LOS c: Discuss the importance of quality of inputs in valuation.

Q1. When using a firm’s reported financial information as inputs into a security valuation model, it is important for the analyst to have confidence that the reported information accurately reflects the operations of the firm. This concern is referred to as:

A)   a confidence factor.

B)   the transparency of earnings.

C)   the quality of earnings.

Q2. Overestimating the growth rate of a firm in using a valuation model would result in a value that is likely to be:

A)   too high.

B)   can't tell from this information.

C)   too low.

Q3. Which of the following would cause an analyst to have concern about a firm’s quality of earnings?

A)   The gain on the sale of a plant was included in operating earnings.

B)   A firm books sales when orders are shipped.

C)   The firm took a write off for a recently impaired asset.

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Q1. When using a firm’s reported financial information as inputs into a security valuation model, it is important for the analyst to have confidence that the reported information accurately reflects the operations of the firm. This concern is referred to as:

A)   a confidence factor.

B)   the transparency of earnings.

C)   the quality of earnings.

Correct answer is C)

The accuracy and level of detail disclosed in financial reports is referred to as the quality of earnings. Efforts of management to obscure the true operating performance of the firm can leave an analyst with little confidence in the security valuation.

Q2. Overestimating the growth rate of a firm in using a valuation model would result in a value that is likely to be:

A)   too high.

B)   can't tell from this information.

C)   too low.

Correct answer is A)

Using an estimate for a firm’s growth rate that is too high would overstate the amount of future returns, resulting in a present value that is too high.

Q3. Which of the following would cause an analyst to have concern about a firm’s quality of earnings?

A)   The gain on the sale of a plant was included in operating earnings.

B)   A firm books sales when orders are shipped.

C)   The firm took a write off for a recently impaired asset.

Correct answer is A)

The inclusion of gains from the sale of assets as operating income would cause the analyst to question the quality of the firm’s earnings.

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