CHAPTER 9—COMPANY ANALYSIS AND STOCK VALUATION
TRUE/FALSE
1. A growth company is one whose stock is undervalued by the market.
2. A cyclical company’s sales and earnings are heavily influenced by aggregate business activity.
3. A stock with low systematic risk is considered to be a defensive stock.
4. A growth company is a firm that has the opportunities and ability to invest capital in projects that
generate rates of return greater than the firm’s cost of debt.
5. With a differentiation strategy, a firm seeks to identify itself as unique in its industry in an area that is
important to buyers.
6. By definition growth companies have growth stocks.
7. Turnarounds are firms with valuable assets that are hidden on the balance sheet.
8. Present value of free cash flow to equity resembles the present value of earnings concept except that it
includes the capital expenditures required to maintain and grow the firm and the change in working
capital required for a growing firm.
9. In the present value of operating free cash flow technique, the firm’s operating free cash flow to the
firm is discounted at the firm’s weighted average cost of capital (WACC).
10. The best known measure of relative value for common stock is the P/E ratio.
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11. Price-to-book value ratio cannot be used to estimate the value of firms with negative earnings or
negative cash flows.
12. The price/cash flow ratio has grown in prominence and use for valuing firms because many analysts
contend that a firm’s cash flow is less subject to manipulation than the firm’s earnings per share.
13. Price-to-sales ratio is still considered the predominant firm valuation technique.
14. The constant growth dividend growth model is not appropriate for the valuation of growth companies.
15. A negative EVA (Economic Value Added) for the year implies that the firm has not earned enough
during the year to cover its capital of capital and the value of the firm has declined.
16. While EVA is considered an internal performance measure, MVA is considered to be an external
performance measure.
17. A defensive company is one whose sales, earnings and cash flows are strongly correlated with the
business cycle.
18. An undervalued stock is a growth stock.
19. An overvalued stock is a non-growth stock.
20. A firm’s competitive strategy can be either defensive or offensive.
21. To benefit from cost leadership a firm must command prices near the industry average.
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22. Two major competitive strategies are low-cost leadership and low-price leadership.
23. According to Peter Lynch a favourable attribute of a firm that may result in favourable stock
performance is when a firm’s product is the latest craze.
24. According to Peter Lynch a favourable attribute of a firm that may result in favourable stock
performance is when a firm buys back its shares.
25. Underpriced stocks can be ranked using the excess return ratio which is calculated as the Market
price/Risk free rate.
26. Operating free cash flow and free cash flow to equity are equivalent cash flow concepts.
27. One way to measure a company’s intrinsic value is to divide the company’s current dividends by the
required return less the dividend growth rate.
28. The sustainable growth rate can be calculated by taking the dividend payout ratio time return on equity
(ROE).
29. Based on the annual reports of Shoppers it has pursued both a low-cost strategy and a differentiation
strategy for different business segments.
MULTIPLE CHOICE
1. A speculative stock possesses a ____ probability of ____ return and is currently ____.
a.
High, negative, underpriced.
b.
High, negative, overpriced.
c.
High, positive, overpriced.
d.
Low, negative, overpriced.
e.
Low, positive, underpriced.
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2. A ____ stock possesses a high probability of low or negative rates of return and a low probability of
normal or high rates of return.
a.
Growth
b.
Defensive
c.
Cyclical
d.
Speculative
e.
Value
3. A growth company is one that has the ability to
a.
Acquire capital at a low cost and is able to invest in projects that yield an average return.
b.
Acquire capital at a low cost and is able to invest in projects that yield a below average
return.
c.
Acquire capital at an average cost and is able to invest in projects that yield an above
average return.
d.
Acquire capital at an average cost and is able to invest in projects that yield an average
return.
e.
Acquire capital at an above average cost and is able to invest in projects that yield an
average return.
4. Porter contends that _________ and ______________ are two important competitive strategies.
a.
Low cost leadership, barrier to entry
b.
New entrant deterrent, differentiation
c.
Low cost leadership, differentiation
d.
Differentiation, monopolistic
e.
Monopolistic simulation, differentiation
5. In a(n) _______________ strategy, a firm seeks to identify itself as unique within its industry.
a.
Defensive
b.
Offensive
c.
Low-cost
d.
Differentiation
e.
None of the above
6. In SWOT analysis, one examines all of the following factors, except
a.
Strengths.
b.
Weaknesses.
c.
Opportunities.
d.
Threats.
e.
Turnarounds.
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7. Which of the following statements concerning SWOT analysis is false?
a.
Strengths are the factors that give the firm a comparative advantage in the marketplace.
b.
Weaknesses result when the company has potentially exploitable advantages over other
firms.
c.
Opportunities are environmental factors that favour the firm.
d.
Threats are environmental factors that can hinder the firm in achieving its goals.
e.
All of the above statements are true.
8. Peter Lynch identified a number of attributes of firms that may result in favourable stock market
performances, including
a.
Products that are faddish, people like change.
b.
Firms that have competitive advantages over their rivals.
c.
Firms that can benefit from cost reductions.
d.
Choices b and c.
e.
All of the above.
9. In Berkshire Hathoway annual reports Warren Buffet highlights business tenants that he believes are
important. Which of the following is not a business tenant of Warren Buffet?
a.
Is the business unique and technologically advanced?
b.
Does the business have a consistent operating history?
c.
Does the business have favourable long-term prospects?
d.
a and b above.
e.
All of the above are business tenants of Warren Buffet.
10. In Berkshire Hathoway annual reports, Warren Buffet highlights financial tenants that he believes are
important. Which of the following is not a financial tenant of Warren Buffet?
a.
Focus on return on equity (ROE) not earnings per share (EPS).
b.
Calculate owner earnings similar to free cash flow after capital expenditures.
c.
High profit margins relative to the industry.
d.
Company should create at least one dollar of market value for every dollar retained.
e.
All of the above are financial tenants of Warren Buffet.
11. Which of the following is not a technique for valuing a firm’s common stock?
a.
Present value of free cash flow to equity
b.
Present value of dividends
c.
Price-earnings ratio
d.
Price-book value ratios
e.
Price-cost of goods sold ratio
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12. Which of the following is not considered when looking at free cash flow to equity technique?
a.
Depreciation expense
b.
Change in working capital
c.
Principal debt repayments
d.
Change in competitive environment
e.
Net income
13. Under the present value of operating free cash flow technique, the firm’s operating free cash flow to
the firm is discounted at the firm’s
a.
Weighted average cost of capital.
b.
Cost of debt.
c.
Internal rate of return.
d.
External cost of new equity.
e.
Net present value.
14. Which of the following is not considered a relative valuation technique?
a.
Price-earnings ratio
b.
Price/cash flow ratio
c.
Price/book value ratio
d.
Price/cost of goods sold ratio
e.
Price/sales ratio
15. Which of the following is not considered in the price-earnings ratio technique?
a.
Firm’s required rate of return on equity (k)
b.
Firm’s dividend payout ratio (D/E)
c.
Firm’s expected growth rate of dividends (g)
d.
All of the above are components of P/E ratio
e.
None of the above are components of P/E ratio
16. Evidence that a firm has high business risk would be provided by its volatile ____.
a.
Fixed costs.
b.
Profit after taxes.
c.
Operating profit.
d.
Sales.
e.
Employee turnover.
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17. Which of the following factors does not indicate market liquidity?
a.
Number of shareholders
b.
High price volatility
c.
Number of shares outstanding
d.
Number of shares traded
e.
Institutional interest
18. A growth company can invest in projects that generate a return greater than the firm’s
a.
Return on equity.
b.
Cost of debt.
c.
Cost of equity.
d.
Cost of capital.
e.
Return on assets.
Exhibit 9-1
USE THE FOLLOWING INFORMATION FOR THE NEXT QUESTION(S)
(1)
The firm’s expected rate of growth of earning per share
(2)
The amount of capital invested in growth investments
(3)
The rate of return earned on the funds relative to the required rate of return
(4)
The required rate of return on the security based on its systematic risk
(5)
The firm’s dividend payout ratio
(6)
The time horizon when these growth investments will be available
19. Refer to Exhibit 9-1. In the listing above, which three factors influence the capital gain component of a
growth company?
a.
1, 3, and 5
b.
2, 3, and 4
c.
2, 3, and 6
d.
3, 4, and 5
e.
3, 4, and 6
20. Refer to Exhibit 9-1. In the listing above, which three factors influence the earnings multiple for a
stock?
a.
1, 4, and 5
b.
1, 4, and 6
c.
2, 4, and 6
d.
2, 5, and 6
e.
4, 5, and 6
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21. An inconsistency between a stock’s P/E ratio and growth rate can be attributed to all of the following,
except
a.
A major difference in the risk involved.
b.
Inaccurate growth estimates.
c.
An undervaluation of the stock.
d.
An overvaluation of the stock.
e.
Competition.
22. A set of performance measures called ___________ are directly related to the capital budgeting
techniques used in corporate finance.
a.
Dividend discount model
b.
Aggressive growth indexes
c.
Growth indexes
d.
Value added
e.
Profit sensitization
23. “Economic profit” is analogous to ____ in capital budgeting.
a.
Weighted average cost of capital
b.
Internal rate of return
c.
Composite discount rates
d.
Discounted cashflows
e.
Net present value
24. Which of the following is not a value added performance measure?
a.
Economic Value Added (EVA)
b.
Market Value Added (MVA)
c.
Franchise Factor
d.
Company Value Added (CVA)
e.
None of the above (that is, all are value added performance measures)
25. Market value-added is a measure of ____ performance.
a.
External
b.
Internal
c.
Competitive
d.
Economic
e.
None of the above.
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26. Which of the following statements concerning global company analysis is false?
a.
Analysis of companies within industries should be extended to include foreign companies.
b.
There is a problem in obtaining data that is required for a thorough company analysis of
foreign companies.
c.
Foreign companies’ financial risk should be evaluated over time.
d.
Differences in relative measures can be explained by the variations in accounting
procedures among countries and investors attitudes within each country.
e.
All of the above statements are true.
27. Which of the following are tenets of Warren Buffett?
a.
Business tenets.
b.
Financial tenets.
c.
Management tenets.
d.
All of the above.
e.
None of the above.
28. Which of the following is a business tenet of Warren Buffett?
a.
Long term prospects.
b.
Resistance to institutional imperative.
c.
Creation of one dollar of market value for every dollar retained.
d.
Purchase at discount to intrinsic value.
e.
Product is not faddish
29. Which of the following is a management tenet of Warren Buffett?
a.
Long term prospects.
b.
Resistance to institutional imperative.
c.
Creation of one dollar of market value for every dollar retained.
d.
Purchase at discount to intrinsic value.
e.
Product is not faddish
30. Which of the following is a financial tenet of Warren Buffett?
a.
Long term prospects.
b.
Resistance to institutional imperative.
c.
Creation of one dollar of market value for every dollar retained.
d.
Purchase at discount to intrinsic value.
e.
Product is not faddish.
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31. Which of the following is a market tenet of Warren Buffett?
a.
Long term prospects.
b.
Resistance to institutional imperative.
c.
Creation of one dollar of market value for every dollar retained.
d.
Purchase at discount to intrinsic value.
e.
Product is not faddish
32. Studies that have examined the relationship between EVA and MVA have found
a.
An inverse relationship.
b.
A positive relationship.
c.
A poor relationship.
d.
EVA always exceeded MVA.
e.
MVA always exceeded EVA.
33. The franchise P/E is a function of
a.
Relative rate of return on new business opportunities
b.
Size of superior return opportunities.
c.
Duration of earnings growth.
d.
Choices a and b.
e.
Choices a, b, and c.
34. Cyclical companies are firms where
a.
Sales, earnings and cash flows are extremely uncertain and not necessarily related to the
economy.
b.
Sales, earnings and cash flows are likely to withstand changes caused by the economic
environment.
c.
Sales, earnings and cash flows are heavily influenced by aggregate business activity.
d.
Sales, earnings and cash flows are growing exponentially.
e.
None of the above.
35. Defensive companies are firms where
a.
Sales, earnings and cash flows are extremely uncertain and not necessarily related to the
economy.
b.
Sales, earnings and cash flows are likely to withstand changes caused by the economic
environment.
c.
Sales, earnings and cash flows are heavily influenced by aggregate business activity.
d.
Sales, earnings and cash flows are growing exponentially.
e.
None of the above.
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36. Speculative companies are firms where
a.
Sales, earnings and cash flows are extremely uncertain and not necessarily related to the
economy.
b.
Sales, earnings and cash flows are likely to withstand changes caused by the economic
environment.
c.
Sales, earnings and cash flows are heavily influenced by aggregate business activity.
d.
Sales, earnings and cash flows are growing exponentially.
e.
None of the above.
37. A firm that follows a defensive competitive strategy could
a.
Lower production costs.
b.
Create a strong brand image.
c.
Use its buying power to obtain price concessions.
d.
Choices a and b.
e.
Choices b and c.
38. A firm that follows a low cost leadership strategy
a.
Must heavily discount its prices.
b.
Must command prices near the industry average.
c.
Must focus on providing exceptional quality and service.
d.
All of the above.
e.
None of the above.
39. A firm that follows a differentiation strategy
a.
Must heavily discount its prices.
b.
Must command prices near the industry average.
c.
Must focus on providing exceptional quality and service.
d.
All of the above.
e.
None of the above.
40. When a firm seeks to identify itself as unique in its industry in an area that is important to buyers it is
known as a
a.
Defensive strategy
b.
Differentiation strategy
c.
Low-cost strategy
d.
Focused strategy
e.
Value strategy
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41. What variables impact the Price/Sales ratio?
a.
Sales growth rate, volatility of sales growth, profit margin
b.
Earnings growth rate, volatility of sales growth, profit margin
c.
Earnings growth rate, volatility of sales growth, operating margin
d.
Sales growth rate, volatility of sales growth, operating margin
e.
Sales growth rate, volatility of profit margin, profit margin
42. A growth company may exist for all of the following reasons except
a.
The company holds patents.
b.
The company possess unique distribution or marketing strategies.
c.
The company is in a competitive environment.
d.
Significant barriers to entry exist.
e.
All of the above are reasons a growth company may exist.
43. Which of the following is not a determinant of the capital gain component?
a.
The percentage of earnings retained for reinvestment.
b.
The relative rate of return earned on the funds retained.
c.
The time period for these growth investments.
d.
The amount of capital invested in growth investments.
e.
All of the above are determinants of the capital gain component.
44. What is the implied growth duration of Bowe Industries given the following:
S&P/TSX Industrials
Bowe Industries
P/E Ratios
15
25
Average Growth (%)
5.0
15.0
Dividend Yield
.06
.02
a.
3.2 years
b.
6.6 years
c.
8.6 years
d.
9.7 years
e.
10.6 years
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45. What is the implied growth duration of Casey Industries given the following:
S&P/TSX Industrials
Casey Industries
P/E Ratios
15
20
Average Growth (%)
5.0
15.0
Dividend Yield
.04
.06
a.
3.2 years
b.
2.8 years
c.
4.8 years
d.
9.6 years
e.
13.2 years
46. What is the implied growth duration of Jones Industries given the following:
S&P/TSX Industrials
Jones Industries
P/E Ratios
12
15
Average Growth (%)
6.0
10.0
Dividend Yield
.05
.03
a.
7.2 years
b.
10.9 years
c.
12.5 years
d.
13.9 years
e.
15.2 years
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47. What is the implied growth duration of Freed Industries given the following:
S&P/TSX Industrials
Freed Industries
P/E Ratios
19
22
Average Growth (%)
11.0
16.0
Dividend Yield
.033
.08
a.
1.8 years
b.
1.3 years
c.
5.0 years
d.
4.5 years
e.
3.5 years
48. What is the implied growth duration of Howard Industries given the following:
S&P/TSX Industrials
Howard Industries
P/E Ratios
14
24
Average Growth (%)
6.0
12.0
Dividend Yield
.07
.04
a.
11.5 years
b.
16.8 years
c.
22.6 years
d.
18.4 years
e.
20.6 years
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Exhibit 9-2
USE THE FOLLOWING INFORMATION FOR THE NEXT PROBLEM(S)
Modular Industries currently has a 16% annual growth rate while the market average is 6%. The
market multiple is 10.
49. Refer to Exhibit 9-2. Determine the justified P/E ratio for Modular Industries assuming Modular can
maintain its superior growth rate for the next 5 years.
a.
6.4
b.
13.1
c.
16.5
d.
23.8
e.
15.7
50. Refer to Exhibit 9-2. Determine the P/E ratio for Modular Industries assuming Modular can maintain
its superior growth rate for the next 8 years.
a.
6.4
b.
20.5
c.
16.5
d.
23.8
e.
29.5
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Exhibit 9-3
USE THE FOLLOWING INFORMATION FOR THE NEXT PROBLEM(S)
Harcourt Industries currently has an 18% annual growth rate while the market average is 8%. The
market multiple is 12.
51. Refer to Exhibit 9-3. Determine the justified P/E ratio for Harcourt Industries assuming Harcourt can
maintain its superior growth rate for the next 9 years.
a.
5.98
b.
13.13
c.
21.20
d.
58.68
e.
26.65
52. Refer to Exhibit 9-3. Determine the P/E ratio for Harcourt Industries assuming Harcourt can maintain
its superior growth rate for the next 3 years.
a.
4.25
b.
12.50
c.
15.67
d.
30.10
e.
42.80