Q11. Carol Jenkins, CFA, works as a stock analyst for Cape Cod Partners, a money-management firm that handles private accounts for high net worth clients. Jenkins’ assignment is to find attractively valued stocks for client portfolios.

Jenkins believes that recent weakness in the technology sector presents an attractive opportunity. She is looking at Massive Tech, the market leader in chipsets for laptop computers, and Mouse & Associates, a tiny software developer specializing in data-storage programs. Jenkins is considering the companies’ relative values in a number of ways. Statistics for Massive and Mouse are provided below:

	Massive Tech	Mouse & Associates
Stock price	$65	$12
Trailing earnings	$4,300	$3.15
Market capitalization	$130,000	$84
Assets	$16,250	$7.0
Equity	$12,000	$5.5
Operating margin	49%	54%
Net margin	12%	22%
Depreciation	$3,500	$6
Amortization	$5,675	$1.5
Fixed investment plus borrowing	$4,200	$0.3
Dividends	$3	$0.02
Shares outstanding	2,000	7

* All figures except stock price, dividends, and percentages are in millions.

In most cases, Jenkins values her stocks relative to a basket of stocks in the same industry in order to avoid significant fundamental differences between companies of different types. However, her picks made based on price/earnings ratios are not doing well against the market. She fears the stocks she selects are not as cheap as she originally thought, relative to her benchmark.

Jenkins also wants to improve Cape Cod’s selection of software stocks. To widen the field beyond the companies she currently follows, Jenkins wants to include Canadian software stocks in Cape Cod’s research universe. Differences in accounting methodologies are not a concern, but Jenkins is still concerned about the difficulty of valuing the different stocks.

Jenkins has assembled the following data about Canadian software companies:

• Most are very small.
• Most carry little debt, but about 20% are heavily leveraged.
• These companies are more likely to be unprofitable compared to U.S. companies.
• Few pay dividends, as is the case in the U.S.
• Many of the companies are government-subsidized, which leads to drastic differences in the level of operating expenses.

Which of the following explanations is least likely to explain why Jenkins’ stock picks underperform?

A)   She is using the mean rather than the median valuation as a benchmark.

B)   Large stocks have an outsized effect on the benchmark data.

C)   Many stocks in the benchmark group are mispriced.

Q12. If she wants to compare Canadian software companies to U.S. software companies, it would be most appropriate for Jenkins to value the companies using the:

A)   price/sales ratio.

B)   price/book ratio.

C)   enterprise value/EBITDA ratio.

Q13. Which valuation ratio is least appropriate for comparing Massive and Mouse?

A)   Price/book because Massive is larger than Mouse.

B)   Enterprise value/EBITDA because Massive and Mouse have very different debt levels.

C)   Price/cash flow because cash flows for small companies can be extremely volatile.

Q14. Mouse & Associates is cheaper than Massive Tech as measured by:

A)   the price/sales ratio and the dividend yield.

B)   the earnings yield but not the price/book.

C)   the price/sales ratio and the price/earnings ratio.

Q15. The price/cash flow ratio of Massive Tech, where cash flow is defined as earnings plus noncash charges, is closest to:

A)   7.89.

B)   9.65.

C)   16.67.

Q16. If Jenkins wants to compare foreign stocks to U.S. stocks and is concerned about differences in accounting, she should start with the:

A)   dividend yield.

B)   price/book ratio.

C)   price/FCFE ratio.

Q17. 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/sales.

B)   Price/book.

C)   Price/cash flow.

Q18. 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/book                             EV/EBITDA

B)  Price/sales                            Price/cash flow

C)  Price/cash flow                     Price/book

Q19. An analyst focusing mostly on financial stocks is likely to prefer valuing stocks via the:

A)   price/sales ratio.

B)   price/book ratio.

C)   dividend yield.