JonnyKay

An argument for 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 volatility facilitates interpretation.

C) earnings can be negative.

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Research shows that P/E differences are significantly related to long-run average stock returns. Both remaining factors reduce the usefulness of the P/E approach.

JonnyKay

Analyst Ariel Cunningham likes using the price/earnings ratio for valuation purposes because studies have shown it is very effective at identifying undervalued stocks. However, she has one main problem with the statistic – it doesn’t work when a company loses money. So Cunningham is considering switching to a different core valuation metric. Given Cunningham’s rationale for using the price/earnings ratio, which option would be her best alternative?

A) Price/book.

B) Price/cash flow.

C) Price/sales.

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Book value is usually positive, but not always. Cash flow is often negative. If the reason Cunningham wants to stop using the P/E ratio is that it does not work for unprofitable companies, her best option is a ratio base on sales, which are positive in all but the rarest of instances.

JonnyKay

Bill Whelan and Chad Delft are arguing about the relative merits of valuation metrics.
Whelan: “My ratio is less volatile than most, and it works particularly well when I look at stocks in cyclical industries.”
Delft: “The problem with your ratio is that it doesn’t reflect differences in the cost structures of companies in different industries. I like to use a metric that strips out all the fluff that distorts true company performance.”
Whelan: “People can’t even agree how to calculate your ratio.”
Which valuation metric do the analysts most likely prefer?

Whelan

Delft

A) Price/sales Price/cash flow

B) Price/book EV/EBITDA

C) Price/cash flow Price/book

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The price/sales ratio is not very volatile, and it is of particular value when dealing with cyclical companies. The price/cash flow ratio considers the stock price relative to cash flows, ignoring the noncash gains and losses that can skew earnings. A major weakness of the price/cash flow ratio is the fact that there are different ways of calculating it, making comparisons difficult at times.

JonnyKay

An analyst focusing mostly on financial stocks is likely to prefer valuing stocks via the:

A) price/sales ratio.

B) dividend yield.

C) price/book ratio.

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The price/book ratio is a preferred tool for valuing financial stocks.

JonnyKay

An argument against using the price-to-earnings (P/E) valuation approach is that:

A) earnings can be negative.

B) research shows that P/E differences are significantly related to long-run average stock returns.

C) earnings power is the primary determinant of investment value.

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

JonnyKay

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.

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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.

JonnyKay

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.

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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.

JonnyKay

A firm is better valued using the discounted cash flow approach than the P/E multiples approach when:

A) earnings per share are negative.

B) expected growth rate is very high.

C) dividend payout is low.

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P/E multiples are not meaningful when the earnings per share are negative. While this problem can be partially offset by using normalized or average earnings per share, the problem cannot be eliminated.

JonnyKay

An argument for using the price-to-earnings (P/E) valuation approach is that:

A) earnings can be negative.

B) management discretion increases the reliability of the ratio.

C) earnings power is the primary determinant of investment value.

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Earnings power is the primary determinant of investment value. Both remaining factors reduce the usefulness of the P/E approach

anshultongia

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.

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.