JonnyKay

The goal of normalizing earnings is to adjust for:

A) seasonal elements.

B) non-cash charges.

C) cyclical elements.

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The goal of normalizing earnings is to adjust for cyclical elements.

JonnyKay

Alpha Software (AS) recently reported a representative annual earnings per share (EPS) of $1.75, which included an extraordinary loss of $0.19 and an expense of $0.10 related to acquisition costs during the accounting period, neither of which are expected to recur. Given that the most recent share price is $65.00, what is a useful AS’s trailing price to earnings (P/E) for valuation purposes?

A) 37.14.

B) 44.52.

C) 31.86.

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Using an underlying earnings concept, an analyst would add back the temporary charges against earnings: $1.75 + $0.19 + $0.10 = $2.04. The resulting trailing P/E = 65.00 / 2.04 = 31.86.

JonnyKay

Glad Tidings Gifts (GTG) recently reported a representative annual earnings per share (EPS) of $2.25, which included an extraordinary loss of $0.17 and an expense of $0.12 related to acquisition costs during the accounting period, neither of which are expected to recur. Given that the most recent share price is $50.00, what is a useful GTG’s trailing price to earnings (P/E) for valuation purposes?

A) 19.69.

B) 22.22.

C) 25.51.

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Using an underlying earnings concept, an analyst would add back the temporary charges against earnings: $2.25 + $0.17 + $0.12 = $2.54. The resulting trailing P/E = 50.00 / 2.54 = 19.69.

JonnyKay

Underlying earnings may be defined as earnings:

A) that exclude non-recurring components.

B) that include non-recurring components.

C) net of capital expenditures needed to keep the business productive.

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Underlying earnings are earnings that exclude non-recurring items. They are also known as persistent, continuing, or core earnings.

JonnyKay

Robin Alberts, CFA, is the head of research for Worth Brothers, a large investment company based in New York. Next week, a group of analysts who have just completed the Worth Brothers’ management training program will begin rotating throughout the various departments and trading desks at the firm. The trainees will be split into small groups, and each group will spend four weeks in each area to learn the basic operations of each department through “hands on” experience. Also, in that time period, each department head is expected to fully evaluate each candidate in order to determine their future placement within the firm.
Alberts decides that she should begin every rotation in the research department by giving each candidate a brief review exam to test their knowledge of the general principles of credit analysis. She asks each candidate to analyze the following three scenarios and to answer two questions on each scenario.

Scenario One
	Firm A	Firm B	Firm C	Firm D
Payout Ratio	75%	--	--	--
Required Rate of Return	12%	12%	12%	12%
Return on Equity (ROE)	20%	15%	30%	14%
Price-to-book Value (PBV) Ratio	--	3.00	0.70	3.50

Scenario Two Cost of Capital Measures for Brown, Inc.
Risk-Free Rate	5%
Expected Return on the Market	12%
Beta	1.5
Tax Rate	40%
Cost of Debt	10%
Proportion of the Firm Financed with Debt	20%
Proportion of the Firm Financed with Equity	80%

Scenario Three The Donner Company as of December 31, 2003 (in $ millions)
Cash	38		Current Liabilities	52
Accounts Receivable	120		Long-term Bonds	123
Inventory	57		Common Stock	75
Property, Plant & Equip.	218		Retained Earnings	183
Total Assets	433		Total Liabilities & Equity	433

	2001	2002	2003
Operating Profit (EBIT)	42	38	43
Interest Expense	16	17	20
Relevant Industry Ratios
Long-term Debt-to-equity Ratio: 0.52
Current Ratio: 3.20
Interest Coverage Ratio: 2.10

Using the information in scenario one which of the following items would increase firm A's PBV?

A) Decrease ROE.

B) A larger spread between ROE and the required rate of return (r).

C) Increase r.

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To increase the PBV do one of the following:

• Increase ROE.
• Decrease r.
• Increase the spread between ROE and r.

(Study Session 12, LOS 41.d)

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Using the information from scenario one which of the following items would decrease Firm A's PBV?

A) Increase r.

B) Increase ROE.

C) Increase the spread between ROE and r.

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To decrease the PBV do one of the following:

• Decrease ROE.
• Increase r.
• Decrease the spread between ROE and r.

(Study Session 12, LOS 41.d)

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Using the information in scenario two, what is the cost of equity capital of Brown, Inc.?

A) 12.0%.

B) 15.5%.

C) 10.5%.

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Use the capital asset pricing model (CAPM) to compute the cost of equity capital as follows:
Kequity = 5% + (1.5)(12% - 5%) = 15.5%.
(Study Session 11, LOS 38.d)

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Using the information in scenario two, what is the weighted-average cost of capital (WACC) of Brown, Inc.?

A) 9.86%.

B) 13.60%.

C) 14.40%.

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WACC = (proportion of firm financed with equity)(cost of equity) + (proportion of firm financed with debt)(cost of debt)(1 − tax rate) = (0.8)(15.5%) = (0.2)(10%)(1 − 0.4) = 13.6%.
(Study Session 11, LOS 38.d)

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Using the information in scenario three, what should Mansted observe about Donner’s solvency and debt capitalization?

A) Both Donner's solvency and debt capitalization ratios are better than the industry average.

B) Donner's solvency ratio is worse but its debt capitalization is better than the industry average.

C) Donner's solvency ratio is better but its debt capitalization is worse than the industry average.

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Donner’s current ratio of (38 + 120 + 57) / 52 = 4.13 is higher (better) than the industry average of 3.2. Donner’s long-term debt-to-equity ratio of 123 / (75 + 183) = 0.48 is lower (better) than the industry average of 0.52. (Study Session 14, LOS 48.c)

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Using the information in scenario three, what should Mansted observe about Donner’s ability to make its interest payments? Donner’s interest coverage ratio is:

A) declining (worsening) over time but is still above the industry average.

B) declining (worsening) over time and is below the industry average.

C) rising (improving) over time and is above the industry average.

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Donner’s interest coverage ratio (42 / 16 = 2.625 in 2001, 38 / 17 = 2.235 in 2002, and 2.150 in 2003) is declining from year to year but is still above the industry average of 2.10. (Study Session 14, LOS 48.d)

JonnyKay

At a CFA society function, Robert Chan comments to Li Chiao that the expected dividend growth rate for Xanedu Industries has decreased 0.5% from 6.0% to 5.5%. Chan claims that since Xanedu will maintain their historic dividend payout ratio (g) of 40% and required return on equity (r) of 12%. Xanedu's justified leading P/E ratio based on forecasted fundamentals will also decrease by 0.5%. Is Chan correct?

A) No, Xanedu's justified leading P/E ratio will decrease by approximately 7.8%.

B) Yes, Xanedu's justified leading P/E ratio will increase by approximately 0.5%.

C) No, Xanedu's justified leading P/E ratio will increase by approximately 7.8%.

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Chan is not correct. P/EXanedu = payout ratio / (r - g)
When the expected dividend growth is 6%, P/E = 0.40 / (0.12 - 0.06) = 6.67
When the expected dividend growth is 5.5%, P/E = 0.40 / (0.12 - 0.055) = 6.15
The percentage change is (6.15 / 6.67) - 1 = -7.80%, representing a 7.80% decrease.

JonnyKay

At a CFA society function, Andrew Caza comments to Nanda Dhople that the expected dividend growth rate (g) for Zeron Enterprises Inc (ZEI) is expected increase 0.5% from 6% to 6.5%. Caza claims that since ZEI will maintain their historic dividend payout ratio (g) of 50% and cost of equity (k) of 10%, ZEI's P/E ratio will also increase by 0.5%. Is Caza correct?

A) No, ZEI's P/E ratio will decrease by approximately 14.32%.

B) No, ZEI's P/E ratio will increase by approximately 14.32%.

C) Yes, ZEI's P/E ratio will increase by approximately 0.5%.

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Caza is not correct. P/EZEI = payout ratio / (k - g)
When the expected dividend growth is 6%, P/E = 0.50 / (0.10 - 0.06) = 12.50
When the expected dividend growth is 6.5%, P/E = 0.50 / (0.10 - 0.065) = 14.29
The percentage change is (14.29 / 12.50) - 1 = 14.32%, representing a 14.32% increase.

JonnyKay

The trailing price-to-earnings (P/E) ratio is defined as:

A) price to next period's expected earnings.

B) the average P/E over the last five years.

C) price to most recent earnings.

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The trailing P/E ratio is price to most recent realized earnings.

JonnyKay

Beachwood Builders merged with Country Point Homes in December 31, 1992. Both companies were builders of mid-scale and luxury homes in their respective markets. On December 31, 2002, because of tax considerations and the need to segment the businesses between mid-scale and luxury homes, Beachwood decided to spin-off Country Point, its luxury home subsidiary, to its common shareholders. Beachwood retained Bernheim Securities to value the spin-off of Country Point to its shareholders.
The following information is available to Bernheim’s investment bankers:

• 
  Country Point’s allocated common equity was $55.6 million as of December 31, 2002.
• 
  Beachwood paid no dividends and has no preferred shareholders.
• 
  Country Point’s free cash flow (FCF) is expected to grow 7% after 2006.
• 
  The current risk-free rate is 6%. The market risk premium is 11%.
• 
  Beachwood Builders had 5 million common shares as of December 31, 2002.
• 
  Country Point’s cost of capital is equal to its return on equity at year-end (round to nearest percentage point).
• 
  Country Point did not have any long-term debt allocated from Beachwood.

The following table for Country Point is also available for analysis

$ (in millions)	2002	2003	2004	2005	2006
Net Income	10	15	20	25	30
Depreciation	5	6	5	6	5
Capital Expenditures	7	8	9	10	12

Bernheim’s investment bankers have determined that the value of Country Point to be $162.6 million and to effect the spin-off, it was appropriate for Beachwood to issue its common shareholders two shares in Country Point for each share that its current shareholders held. The appropriate initial offering price per share for the spin-off to Beachwood’s shareholders should be:

A) $16.26.

B) $14.45.

C) $32.50.

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Since the shareholders receive two shares of the spin-off for every share they currently hold, each Beachwood common shareholder would receive two common shares of Country Point. At December 31, 2002, Beachwood had 5 million shares. Therefore, 10 million common shares were to be issued for the spin-off. If the value of the spin-off was valued at $162.6 million and divided by 10 million, you will arrive at a spin-off price per share of $16.26 (= $162.6 million / 10 million).

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Immediately after the spin-off, Country Point’s book value per share would be:

A) $5.56.

B) $16.25.

C) $11.12.

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The allocated common equity or book value of Country Point was $55.6 million at year-end 2002 and 10 million shares were allocated for the spin-off. The book value would be $5.56 per share (= $55.6 million / 10 million).

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Based on the initial offering price of the spin-off, the estimated price-to-book (P/B) ratio is:

A) 2.92 times.

B) 2.00 times.

C) 1.46 times.

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The P/B ratio is determined by taking the spin-off price and dividing it by the book value per share (BVPS). Hence, the ratio is 2.92 × book (= $16.26 per share spin-off price / $5.56 BVPS).

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Based on Bernheim’s careful analysis, comparable firms to Country Point trade at a P/B ratio of 3.5 times. The expected price per share of the spin-off assuming a liquid and efficient market for Country Point’s common shares would be:

A) $56.88.

B) $38.92.

C) $19.46.

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If we assume that the comparable P/B ratio is 3.5 times, then we simply multiply the book value by 3.5 to arrive at $19.46 ($5.56 × 3.5).

JonnyKay

Analysts and portfolio managers at Big Picture Investments are having their weekly investment meeting. CEO Bob Powell, CFA, believes the firm’s portfolios are too heavily weighted toward growth stocks. “I expect value to make a comeback over the next 12 months. We need to get more value stocks in the Big Picture portfolios." Four of Powell’s analysts, all of whom hold the CFA charter, were at the meeting – Laura Barnes, Chester Lincoln, Zelda Marks, and Thaddeus Bosley. Powell suggested Big Picture should start selecting stocks with the lowest price-to-earnings (P/E) multiples. Here are the analysts’ comments:

• Barnes said numerous academic studies have shown that low P/E stocks tend to outperform those with high P/Es. She uses the P/E ratio as the basis of most of her valuation analysis. “I prefer to use the justified P/E ratio because it is inversely related to the required rate of return.”
• Lincoln warned against using P/E ratios to evaluate technology stocks. He suggests using price-to-book (P/B) ratios instead, because they are useful for explaining long-term stock returns. “Book value is a good measure of value for companies with a lot of liquid assets, and it is easier to calculate than the P/E because you rarely have to adjust book value.”
• Bosley prefers the price/sales (P/S) ratio and the earnings yield. “The P/S ratio is particularly useful for valuing companies in cyclical industries because it isn’t affected by sharp changes in profitability caused by economic cycles.”
• Marks acknowledges that the P/E ratio is a useful valuation measurement. However, she prefers using the price/free-cash-flow ratio. “Free cash flow (FCF) is more difficult to manipulate than earnings, and it has proven value as a predictor of stock returns.”

Powell has provided Barnes with a group of small-cap stocks to analyze. The stocks come from a variety of different sectors and have widely different financial structures and growth profiles. She has been asked to determine which of these stocks represent attractive values. She is considering four possible methods for the job:

• The PEG ratio, because it corrects for risk if the stocks have similar expected returns.
• Comparing P/E ratios to the average stock in the S&P 500 Index, because the benchmark should serve as a good proxy for the average small-cap stock valuation.
• Comparing P/E ratios to the median stock in the S&P 500 Index, because outliers can skew the average P/E upward.
• The P/S ratio, because it works well for companies in different stages of the business cycle.

Which analyst’s quote is least accurate?

A) Lincoln’s.

B) Bosley’s.

C) Barnes’.

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Book value must be adjusted constantly, and it is generally more complicated to calculate than earnings. The other three statements are true. (Study Session 12, LOS 41.c)

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Barnes is contemplating the use of a price/earnings ratio to value a start-up medical technology firm. Which of the following is the most compelling reason not to use the P/E ratio?

A) The company is likely to be unprofitable.

B) P/E ratios for medical-technology firms with different specialties are not comparable.

C) Earnings per share are not a good determinant of investment value for medical-technology companies.

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Earnings are the chief determinant of value for most companies, including med-tech. P/E is the most common valuation method and the best known by lay investors. Comparability of P/E ratios across industries is always problematic, but not as much so for within the med-tech industry. A start-up company is very likely to have negative earnings, which renders the P/E ratio useless. (Study Session 12, LOS 41.c)

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Based on their responses to Powell, which of the analysts is most likely concerned about earnings volatility?

A) Lincoln.

B) Bosley.

C) Barnes.

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Book value tends to be more stable than earnings. Therefore, Lincoln’s favorite valuation tool, the P/B ratio, is less volatile than the P/E. The P/S ratio tends to be less volatile than the P/E as well, but Bosley’s other favorite, earnings yield, is just as volatile. The method preferred by Barnes is likely to be more volatile than the P/B ratio. (Study Session 12, LOS 41.c)

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Based on their responses to Powell, which of the analysts has proposed a method that has the best chance to work for determining the relative value start-up companies?

A) Marks.

B) Bosley.

C) Lincoln.

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Start-up companies tend to be unprofitable, and also often have negative free cash flow. Book value has some predictive power for such companies, but this is also often negative for new and unprofitable companies. The price/sales ratio, one of Bosley’s favorites, is the only metric that will work even if earnings, cash flows, and book value are negative. (Study Session 12, LOS 41.c, d)

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Barnes would be least likely to use EV/EBITDA ratio, rather than the P/E ratio, when analyzing a company that:

A) reports a lot of depreciation expense.

B) has a different capital structure than most of its peers.

C) pays a dividend, and is likely to deliver little earnings growth.

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For companies that report a lot of depreciation expense or must be compared to companies with different levels of financial leverage, the EV/EBITDA ratio may be more useful than the P/E. For companies that pay a dividend and have little profit growth, both should work fine. Given Barnes’ stated preference for the P/E ratio, she is least likely to use the EV/EBITDA ratio with the dividend-paying firm. (Study Session 12, LOS 41.c)

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Barnes is considering the four methods previously described to analyze the small-cap stocks provided to her by Powell. For which method does Barnes provide the weakest justification?

A) The price/sales ratio.

B) The mean P/E of S&P 500 companies.

C) The PEG ratio.

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No valuation method will work dependably across all types of stocks. The four Barnes proposed are probably as good as any. But the PEG ratio does not correct for risk – it works as a comparison tool only if the companies have similar expected risks and returns. The other justifications are reasonable. (Study Session 12, LOS 41.c)