JonnyKay

The price-to-book value (PBV) ratio for a high-growth firm will:

A) increase as the growth rate in either the high-growth or stable-growth period increases.

B) increase as the growth rate in either the high-growth or stable-growth period decreases.

C) increase as the growth rate in the high-growth period increases and decrease as the growth rate in the stable-growth period increases.

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The PBV ratio for a high-growth firm will be determined by growth rates in earnings in both the high-growth and stable-growth periods. The PBV ratio increases as the growth rate increases in either period.

JonnyKay

An increase in return on equity (ROE) will cause a price-to-earnings (P/E) multiple to:

A) there is insufficient information to tell.

B) decrease.

C) increase.

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An increase in ROE will increase growth through the g = (ROE × retention) relation. Thus, as growth increases, the following expression for trailing P/E should increase:

P0/E0 = [(1 – b)(1 + g)] / (r – g)

Note that the topic review does not allow for any interactive relationship between leverage, ROE, and growth. Thus, no explicit consideration is given to whether the increase in ROE results from risk-increasing leverage that could cause an offsetting increase in the required rate of return

JonnyKay

An increase in return on equity (ROE) will cause a price-to-book (P/B) multiple to:

A) decrease.

B) increase.

C) there is insufficient information to tell.

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An increase in ROE should increase the price to book (P/B) ratio:

P0 / B0 = (ROE – g) / (r – g)

JonnyKay

An increase in profit margin will cause a price-to-sales (P/S) multiple to increase if:

A) the required rate of return increases.

B) there is insufficient information to tell.

C) the growth rate in sales does not decrease proportionately.

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An increase (decrease) in the profit margin increases (decreases) the growth rate if sales do not decrease (increase) proportionately. Increases in the required rate of return would decrease the P/S ratio. This is clear in the expression for trailing P/S:

P0 / S0 = [(E0 / S0)(1 – b)(1 + g)] / (r – g)

JonnyKay

A common justification for using earnings yields in valuation is that:

A) negative earnings render P/E ratios meaningless and prices are never negative.

B) earnings are more stable than dividends.

C) earnings are usually greater than free cash flows.

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Negative earnings render P/E ratios meaningless. In such cases, it is common to use normalized earnings per share (EPS) and/or restate the ratio as the earnings yield or E/P because price is never negative. Price to earnings (P/E) ranking can then proceed as usual.

JonnyKay

The observation that negative price to earnings (P/E) ratios are meaningless and prices are never negative is used to justify which valuation approach?

A) Dividend discount model.

B) Earnings yield.

C) Dividend yield.

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The observation is used to justify the earnings yield approach. Negative P/E ratios are meaningless. In such cases, it is common to use normalized earnings per share (EPS) and/or restate the ratio as the earnings yield or E/P because price is never negative. Price to earnings (P/E) ranking can then proceed as usual.

JonnyKay

A common pitfall in interpreting earnings yields in valuation is:

A) using underlying earnings.

B) look-ahead bias.

C) using negative earnings.

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A common pitfall is look-ahead bias, wherein the analyst uses information that was not available to the investor when calculating the earnings yield.

JonnyKay

The average return on equity (ROE) earnings normalization method relies on:

A) average ROE over the most recent cycle.

B) average earnings per share (EPS) over the most recent cycle.

C) the earnings yield.

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The average return on equity normalization method normalizes EPS as the average ROE over the most recent full cycle multiplied by book value per share.

JonnyKay

A method commonly used to normalize earnings is the method of:

A) comparables.

B) historical average earnings per share (EPS).

C) average return on assets.

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A common method in normalizing earnings uses the historical average EPS.

JonnyKay

Which of the following statements about cyclical firms is least accurate?

A) The price-to-earnings (P/E) multiple of a cyclical firm normally peaks at the depths of recession and bottoms out at the peak of economic boom.

B) The problems encountered when using the price-to-earnings (P/E) multiples of cyclical firms can be completely eliminated by using average or normalized earnings.

C) Cyclical firms have volatile earnings, and their price-to-earnings (P/E) multiple is not very useful for valuation.

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The P/E multiples for cyclical firms are not very useful for valuation. Earnings will follow the economy, and prices will reflect expectations about the future. Thus, most of the time, the P/E multiple of a cyclical firm will peak at the depths of recession and bottom out at the peak of an economic boom. This problem can be minimized to some extent by using average or normalized earnings but will not be eliminated completely.