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LOS a, (Part 2): Discuss the possible drawbacks to the use of price to earnings (P/E), price to book value (P/BV), price to sales (P/S), and price to cash flow (P/CF) in equity valuation.
Q1. One disadvantage of using the price/sales (P/S) multiple for stock valuation is that:
A) profit margins are not consistent across firms within an industry.
B) P/S multiple does not provide a framework to evaluate the effects of corporate policy decisions and price changes.
C) sales are relatively stable and might not change even though earnings and value might change significantly.
Q2. Which of the following is least likely an advantage of using price/sales (P/S) multiple?
A) P/S multiples are more reliable because sales data cannot be distorted by management.
B) P/S multiples provide a meaningful framework for evaluating distressed firms.
C) P/S multiples are not as volatile as P/E multiples and hence may be more reliable in valuation analysis.
Q3. Which of the following is a disadvantage of using price-to-sales (P/S) multiples in stock valuations?
A) It is difficult to capture the effects of changes in pricing policies using P/S ratios.
B) The use of P/S multiples can miss problems associated with cost control.
C) P/S multiples are more volatile than price-to-earnings (P/E) multiples.
Q4. An argument against using the price to cash flow (P/CF) valuation approach is that:
A) cash flows are not as easy to manipulate or distort as EPS and book value.
B) price to cash flow ratios are not as volatile as price-to-earnings (P/E) multiples.
C) non-cash revenue and net changes in working capital are ignored when using earnings per share (EPS) plus non-cash charges as an estimate.
Q5. An argument against using the price-to-earnings (P/E) valuation approach is that:
A) research shows that P/E differences are significantly related to long-run average stock returns.
B) earnings power is the primary determinant of investment value.
C) earnings can be negative.
Q6. An argument against using the price-to-sales (P/S) valuation approach is that:
A) P/S ratios are not as volatile as price-to-earnings (P/E) multiples.
B) sales figures are not as easy to manipulate or distort as earnings per share (EPS) and book value.
C) P/S ratios do not express differences in cost structures across companies.
Q7. Which of the following is a disadvantage of using the price-to-book value (PBV) ratio?
A) Book values are affected by accounting standards, which may vary across firms and countries.
B) Book value may not mean much for manufacturing firms with significant fixed costs.
C) Firms with negative earnings cannot be evaluated with the PBV ratios.
LOS a, (Part 2): Discuss the possible drawbacks to the use of price to earnings (P/E), price to book value (P/BV), price to sales (P/S), and price to cash flow (P/CF) in equity valuation.fficeffice" />
Q1. One disadvantage of using the price/sales (P/S) multiple for stock valuation is that:
A) profit margins are not consistent across firms within an industry.
B) P/S multiple does not provide a framework to evaluate the effects of corporate policy decisions and price changes.
C) sales are relatively stable and might not change even though earnings and value might change significantly.
Correct answer is C)
The stability of sales (relative to earnings and book value) can be a disadvantage. For example, revenues may remain stable but earnings and book values can drop significantly due to a sharp increase in expenses.
Q2. Which of the following is least likely an advantage of using price/sales (P/S) multiple?
A) P/S multiples are more reliable because sales data cannot be distorted by management.
B) P/S multiples provide a meaningful framework for evaluating distressed firms.
C) P/S multiples are not as volatile as P/E multiples and hence may be more reliable in valuation analysis.
Correct answer is A)
Accounting data on sales is used to calculate the P/S multiple. The P/S multiple is thought to be more reliable only because sales figures are not as easy to manipulate as the earnings and book value, both of which are significantly affected by accounting conventions.
Q3. Which of the following is a disadvantage of using price-to-sales (P/S) multiples in stock valuations?
A) It is difficult to capture the effects of changes in pricing policies using P/S ratios.
B) The use of P/S multiples can miss problems associated with cost control.
C) P/S multiples are more volatile than price-to-earnings (P/E) multiples.
Correct answer is B)
Due to the stability of using sales relative to earnings in the P/S multiple, an analyst may miss problems of troubled firms concerning its cost control. P/S multiples are actually less volatile than P/E ratios, which is an advantage in using the P/S multiple. Also, P/S ratios provide a useful framework for evaluating effects of pricing changes on firm value.
Q4. An argument against using the price to cash flow (P/CF) valuation approach is that:
A) cash flows are not as easy to manipulate or distort as EPS and book value.
B) price to cash flow ratios are not as volatile as price-to-earnings (P/E) multiples.
C) non-cash revenue and net changes in working capital are ignored when using earnings per share (EPS) plus non-cash charges as an estimate.
Correct answer is C)
Items affecting actual cash flow from operations are ignored when the EPS plus non-cash charges estimate is used. For example, non-cash revenue and net changes in working capital are ignored. The other responses are arguments in favor of using the price to cash flow approach.
Q5. An argument against using the price-to-earnings (P/E) valuation approach is that:
A) research shows that P/E differences are significantly related to long-run average stock returns.
B) earnings power is the primary determinant of investment value.
C) earnings can be negative.
Correct answer is C)
Negative earnings render the P/E ratio useless. Both remaining factors increase the usefulness of the P/E approach.
Q6. An argument against using the price-to-sales (P/S) valuation approach is that:
A) P/S ratios are not as volatile as price-to-earnings (P/E) multiples.
B) sales figures are not as easy to manipulate or distort as earnings per share (EPS) and book value.
C) P/S ratios do not express differences in cost structures across companies.
Correct answer is C)
P/S ratios do not express differences in cost structures across companies. Both remaining responses are advantages of the P/S ratios, not disadvantages.
Q7. Which of the following is a disadvantage of using the price-to-book value (PBV) ratio?
A) Book values are affected by accounting standards, which may vary across firms and countries.
B) Book value may not mean much for manufacturing firms with significant fixed costs.
C) Firms with negative earnings cannot be evaluated with the PBV ratios.
Correct answer is A)
The disadvantages of using PBV ratios are:
1. Book values are affected by accounting standards, which may vary across firms and countries.
2. Book value may not mean much for service firms without significant fixed costs.
3. Book value of equity can be made negative by a series of negative earnings, which limits the usefulness of the variable.
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