Reading 60: Equity Valuation: Concepts and Basic Tools-LOS k 2011, advantages, statements, following, valuation

1215

Session 14: Equity Analysis and Valuation
Reading 60: Equity Valuation: Concepts and Basic Tools

LOS k: Explain the advantages and disadvantages of each category of valuation model.

 

 

Regarding the estimates required in the constant growth dividend discount model, which of the following statements is most accurate?

A) Dividend forecasts are less reliable than estimates of other inputs.

B) The model is most influenced by the estimates of "k" and "g."

C) The variables "k" and "g" are easy to forecast.

---

The relationship between "k" and "g" is critical - small changes in the difference between these two variables results in large value fluctuations.

 

1215

Which of the following is least likely an advantage of using price/sales (P/S) multiple?

A) P/S multiples provide a meaningful framework for evaluating distressed firms.

B) P/S multiples are more reliable because sales data cannot be distorted by management.

C) P/S multiples are not as volatile as P/E multiples and hence may be more reliable in valuation analysis.

---

Accounting data on sales is used to calculate the P/S multiple. The P/S multiple is thought to be more reliable because sales figures are not as easy to manipulate as the earnings and book value, both of which are significantly affected by accounting conventions. However, it is not true that "sales data cannot be distorted by management" because aggressive revenue recognition practices can influence reported sales.

1215

Which of the following is NOT an advantage of using price-to-book value (PBV) multiples in stock valuation?

A) Book values are very meaningful for firms in service industries.

B) Book value is often positive, even when earnings are negative.

C) PBV ratios can be compared across similar firms if accounting standards are consistent.

---

Book values are NOT very meaningful for firms in service industries.

1215

One advantage of price/sales (P/S) multiples over price to earnings (P/E) and price-to-book value (PBV) multiples is that:

A) P/S is easier to calculate.

B) P/S can be used for distressed firms.

C) Regression shows a strong relationship between stock prices and sales.

---

Unlike the PBV and P/E multiples, which can become negative and not meaningful, the price/sales multiple is meaningful even for distressed firms (that may have negative earnings or book value).

1215

An argument against using the price to cash flow (P/CF) valuation approach is that:

A) non-cash revenue and net changes in working capital are ignored when using earnings per share (EPS) plus non-cash charges as an estimate.

B) cash flows are not as easy to manipulate or distort as EPS and book value.

C) price to cash flow ratios are not as volatile as price-to-earnings (P/E) multiples.

---

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. Both remaining responses are arguments in favor of using the price to cash flow approach.

1215

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.

---

Negative earnings render the P/E ratio useless. Both remaining factors increase the usefulness of the P/E approach.

1215

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.

---

P/S ratios do not express differences in cost structures across companies. Both remaining responses are advantages of the P/S ratios, not disadvantages.

1215

Which of the following is a disadvantage of using the price-to-book value (PBV) ratio?

A) Book value may not mean much for manufacturing firms with significant fixed costs.

B) Firms with negative earnings cannot be evaluated with the PBV ratios.

C) Book values are affected by accounting standards, which may vary across firms and countries.

---

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.

1215

One advantage to using the price/book value (P/B) ratio over using the price/earnings (P/E) ratio is that P/B can be used when:

A) earnings or cash flows are negative.

B) stock markets are volatile.

C) the firm is in a slow growth phase.

---

When earnings are negative, P/E ratios cannot be used but P/B ratios can be used. The firm's rate of growth and the volatility of markets do not suggest advantages of using P/B ratios rather than P/E ratios.