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 companies 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.
7. One problem with the price-earnings ratios 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.
its 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 percent 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
12. The price differential, or the amount by which the market has discounted share price for risk, is
calculated by
a.
subtracting the book value from the residual income model book value calculated using the
risk free rate.
b.
subtracting the market price from the residual income model price calculated using the risk
free rate.
c.
multiplying the theoretical price-earnings ratio by the market price.
d.
subtracting the residual income model price calculated using RE from the residual income
model price calculated using the risk free rate.
13. 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
14. 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
15. A company with a PEG ratio of less than one would be interpreted as having a stock price
a.
are 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
16. 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
17. Assuming that Ska’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
18. 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.
19. 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.
Multiperiod discounted earnings models.
20. 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.
21. 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
22. 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
23. 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.
24. 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
25. 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
26. 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
27. 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
________________________________________.
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 difference between the current stock price and
risk-neutral value.
15. 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.
16. Studies have shown that 50-70% of the variability in PE ratios across firms comes from and
.
____________________________
____________________________
17. When a company has a high market to book ratio this could be a result of the company
having__________________________________________________.
18. The PEG ratio does not take into account differences in ____________________ and
________________________________________ across firms.
19. Firms with low P/E ratios tend to have current residual income that is greater than
_____________________________________________.
20. A company with a PEG ratio of lessthan 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 companies reputation would be damaged by
a scandal or defective product that caused personal injury or death
2. Discuss how risk and profitability factors cause differences in price-earnings ratios across firms. Explain
the difference between abnormal and normal earnings.
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.
4. What is a price differential and how is it computed? What information does a price differential provide
to an analyst?
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.
6. The use of P/E ratios in valuation can result in measurement bias. What two items can result in
measurement error and why?
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?
8. What is the value of reverse engineering stock prices? How does the process work?
9. Why is book value often meaningless? What improvements to financial statements would make it more
meaningful?
10. Explain the analysts’ role in making the capital markets efficient.
11. What does a price differential measure? How does a price differential relate to risk?
PROBLEM
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
Cost of Equity
Growth Rate
P/E
1
0.13
0.09
2
0.13
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.
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
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 =
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
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 =
Cumulative
Residual
PV of Residual
Book Value
ROCE times
Present
ROCE times
Expected
Residual
Growth Factor
Cumulative
Value
Cumulative
ROCE
ROCE
to Year t-1
Growth
Factor
Growth
0.14
0.06
0.0600
0.14
0.06
0.0684
0.14
0.06
0.0780
0.14
0.06
0.0888
0.14
0.06
0.1014
0.08
0.0000
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.
Cumulative
PV of Residual
Book Value
ROCE times
ROCE times
Expected
Residual
Growth Factor
Cumulative
Value
Cumulative
Year
ROCE
ROCE
to Year t-1
Growth
2011
0.18
0.06
0.0600
0.8929
2012
0.18
0.06
0.0708
0.7972
2013
0.18
0.06
0.0834
0.7118
2014
0.18
0.06
0.0984
0.6355
2015
0.12
0.0000
0.5674
V/B Ratio =
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?
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.
Valuation multiple for value-irrelevant earnings
Permanent
75% ($15.00 x 0.75) x 6.67 =
Transitory
20% ($15.00 x 0.20) x 1 =
Implied share price:
Valuation multiple for value-irrelevant earnings
Permanent
65% ($15.00 x 0.65) x 6.67 =
Implied share price:
(share price/reported EPS):
4.6