firms with different specialties are not comparable

Explanation

Earnings are the chief determinant of value for most companies, including med-tech P/E is the most common valuation method and thebest known by lay investors Comparability of P/E ratios across industries is always problematic, but not as much so for within the med-tech industry A start-up company is very likely to have negative earnings, which renders the P/E ratio useless (Study Session 12, LOS37.c)

Based on their responses to Powell, which of the analysts is most likely concerned about earnings volatility?

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Based on their responses to Powell, which of the analysts has proposed a method that has the best chance to work for determining therelative value start-up companies?

Barnes would be least likely to use EV/EBITDA ratio, rather than the P/E ratio, when analyzing a company that:

reports a lot of depreciation expense

has a different capital structure than most of its peers

pays a dividend, and is likely to deliver little earnings growth

Explanation

For companies that report a lot of depreciation expense or must be compared to companies with different levels of financial leverage, theEV/EBITDA ratio may be more useful than the P/E For companies that pay a dividend and have little profit growth, both should work fine.Given Barnes' stated preference for the P/E ratio, she is least likely to use the EV/EBITDA ratio with the dividend-paying firm (StudySession 12, LOS 37.c, n)

Barnes is considering the four methods previously described to analyze the small-cap stocks provided to her by Powell For which methoddoes Barnes provide the weakest justification?

The price/sales ratio

The mean P/E of S&P 500 companies

The PEG ratio

Explanation

No valuation method will work dependably across all types of stocks The four Barnes proposed are probably as good as any But thePEG ratio does not correct for risk - it works as a comparison tool only if the companies have similar expected risks and returns Theother justifications are reasonable (Study Session 12, LOS 37.c, k)

Which of the following factors is a source of differences in cross-border valuation comparisons?

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Different accounting conventions make cross-border comparisons for valuation purposes challenging.

Enhanced Systems, Inc., (ESI) has a leading price to book value (P/B) of four while the median P/B of a peer group of companies withinthe industry is six Based on the method of comparables, an analyst would most likely conclude that ESI should be:

bought as an undervalued stock

sold as an overvalued stock

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An argument against using the price-to-earnings (P/E) valuation approach is that:

research shows that P/E differences are significantly related to long-run average stock

returns

earnings can be negative

earnings power is the primary determinant of investment value

Explanation

Negative earnings render the P/E ratio useless Both remaining factors increase the usefulness of the P/E approach

An increase in growth will cause a price-to-earnings (P/E) multiple to:

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Based on return differential:

P / BV = (ROE − g) / (r − g) = (0.16 − 0.056) / (0.13 − 0.056) = 1.41

An analyst has gathered the following fundamental data:

Low Volume

Low Margin High Volume

High Margin Low Volume

Low Margin High Volume

The P/S multiple = [Profit Margin × Payout Ratio × (1 + g)] / (r − g) = (0.10 × 0.4 × 1.09) / (0.11 − 0.09) = 2.18

What is the P/S multiple for Firm B in the low-margin, high-volume strategy?

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The definition of a PEG ratio is price to earnings (P/E):

divided by average historical earnings growth rate

divided by the average growth rate of the peer group

divided by the expected earnings growth rate

Explanation

The PEG ratio is P/E divided by the expected earnings growth rate

A firm is better valued using the discounted cash flow approach than the P/E multiples approach when:

earnings per share are negative

expected growth rate is very high

dividend payout is low

Explanation

P/E multiples are not meaningful when the earnings per share are negative While this problem can be partially offset by using normalized

or average earnings per share, the problem cannot be eliminated

An increase in which of the following variables will least likley result in a corresponding increase in the price-to-book value (PBV) ratio for

a high-growth firm?

Growth rates in earnings

Required rate of return

Payout ratios

Explanation

The PBV ratio decreases as the required rate of return increases

Which of the following is a common momentum valuation indicator?

Price to free cash flow to equity (P/FCFE)

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An analyst focusing mostly on financial stocks is likely to prefer valuing stocks via the:

price/book ratio

dividend yield

price/sales ratio

Explanation

The price/book ratio is a preferred tool for valuing financial stocks

An analyst is valuing a company with a dividend payout ratio of 0.35, a beta of 1.45, and an expected earnings growth rate of 0.08 Aregression on comparable companies produces the following equation:

Predicted price to earnings (P/E) = 7.65 + (3.75 × dividend payout) + (15.35 × growth) − (0.70 × beta)

What is the predicted P/E using the above regression?

bought as an undervalued stock

sold or sold short as an overvalued stock

Explanation

The price per dollar of book value is the same as that for the median of the peer group, which implies that it is likely properly valued

At a regional security analysts conference, Sandeep Singh made the following comment: "A PEG ratio is a very useful valuation metricbecause it generates meaningful results for all equities, regardless of the rate of dividend growth." Is Singh correct?

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No, because the PEG ratio generates highly questionable results for low-growth

Which of the following measures of cash flow is most closely linked with valuation theory?

Free cash flow to equity (FCFE)

Earnings before interest, taxes, depreciation, and amortization (EBITDA)

Cash flow from operations (CFO)

Expected Return on Equity = 16.75%

Required rate of return = 12.5%

What will be the appropriate price-to-book value (PBV) ratio for the Garber Company based on return differential?

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An analyst gathered the following data for TRK Construction [all amounts in Swiss francs (Sf)]:

Cash and marketable securities Sf 75 million

Depreciation and amortization Sf 12 million

EBITDA = (net income + interest + taxes + depreciation / amortization)

EV = (market value of common stock + market value of debt - cash and investments)

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* All figures except stock price, dividends, and percentages are in millions.

In most cases, Jenkins values her stocks relative to a basket of stocks in the same industry in order to avoid significant fundamentaldifferences between companies of different types However, her picks made based on price/earnings ratios are not doing well against themarket She fears the stocks she selects are not as cheap as she originally thought, relative to her benchmark

Jenkins also wants to improve Cape Cod's selection of software stocks To widen the field beyond the companies she currently follows,Jenkins wants to include Canadian software stocks in Cape Cod's research universe Differences in accounting methodologies are not aconcern, but Jenkins is still concerned about the difficulty of valuing the different stocks

Jenkins has assembled the following data about Canadian software companies:

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Most are very small

Most carry little debt, but about 20% are heavily leveraged

These companies are more likely to be unprofitable compared to U.S companies

Few pay dividends, as is the case in the U.S

Many of the companies are government-subsidized, which leads to drastic differences in the level of operating expenses

Which of the following explanations is least likely to explain why Jenkins' stock picks underperform?

Many stocks in the benchmark group are mispriced

Large stocks have an outsized effect on the benchmark data

She is using the mean rather than the median valuation as a benchmark

Explanation

Capitalization weights are not an issue unless the benchmark is a cap-weighted index Jenkins is using a basket of stocks in the sameindustry, which can be assumed to be a simple arithmetic average Average valuations reflect outliers; medians do not P/Es can get veryhigh, but can never fall below zero As such, the outliers are going to trend high, and the median is likely to be considerably lower than themean A stock that looks cheap relative to the mean may look expensive relative to the median Stocks of different sizes often havedifferent average or median valuations Mispricing of stocks in the benchmark is always a risk (Study Session 12, LOS 37.j)

If she wants to compare Canadian software companies to U.S software companies, it would be most appropriate for Jenkins to value thecompanies using the:

Which valuation ratio is least appropriate for comparing Massive and Mouse?

Price/book because Massive is larger than Mouse

Price/cash flow because cash flows for small companies can be extremely volatile

Enterprise value/EBITDA because Massive and Mouse have very different debt levels

Explanation

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Mouse & Associates is cheaper than Massive Tech as measured by:

the price/sales ratio and the price/earnings ratio

the earnings yield but not the price/book

the price/sales ratio and the dividend yield

Explanation

To calculate the P/E, divide the market capitalization by the earnings Lower is cheaper

To calculate the P/B, divide the market capitalization by the equity Lower is cheaper

To calculate the P/S, determine sales by dividing the earnings by the net margin Then divide the market capitalization by the sales.Lower is cheaper

To calculate the earnings yield, divide the earnings by the market capitalization Higher is cheaper

To calculate the dividend yield, divide the dividends by the price Higher is cheaper

Massive Tech Mouse & Associates

(Study Session 12, LOS 37.d)

The price/cash flow ratio of Massive Tech, where cash flow is defined as earnings plus noncash charges, is closest to:

9.65

16.67

7.89

Explanation

Cash flow = net income plus depreciation plus amortization = ($4,300 + 3,500 + 5,675) = $13,475 million

P/CF = market capitalization/cash flow = ($130,000/13,475) = 9.65 (Study Session 12, LOS 37.d)

If Jenkins wants to compare foreign stocks to U.S stocks and is concerned about differences in accounting, she should start with the:price/FCFE ratio

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Robin Alberts, CFA, is the head of research for Worth Brothers, a large investment company based in New York Next week, a group ofanalysts who have just completed the Worth Brothers' management training program will begin rotating throughout the various

departments and trading desks at the firm The trainees will be split into small groups, and each group will spend four weeks in each area

to learn the basic operations of each department through "hands on" experience Also, in that time period, each department head isexpected to fully evaluate each candidate in order to determine their future placement within the firm

Alberts decides that she should begin every rotation in the research department by giving each candidate a brief review exam to test theirknowledge of the general principles of credit analysis She asks each candidate to analyze the following three scenarios and to answertwo questions on each scenario

Scenario One

Firm A Firm B Firm C Firm D

Price-to-book Value (PBV) Ratio 3.00 0.70 3.50

Scenario Two Cost of Capital Measures for Brown, Inc.

Proportion of the Firm Financed with Debt 20%

Proportion of the Firm Financed with Equity 80%

Scenario Three The Donner Company

as of December 31, 2003 (in $ millions)

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Property, Plant & Equip 218 Retained Earnings 183

Total Assets 433 Total Liabilities & Equity 433

2001 2002 2003

Operating Profit (EBIT) 42 38 43

Relevant Industry Ratios

Long-term Debt-to-equity Ratio: 0.52

Current Ratio: 3.20

Interest Coverage Ratio: 2.10

Using the information in scenario one which of the following items would increase firm A's PBV?

Increase the spread between ROE and r

Using the information from scenario one which of the following items would decrease Firm A's PBV?

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Decrease the spread between ROE and r

Using the information in scenario two, what is the cost of equity capital of Brown, Inc.?

Using the information in scenario two, what is the weighted-average cost of capital (WACC) of Brown, Inc.?

Using the information in scenario three, what should Mansted observe about Donner's solvency and debt capitalization?

Donner's solvency ratio is worse but its debt capitalization is better than the industry

average

Donner's solvency ratio is better but its debt capitalization is worse than the industry average

Both Donner's solvency and debt capitalization ratios are better than the industry average

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interest coverage ratio is:

declining (worsening) over time but is still above the industry average

declining (worsening) over time and is below the industry average

rising (improving) over time and is above the industry average

more meaningful the larger the historical size of forecast errors

scaled by the earnings surprise

Explanation

A given size forecast error is more (less) meaningful the smaller (larger) the historical size of forecast errors

A common pitfall in interpreting earnings yields in valuation is:

using underlying earnings

using negative earnings

look-ahead bias

Explanation

A common pitfall is look-ahead bias, wherein the analyst uses information that was not available to the investor when calculating theearnings yield

An analyst has gathered the following fundamental data:

Firm A Firm B Firm C Firm D

Required Rate of Return 12% 12% 12% 12%

Return on Equity (ROE) 20% 15% 30% 14%

Price/Book Value (PBV) Ratio 3.00 0.70 3.50

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Method of forecasted fundamentals.

Free cash flow to the firm

Method of comparables

Explanation

The method of forecasted fundamentals is based on the rationale that stock values differ due to differences in the expected values offundamentals such as sales, earnings, or related growth rates

The net impact of an increase in payout ratio on price-to-book value (PBV) ratio cannot be determined because it might also:

decrease the market value of the firm

decrease expected growth

decrease required rate of return

Explanation

If payout increases, the growth of the firm may slow down, because internally generated funds are not being invested in new, profitableprojects Hence, the net impact on the PBV ratio from change in payout ratio cannot be determined

An argument against using the price-to-sales (P/S) valuation approach is that:

P/S ratios are not as volatile as price-to-earnings (P/E) multiples

P/S ratios do not express differences in cost structures across companies

sales figures are not as easy to manipulate or distort as earnings per share (EPS) and book

value

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Which of the following price multiples is most severely damaged by international accounting differences?

Price to free cash flow to equity (P/FCFE)

Price to cash flow from operations (P/CFO)

Enterprise value to earnings before interest, taxes, depreciation, and amortization

(EV/EBITDA)

Explanation

EV/EBITDA is the most seriously affect because it is most closely tied to accounting conventions

An increase in growth will cause a price to cash flow multiple to:

A common justification for using earnings yields in valuation is that:

earnings are more stable than dividends

earnings are usually greater than free cash flows

negative earnings render P/E ratios meaningless and prices are never negative

Explanation

Negative earnings render P/E ratios meaningless In such cases, it is common to use normalized earnings per share (EPS) and/or restatethe ratio as the earnings yield or E/P because price is never negative Price to earnings (P/E) ranking can then proceed as usual

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Precision Tools is expected to have earnings per share (EPS) of $5.00 per share in five years, a dividend per share of $2.00, a cost ofequity of 12%, and a long-term expected growth rate of 5% What is the terminal trailing price-to-earnings (P/E) ratio in five years?7.14

6.00

9.00

Explanation

P /E = (0.40 × 1.05) / (0.12 - 0.05) = 6.00

The price-to-book value (PBV) ratio for a high-growth firm will:

increase as the growth rate in either the high-growth or stable-growth period decreases

increase as the growth rate in either the high-growth or stable-growth period increases

increase as the growth rate in the high-growth period increases and decrease as the growth

rate in the stable-growth period increases

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