978-1337614689 Chapter 14

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Chapter 14—Valuation: Market-Based Approaches

MULTIPLE CHOICE

1. 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

2. 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.

3. 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.

4. Under the value-to-book model a firm in steady 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.

5. Under the value-to-book model new projects will be less profitable only when:

a. ROCE equals ROA

b. ROCE equals RE

c. ROCE is greater than RE

d. ROCE is less than RE

6. 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.

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ANS: B PTS: 1

7. 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 divides 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.

8. 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.

9. 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

10. 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

11. Which of the following is not a reason why price-earnings ratios would differ across firms?

a. Risk

b. Profitability

c. Growth

d. Operating leverage

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ANS: D PTS: 1

12. 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

13. 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

14. 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.

15. 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

16. 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

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

a. future actual income.

b. future residual income.

c. past actual income.

d. past residual income.

18. 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.

19. 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.

20. 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

21. 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

22. 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.

23. 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

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d. retaining earnings or issuing equity capital and deploying the capital in activities that

generate ROCE levels that are lower than current levels

24. 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

25. 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 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

26. 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

COMPLETION

1. The market price of a share of common equity reflects the

_____________________________________________ of all of the market participants following that

particular stock.

2. Market multiples capture ____________________ valuation per dollar of book value or per dollar of

earnings.

3. The value-to-book ratio reflects an analyst’s expectation of the firm’s ____________________ value to

book value.

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

______________________________.

5. The value-to-book model indicates that a firm in steady state equilibrium earnings ROCE=RE will be

valued at _________________________.

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

________________________________________.

ANS:

7. The risk of the firm increases the _____________________________________________.

8. The PE multiple assumes that firm value is the present value of a constant stream of

_____________________________________________, discounted at a constant expected future

discount rate.

9. 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

_______________________________________________________.

10. Industries with relatively high market–to-book ratios are more likely to have

___________________________________ assets.

11. The theoretical PE model does not work when the growth rate in ____________________ exceeds the

cost of equity capital.

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

_________________________________________________________________.

13. To estimate security’s risk-neutral value we can use the

_____________________________________________ and risk-free rates of return.

14. 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.

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

_______.

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PTS: 1

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

__________________________________________________.

17. The PEG ratio does not take into account differences in ____________________ and

________________________________________ across firms.

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

_____________________________________________.

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

relative to ______________________________.

SHORT ANSWER

1. If the market price of a share of stock is based on the expectations of all of the market participants and

the trading volume in that stock, what would happen if the company’s reputation were damaged by a

scandal or defective product that caused personal injury or death?

ANS:

The market participants probably would not want to be associated with a company whose reputation has

2. Discuss how risk and profitability factors cause differences in price-earnings ratios across firms. Explain

the difference between abnormal and normal earnings.

ANS:

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Abnormal earnings are referred to as residual income. Residual income is the difference between

expected comprehensive income in year x and required earnings of the firm in year x. Residual income

3. A firm’s value-to-book and market-to-book ratios may differ from one for a number of reasons. Discuss

how a successful, internally funded research and development program would create a situation where

the value-to-book and market-to-book ratios differ from one another.

ANS:

Because research and development activities are expensed when incurred under U.S. GAAP, a

4. What is a price differential and how is it computed? What information does a price differential provide

to an analyst?

ANS:

The price differential is the amount the market has discounted share price for risk. It is calculated by

subtracting the market price from the residual income model price calculated using the risk-free rate of

5. In research examining market efficiency, Bernard and Thomas examined quarterly earnings

announcements. Discuss how Bernard and Thomas test the issue of market efficiency and the results of

their research.

ANS:

Bernard and Thomas examined market efficiency by forming 10 portfolios each quarter over the period

1974 to 1986 based on the size of firms’ standardized unexpected earnings (SUE). They then calculated

6. The use of P/E ratios in valuation can result in measurement bias. What two items can result in

measurement error and why?

ANS:

1. Growth – Simple P/E ratios do not take into account firm-specific differences in long-term

earnings growth.

7. What information can a PEG ratio provide about a company’s stock price? What does a PEG ratio

greater than one mean? Less than one?

ANS:

Analysts use the PEG ratio as a rule of thumb to assess share price relative to earnings and expected

8. What is the value of reverse engineering stock prices? How does the process work?

ANS:

The process allows the analyst to infer a set of assumptions that appear to be impounded in a company’s

stock price. The analyst can then assess whether the assumptions the market appears to be making are

9. Why is book value often meaningless? What improvements to financial statements would make it more

meaningful?

ANS:

10. Explain the analysts’ role in making the capital markets efficient.

ANS:

Analysts play a key role in making the capital markets efficient by being active acquirers and processors

1. a. Compute the price-earnings ratio under the following sets of assumptions:

Cost of Equity Growth Rate P/E

Scenario Capital in Earnings Ratio

1 0.13 0.09

2 0.13 0.11

3 0.15 0.09

4 0.18 0.09

5 0.18 0.11

b. Assess the sensitivity of the price-earnings ratio to changes in the cost of equity capital and changes in

the growth rate.

ANS:

a. Cost of Equity Growth Rate P/E

Scenario Capital in Earnings Ratio

1 0.13 0.09 25.00

2. Assume an analyst is evaluating a firm with $1,000 of book value of common equity and a cost of equity

capital equal to 12 percent. Assume that the analyst forecasts that the firm will earn ROCE of 18 percent

until year 2015, when the firm will start earning ROCE equal to 12 percent. The company pays no

dividends and will not engage in any stock transactions. Use this information to complete the following

table and calculate the firm’s value–to-book ratio.

Cumulative Residual PV of Residual

Book Value ROCE times Present ROCE times

Expected Residual Growth Factor Cumulative Value Cumulative

Year ROCE ROCE to Year t-1 Growth Factor Growth

2011 0.18 0.8929

2012 0.18 0.7972

2013 0.18 0.7118

2014 0.18 0.6355

2015 0.12 0.5674

V/B Ratio =

ANS:

Cumulative Residual PV of Residual

Book Value ROCE times Present ROCE times

Expected Residual Growth Factor Cumulative Value Cumulative

Year ROCE ROCE to Year t-1 Growth Factor Growth

3. Assume an analyst is evaluating a firm with $1,000 of book value of common equity and a cost of equity

capital equal to 8 percent. Assume that the analyst forecasts that the firm will earn ROCE of 14 percent

until year 2016, when the firm will start earning ROCE equal to 8 percent. The company pays no

dividends and will not engage in any stock transactions. Use this information to complete the following

table and calculate the firm’s value–to-book ratio.

Cumulative Residual PV of Residual

Book Value ROCE times Present ROCE times

Expected Residual Growth Factor Cumulative Value Cumulative

Year ROCE ROCE to Year t-1 Growth Factor Growth

2011 0.14 0.9259

2012 0.14 0.8573

2013 0.14 0.7938

2014 0.14 0.7350

2015 0.14 0.6806

2016 0.08 0.6302

V/B Ratio =

ANS:

Cumulative Residual PV of Residual

Book Value ROCE times Present ROCE times

Expected Residual Growth Factor Cumulative Value Cumulative

Year ROCE ROCE to Year t-1 Growth Factor Growth

4. Investors have invested $30,000 in common equity in a company. The investors expect that the company

will reinvest all income back into projects. The company is forecasted to earn $7,000 the first year,

$6,000 the second year, $5,750 the third year, and $6,442 each year after the third year. The company’s

current stock price is $18 per share. Assuming that the company has 4,300 shares outstanding and the

risk-free rate of interest is 7%, calculate the price differential for this company.

ANS:

Required rate of return 7.00%

BV Equity Required Income Forecasted Income PV Factor PV

of Residual income

Beg year1 $30,000 $1,800 $7,000 0.943396 $4,906

5. Assume a zero-growth rate for earnings and dividends in each situation below. Also assume that all

earnings are paid out as dividends and that the earnings-based valuation model is being used.

Situation 1: Das Company’s earnings are expected to be $9 per share and its stock price is $36. What is

the required rate of return on the firm’s equity?

Situation 2: South Company’s earnings are expected to be $6 per share and its required rate of return on

equity is 26%. What is the current price of the stock?

Situation 3: Jones Company’s current stock price is $60 and its required rate of return on equity is 15%.

What is the firm’s expected earnings?

ANS:

Situation 1: $36.00 = $9.00/r

6. Use the following information to answer the requirements:

Company X Company Y

Reported EPS $15.00 $15.00

EPS decomposed:

Permanent 75% 65%

Transitory 20% 25%

Value-irrelevant 5% 10%

Required:

a. Use a risk-adjusted cost of capital of 15% to calculate each firm’s implied share price and earning

multiples. What are the implicit share prices and earnings multiples for the two firms different?

b. Repeat requirement a., but use a risk-adjusted cost of capital of 8% instead.

ANS:

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a.

Company X

Reported EPS: $15.00

EPS decomposition:

Implied Valuation

Company Y

b.

Company X

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Implied Valuation

Permanent 75% ($15.00 x 0.75) x 12.5 = $140.625

Transitory 20% ($15.00 x 0.20) x 1 = 3.00

Value-irrelevant 5% ($15.00 x 0.05) x 0 = 0.00

Implied share price: $143.625

Implied earnings multiple (share price/reported EPS): 9.6

Company Y

Implied Valuation

As before, the implied share price and earnings multiple of Company X are higher than that of

Company Y because the reported earnings of X are higher quality than those of Y. Moreover,