Reading 37- LOS g ～ Q1－7

1.Which of the following two ratios are likely to be used for determining value as a function of company peer benchmarks?

A)   Price-to-sales and debt/equity.

B)   Price-to-cash flow and gross profit margin.

C)   Price-to-earnings and price-to-book.

D)   Return on equity and net profit margin.

The correct answer was  C)

Relative valuation looks at market-based ratios of comparable companies in the industry. Price-to-sales, price-to-book, price-to-earnings, and price-to-cash flow are examples of ratios used in relative valuation analysis.

2.A valuation of a firm based on a review of other firms' price to earnings, price to sales, and price to return on investment ratios is an example of a:

A)   broad-based valuation.

B)   market band valuation.

C)   relative valuation.

D)   relative strength valuation.

The correct answer was  C)

An approach using market multiples to establish the value of the subject firm in relation to similar firms is an example of a relative valuation approach.

3.A valuation of a firm based on the comparison of the firm with the market value of other firms is known as a:

A)   comparison valuation.

B)   peer group valuation.

C)   appraisal valuation.

D)   relative valuation.

The correct answer was  D)

A relative valuation is a valuation based on comparing the firm to other firms with similar characteristics. Market multiples are commonly used as the basis of relative valuations.

4.A valuation of a firm based on the intrinsic value of the firm’s investment characteristics is known as an:

A)   absolute valuation.

B)   asset based valuation.

C)   absolution valuation.

D)   attribute valuation.

The correct answer was  A)

An absolute valuation approach attempts to determine the value of the firm based on its specific characteristics without regard to the market prices of other firms.

5.Joe Dentice has an opportunity to buy 5 percent of Gold Star Oil, Inc., a closely held oil company. He wants to value the company so as to be able to make a decision on the fair price to pay for the investment.

List the steps in the top down valuation approach as it is applicable for Gold Star investment. Forecast the growth of:

A)   each firm in the oil industry, the growth rate of the oil industry, and the growth rate of the economy.

B)   the overall economy, and the growth of each firm in the industry.

C)   the overall economy, growth of the industry, and the growth rate of Gold Star.

D)   Gold Star, the growth of each firm in the industry, and then the growth of the oil industry.

The correct answer was  C)

The top down model for valuation would begin with analysis of the overall economy and the expectation of the growth rate in the economy. Further, the impact of the expected growth rate of the economy on the oil industry needs to be ascertained. The second component is the analysis of the oil industry in which Gold Star operates. That involves the determination of the competitive forces in the industry and the future threats and opportunities faced by the industry. It also determines the variables that determine the future profitability of the entire oil industry. The analyst then forms future expectations of these variables given the expectations about the overall economy. The expectations of variables determining the growth and profitability of the oil industry are then used to determine the expectations of the overall growth of Gold Star. In the company analysis, the analyst reviews the quality of earnings, financial ratios, management and intangibles to ascertain the growth prospects for the company. The analyst then selects an appropriate model to value the company. Assumptions used in the valuation must be clearly spelled out and updated to reflect new information.

6.Which of the following models would be most suitable to value Gold Star?

A)   Absolute valuation.

B)   Relative valuation.

C)   Price-to-earnings ratio.

D)   Liquidation value.

The correct answer was  A)

Absolute valuation models or intrinsic value models such as the dividend growth rate model and the free cash flow model value a company independent of peer valuation. The valuation is based on the present value of cash-flows for the specific company. Relative valuation models such as P/E ratio compare the earnings multiple to that of similar companies to make a judgment about the valuation. If the P/E ratio is higher than peer company P/E ratio, it is said to be overvalued. Conversely, if the P/E ratio is lower than peer company P/E ratio, it is said to be undervalued. Caution should be taken to make sure that peer companies are indeed comparable. For the valuation of Gold Star, absolute valuation would be suitable since it is closely held and hence market valuation is not available.

7.Which discounts must be taken into account while valuing the investment opportunity? Joe should take into account the:

A)   marketability, liquidity, and majority discounts in the valuation.

B)   marketability, liquidity, and control premium in the valuation.

C)   size of the block trade, transfer rights, and lack of public information in the valuation.

D)   marketability, liquidity, and minority discounts in the valuation.

The correct answer was  D)

Since Gold Star is closely held, the investment is not easily marketable. Closely linked is the fact that the investment cannot be easily liquidated and the cost of selling the investment needs to be discounted from the value. Finally, since only 5 percent of the stock is being invested in, the control of the operations of the company still remains with the majority shareholders. This lack of control needs to be quantified and discounted from Gold Star’s valuation.