Reading 37- LOS e ～ Q4－9

4.Marko Larraza recently sold a majority stake in his business, Larraza Loaves, to a national food manufacturer, and has been looking to invest the proceeds in a portfolio of actively managed equities. Larraza hired Alhaadi Wewege, a portfolio manager to help him select appropriate companies for consideration.

Larraza has researched two publicly traded companies that he would like Wewege to analyze for potential inclusion in the portfolio: Generic Gems, a wholesaler of gemstones, and Consolidated Cereals, a breakfast food manufacturer. Larraza has provided Wewege with the following information about the two firms:

Table 1: Valuation Inputs

Based on his knowledge of the market, Wewege believes that the required return for each company should equal the previous year’s holding period return on the relevant industry index. The Jewelry & Gemstone index returned 11 percent last year, while the Food & Beverage index returned 7 percent.

Larraza questions Wewege’s assumption about the appropriate return for Consolidated Cereals. “When I sold my bakery, I justified giving the buyer a discount on the price based on the lack of marketability and lack of liquidity since the shares aren’t publicly traded.” Wewege counters that the discount on the sale of Larraza Loaves was justified because the purchaser acquired a controlling interest, not because the shares were illiquid.

Wewege also points out that the valuation of Larraza Loaves was made using an asset-based model, which is an example of an absolute valuation model. He points out that using a liquidation value is inappropriate for a going concern. Larraza counters that Larraza Loaves was also valued using a dividend discount model, which is considered a relative valuation model. Larraza argues that a dividend discount model is an appropriate valuation approach for a going concern.

“Graham and Dodd first advanced the idea that the value of a stock could be determined by discounting future dividends,” points out Larraza, in justification of a dividend discount approach. Wewege acknowledges that Graham and Dodd’s investment valuation approach was the forerunner of the absolute valuation models of today.

Are Wewege and Larraza correct in their statements concerning the price discount on the sale of Larraza Loaves?

The correct answer was  A)

Wewege is incorrect because purchase of a controlling interest justifies a premium, not a discount. Larraza is correct that lack of marketability and lack of liquidity are both justifications for a discount in the value of a position.

5.The ex post alphas for Consolidated Cereals and Generic Gems are closest to:

The correct answer was  C)

Ex post alpha is the historical holding period return minus the historical return on similar assets. The historical return for Consolidated Cereals is (14.25 – 14.00 + 1.00) / 14.00 = 1.25/14.00 = 8.9%. Since the index return was 7%, the ex post alpha for Consolidated Cereals equals (8.9 – 7.0) = 1.9%. The historical return for Generic Gems is (32.50 – 29.00 + 0.70) / 29.00 = 4.20/29.00 = 14.5%. Since the index returned 11%, the ex post alpha for Generic Gems is (14.5 – 11.0) = 3.5%.

6.Are Wewege and Larraza correct in their statements concerning absolute and relative valuation models?

The correct answer was  B)

Wewege is correct that an asset-based model is an absolute valuation model. Larraza is incorrect because a dividend discount model is also considered an absolute, not a relative, valuation model.

7.Are Wewege and Larraza correct in their statements about appropriate valuation approaches for a going concern?

The correct answer was  D)

Wewege is correct that a liquidation valuation is an inappropriate method of valuing a going concern since liquidation value is based on the assumption that the firm will cease operation and its assets will be sold. Larraza is correct that a dividend discount model is an appropriate valuation approach for a going concern since the assumption is that the firm continues operating and the future dividends arise from its continued operations.

8.Which of the following quality of earnings issues is least likely to be directly addressed in the footnotes to accounting statements and other disclosures?

A)   Sustainability of growth.

B)   Choice of depreciation and amortization rates.

C)   Reclassification of non-operating items as operating income.

D)   Capitalization of expenses.

The correct answer was  A)

Sustainability of growth is not an issue directly addressed in the footnotes to financial statements, although various disclosures may provide information that has indirect implications for sustainability of growth. Choice of depreciation and amortization rates, reclassification of non-operating items as operating income, and capitalization of expenses are all issues of management discretion that may be discerned through a detailed examination of the footnotes.

9.Are Wewege and Larraza correct in their statements about Graham and Dodd?

The correct answer was  A)

Larraza is incorrect because Graham and Dodd determined the value of a security based on an analysis of the firm’s income statement and balance sheet. The dividend discount framework was advanced by John Burr Williams. Wewege is incorrect because the financial statement analysis approach put forth by Graham and Dodd is the forerunner of modern relative valuation models. Williams’ approach provided the foundation for modern dividend discount and free cash flow models, which are absolute valuation models.