05 Market-Based Valuation - P... Nterprise Value Multiples

Market-Based Valuation: Price and Enterprise Value Multiples
Test ID: 7441438
Question #1 of 140 Question ID: 463339
An argument for using the price-to-earnings (P/E) valuation approach is that:
ᅞ A) management discretion increases the reliability of the ratio.
ᅞ B) earnings can be negative.
ᅚ C) earnings power is the primary determinant of investment value.
Explanation
Earnings power is the primary determinant of investment value. Both remaining factors reduce the usefulness of the P/E approach.
An analyst has gathered the following data about Jackson, Inc.:

Payout ratio = 60%.
Expected growth rate in dividends = 6.7%.
Required rate of return = 12.5%.
What will be the appropriate price-to-book value (PBV) ratio for Jackson, based on fundamentals?
ᅞ A) 1.38.
ᅞ B) 0.58.
ᅚ C) 1.73.
Explanation
Return on equity (ROE) = g / (1 − payout ratio) = 0.067 / 0.40 = 0.1675 or 16.75%.

Based on fundamentals:
PBV = (0.1675 − 0.067) / (0.125 − 0.067) = 1.73.
Consider the statement: "Unlike many valuation metrics that incorporate dividend discounting, the PEG ratio may be used to
value firms with zero expected dividend growth prospects." Is this statement correct?
ᅞ A) Yes, because the expected dividend growth rate is cancelled out in the
computation of the PEG ratio.
ᅞ B) Yes, because the computation of the PEG ratio does not use the rate of expected
dividend growth.
ᅚ C) No, because the PEG ratio is undefined for zero-growth companies.
Explanation
The PEG ratio measures the tradeoff between P/E and expected earnings growth (g). The formula for the PEG ratio is: PEG =
(P/E) / g. Firms with zero expected earnings growth will have an infinite (or undefined) PEG ratio due to division by zero.
An analyst begins an equity analysis of Company A by estimating future cash flows, discounting them back to the present, and
dividing the result by the outstanding number of shares. This analyst is most likely using the:
ᅚ A) the method of forecasted fundamentals.

ᅞ B) technical analysis.
ᅞ C) the method of comparables.
Explanation
This analysis is comparing forecasted discounted cash flows (DCF) to a fundamental variable (shares). This suggests the
method for forecasted fundamentals.
Two security analysts, Ramon Long and Sri Beujeau, disagree about certain aspects of the PEG ratio. Long argues that:
"unlike typical valuation metrics that incorporate dividend discounting, the PEG ratio is unique because it generates meaningful
results for firms with negative expected earnings-growth." Is Long correct?
ᅞ A) Yes, because the expected earnings-growth rate is cancelled out in the

computation of the PEG ratio.
ᅚ B) No, because the PEG ratio generates meaningless results for negative earnings-
growth companies.
ᅞ C) Yes, because the computation of the PEG ratio does not use the rate of expected
earnings growth.
Explanation
The PEG ratio is: PEG = (P/E) / earnings growth. As such, firms with negative expected earnings growth will have a negative
PEG ratio, which is meaningless.
What is the justified trailing price-to-earnings (P/E) multiple of a stock that has a payout ratio of 65% if the shareholders require a return of
10% on their investment and the expected growth rate in dividends is 6%?
ᅚ A) 17.23.
ᅞ B) 9.28.
ᅞ C) 16.25.
Explanation
P0/E0 = (0.65 × 1.06) / (0.10 - 0.06) = 17.225
Proprietary Technologies, Inc., (PTI) has a leading price-to-earnings (P/E) ratio of 28 while the median leading P/E of a peer group of
companies within the industry is 38. Based on the method of comparables, an analyst would most likely conclude that PTI should be:
ᅚ A) bought as an undervalued stock.
ᅞ B) sold short as an overvalued stock.
ᅞ C) sold as an overvalued stock.
Explanation
The price per dollar of earnings is considerably lower than that for the median of the peer group, which implies that it may well be
undervalued.
Earnings before interest, taxes, depreciation, and amortization (EBITDA) is best suited as a measure of:
ᅚ A) total company value.
ᅞ B) debt capacity.
ᅞ C) equity value.
Explanation
EBITDA is a pre-tax, pre-interest measure, which represents a flow to both equity and debt. Thus, it is better suited as an indicator of total
company value than just equity value.
Industrial Light had earnings per share (EPS) of $5.00 past year, a dividend per share of $2.50, a cost of equity of 12%, and a
long-term expected growth rate of 5%. What is the trailing price-to-earnings (P/E) ratio?
ᅞ A) 7.14.
ᅚ B) 7.50.
ᅞ C) 3.75.
Explanation
P/E =
1 − b = 1 − (2.50/5.00) = 0.50
P5 / E5 = (0.50 × 1.05) / (0.12 − 0.05) = 7.50

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
ᅞ A) Price/book EV/EBITDA
ᅞ B) Price/cash flow Price/book
ᅚ C) Price/sales Price/cash flow
Explanation
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.
Margin and Sales Trade-off for CVR, Inc. and Home, Inc., for Next Year
Sales/Book
Firm Strategy Retention Rate Profit Margin Value (SBV) of
Equity
CVR, Inc. High Margin / Low Volume 20% 8% 1.25
CVR, Inc. Low Margin / High Volume 20% 2% 4.00
Home,
High Margin / Low Volume 40% 9% 2.00
Inc.
Home,
Low Margin / High Volume 40% 1% 20.0
Inc.
Note: CVR, Inc., has a book value of equity of $80 and a required rate of return of 10%. Home, Inc., has a book value of equity of $100
and a required rate of return of 11%.
If Home, Inc., has a required return for shareholders of 11%, what is its appropriate leading price-to-sales (Po / S1) multiple if the firm
undertakes the low margin/high volume strategy?
ᅚ A) 0.20.
ᅞ B) 0.80.
ᅞ C) 1.00.
Explanation
g = Retention Rate × Profit Margin × SBV of equity = 0.40 × 0.01 × 20.0 = 0.08.
If profit margin is based on the expected earnings next period,

P/S = (profit margin × payout ratio) / (r − g) = (0.01 × 0.60) / (0.11 − 0.08) = 0.20.
The warranted or intrinsic price multiple is called the:
ᅞ A) multiple implied by historical growth.
ᅚ B) justified price multiple.
ᅞ C) multiple implied by the market price.
Explanation
A justified price multiple is the warranted or intrinsic price multiple. It is the estimated fair value of that multiple.
Margin and Sales Trade-off for CVR, Inc. and Home, Inc., for Next Year
Sales/Book
Firm Strategy Retention Rate Profit Margin
Value of Equity
CVR, Inc. High Margin / Low Volume 20% 8% 1.25
CVR, Inc. Low Margin / High Volume 20% 2% 4.00
Home,
High Margin / Low Volume 40% 9% 2.00
Inc.
Home,
Low Margin / High Volume 40% 1% 20.0
Inc.
(Note: CVR, Inc., has a book value of equity of $80 and a required rate of return of 10%. Home, Inc., has a book value of equity of $100
and a required rate of return of 11%.)
If CVR, Inc., has a required return for shareholders of 10%, what is its appropriate leading price-to-sales (P/S) multiple if the firm
undertakes the high margin/low volume strategy?
ᅚ A) 0.80.
ᅞ B) 1.46.
ᅞ C) 0.20.
Explanation
g = Retention Rate × Profit Margin × Sales/book value of equity = 0.20 × 0.08 × 1.25 = 0.02.
If profit margin is based on the expected earnings next period,

Leading P/S = (profit margin × payout ratio) / (r − g) = (0.08 × 0.80) / (0.10 − 0.02) = 0.80.
An analyst gathers the following information for ABC Industries:
Market Value of Debt $110 million
Market Value of Equity $90 million
Book Value of Debt $100 million

Book Value of Equity $50 million
EBITDA $75 million
The EV/EBITDA is closest to:
ᅞ A) 2.00.
ᅞ B) 2.13.
ᅚ C) 2.67.
Explanation
EV uses market values for debt and equity. (110 + 90) / 75 = 2.67.
The Farmer Co. has a payout ratio of 70% and a return on equity (ROE) of 14%. What will be the appropriate price-to-book value (PBV)
based on fundamentals if the expected growth rate in dividends is 4.2% and the required rate of return is 11%?
ᅞ A) 1.50.
ᅚ B) 1.44.
ᅞ C) 0.64.
Explanation
Based on fundamentals:
P/BV = (0.14 − 0.042) / (0.11 − 0.042) = 1.44.
Which of the following statements about cyclical firms is least accurate?
ᅚ A) 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.
ᅞ B) Cyclical firms have volatile earnings, and their price-to-earnings (P/E) multiple is not very
useful for valuation.
ᅞ C) 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.
Explanation
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.
ᅞ A) bought as an undervalued stock.
ᅞ B) viewed as a properly valued stock.
ᅚ C) sold or sold short as an overvalued stock.
Explanation
The price per dollar of earnings is considerably higher than that for the median of the peer group, which implies that it may well be
overvalued.
Questions #18-23 of 140
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?
ᅞ A) Barnes'.
ᅞ B) Bosley's.
ᅚ C) Lincoln's.
Explanation
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 37.c)
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?
ᅞ A) Earnings per share are not a good determinant of investment value for medical-
technology companies.
ᅚ B) The company is likely to be unprofitable.
ᅞ C) P/E ratios for medical-technology firms with different specialties are not comparable.
Explanation
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
37.c)
Based on their responses to Powell, which of the analysts is most likely concerned about earnings volatility?
ᅞ A) Bosley.
ᅞ B) Barnes.
ᅚ C) Lincoln.
Explanation
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 37.c)
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?
ᅞ A) Lincoln.
ᅞ B) Marks.
ᅚ C) Bosley.
Explanation
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 13, LOS 37.c)
Barnes would be least likely to use EV/EBITDA ratio, rather than the P/E ratio, when analyzing a company that:
ᅞ A) reports a lot of depreciation expense.
ᅞ B) has a different capital structure than most of its peers.
ᅚ C) pays a dividend, and is likely to deliver little earnings growth.
Explanation
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 37.c, n)
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?
ᅞ A) The price/sales ratio.
ᅞ B) The mean P/E of S&P 500 companies.
ᅚ C) The PEG ratio.
Explanation
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 37.c, k)
Which of the following factors is a source of differences in cross-border valuation comparisons?

ᅞ A) Comparative advantage.
ᅚ B) Accounting methods.
ᅞ C) Intra-country market indicators.
Explanation
Different accounting conventions make cross-border comparisons for valuation purposes challenging.
Enhanced Systems, Inc., (ESI) has a leading price to book value (P/B) of four while the median P/B of a peer group of companies within
the industry is six. Based on the method of comparables, an analyst would most likely conclude that ESI should be:
ᅚ A) bought as an undervalued stock.
ᅞ B) sold as an overvalued stock.
ᅞ C) viewed as a properly valued stock.
Explanation
The price per dollar of book value is considerably lower than that for the median of the peer group, which implies that it may well be
undervalued.
What is the appropriate price-to-sales (P/S) multiple of a stock that has a retention ratio of 45%, a return on equity (ROE) of 14%, an
earnings per share (EPS) of $5.25, sales per share of $245.54, an expected growth rate in dividends and earnings of 6.5%, and
shareholders require a return of 11% on their investment?
ᅞ A) 0.158.
ᅚ B) 0.278.
ᅞ C) 0.227.
Explanation
Recall that profit margin is measured as E0 / S0. In this example, the profit margin is (5.25 / 245.54) = 0.0214. Thus:
P0 / S0 = [(E0 / S0)(1 − b)(1 + g)] / (r − g) = [0.0214(0.55)(1.065)] / (0.11 − 0.065) = 0.278
What is the justified trailing price-to-earnings (P/E) multiple of a stock that has a payout ratio of 40% if the shareholders require a return of
16% on their investment and the expected growth rate in dividends is 6%?
ᅚ A) 4.24.
ᅞ B) 6.36.
ᅞ C) 4.00.
Explanation
P0/E0 = (0.40 × 1.06) / (0.16 - 0.06) = 4.24
An argument against using the price-to-earnings (P/E) valuation approach is that:
ᅞ A) research shows that P/E differences are significantly related to long-run average stock
returns.
ᅚ B) earnings can be negative.
ᅞ C) earnings power is the primary determinant of investment value.
Explanation
Negative earnings render the P/E ratio useless. Both remaining factors increase the usefulness of the P/E approach.
An increase in growth will cause a price-to-earnings (P/E) multiple to:
ᅚ A) increase.
ᅞ B) decrease.
ᅞ C) there is insufficient information to tell.
Explanation
An increase in growth will decrease the denominator and increase the numerator in the trailing P/E expression, both of which should
increase the P/E ratio:
P0/E0 = [(1 - b)(1 + g)] / (r - g)
Note that the topic review does not allow for any interactive relationship between retention and growth. Thus, no explicit consideration is
given to how the growth increase was generated.
The Farmer Co. has a payout ratio of 65% and a return on equity (ROE) of 16% (assume that this is expected ROE for the upcoming
year). What will be the appropriate price-to-book value (PBV) based on return differential if the expected growth rate in dividends is 5.6%
and the required rate of return is 13%?
ᅞ A) 0.71.
ᅞ B) 1.48.
ᅚ C) 1.41.
Explanation
Based on return differential:
P0 / BV0 = (ROE1 − g) / (r − g) = (0.16 − 0.056) / (0.13 − 0.056) = 1.41.
An analyst has gathered the following fundamental data:
Firm A Firm A Firm B Firm B
High Margin Low Margin High Margin Low Margin

Strategy
Low Volume High Volume Low Volume High Volume
Payout Ratio 40% 40% 40% 40%
Required Rate of Return 11% 11% 11% 11%
Growth Rate in Dividends 9% 5% 5% 7%
Sales/Book Value of Equity 1.5 4.5 1.0 3
Profit Margin 10% 2% 9% 4%
Book Value $150 $150 $125 $125
What is the price-to-sales (P/S) multiple for Firm A in the high-margin, low-volume strategy?
ᅚ A) 2.18.
ᅞ B) 2.00.
ᅞ C) 0.13.
Explanation
The P/S multiple = [Profit Margin × Payout Ratio × (1 + g)] / (r − g) = (0.10 × 0.4 × 1.09) / (0.11 − 0.09) = 2.18.
What is the P/S multiple for Firm B in the low-margin, high-volume strategy?
ᅞ A) 0.60.
ᅞ B) 2.00.
ᅚ C) 0.43.
Explanation
The P/S multiple = [Profit Margin × Payout Ratio × (1 + g)] / (r − g) = (0.04 × 0.4 × 1.07) / (0.11 − 0.07) = 0.428 or 0.43.

The definition of a PEG ratio is price to earnings (P/E):
ᅞ A) divided by average historical earnings growth rate.
ᅞ B) divided by the average growth rate of the peer group.
ᅚ C) divided by the expected earnings growth rate.
Explanation
The PEG ratio is P/E divided by the expected earnings growth rate.
A firm is better valued using the discounted cash flow approach than the P/E multiples approach when:
ᅚ A) earnings per share are negative.
ᅞ B) expected growth rate is very high.
ᅞ C) dividend payout is low.
Explanation
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.
An increase in which of the following variables will least likley result in a corresponding increase in the price-to-book value (PBV) ratio for
a high-growth firm?
ᅞ A) Growth rates in earnings.
ᅚ B) Required rate of return
ᅞ C) Payout ratios.
Explanation
The PBV ratio decreases as the required rate of return increases.
Which of the following is a common momentum valuation indicator?
ᅞ A) Price to free cash flow to equity (P/FCFE).
ᅚ B) Relative strength.
ᅞ C) Dividend yield (D/P).
Explanation
Relative strength is generally considered a momentum valuation indicator.

An analyst focusing mostly on financial stocks is likely to prefer valuing stocks via the:
ᅚ A) price/book ratio.
ᅞ B) dividend yield.
ᅞ C) price/sales ratio.
Explanation
The price/book ratio is a preferred tool for valuing financial stocks.
An analyst is valuing a company with a dividend payout ratio of 0.35, a beta of 1.45, and an expected earnings growth rate of 0.08. A
regression on comparable companies produces the following equation:
Predicted price to earnings (P/E) = 7.65 + (3.75 × dividend payout) + (15.35 × growth) − (0.70 × beta)
What is the predicted P/E using the above regression?
ᅚ A) 9.18.
ᅞ B) 7.65.
ᅞ C) 11.21.
Explanation
Predicted P/E = 7.65 + (3.75 × 0.35) + (15.35 × 0.08) − (0.70 × 1.45) = 9.1755
Enhanced Systems, Inc., has a price to book value (P/B) of five while the median P/B of a peer group of companies within the industry is
five. Based on the method of comparables, an analyst would most likely conclude that ESI should be:
ᅚ A) viewed as a properly valued stock.
ᅞ B) bought as an undervalued stock.
ᅞ C) sold or sold short as an overvalued stock.
Explanation
The price per dollar of book value is the same as that for the median of the peer group, which implies that it is likely properly valued.
At a regional security analysts conference, Sandeep Singh made the following comment: "A PEG ratio is a very useful valuation metric
because it generates meaningful results for all equities, regardless of the rate of dividend growth." Is Singh correct?
ᅚ A) No, because the PEG ratio generates highly questionable results for low-growth
companies.
ᅞ B) Yes, because the computation of the PEG ratio does include the rate of expected dividend
growth.
ᅞ C) Yes, because the expected dividend growth rate is cancelled out in the computation of the
PEG ratio.
Explanation
The PEG ratio measures the tradeoff between P/E and expected earnings growth (g). The formula for the PEG ratio is: PEG = (P/E) / g.
PEG ratios generate questionable results for low-growth companies. Also, the PEG ratio is undefined for companies with zero expected
growth (division by zero) or meaningless for companies with negative expected earnings growth.
Which of the following measures of cash flow is most closely linked with valuation theory?
ᅚ A) Free cash flow to equity (FCFE).
ᅞ B) Earnings before interest, taxes, depreciation, and amortization (EBITDA).
ᅞ C) Cash flow from operations (CFO).
Explanation
FCFE is most strongly linked to valuation theory. Both remaining proxies are in need of significant adjustment to accurately measure cash
flow in valuation.
An analyst has gathered the following data about the Garber Company:
Payout Ratio = 60%.
Expected Return on Equity = 16.75%.
Required rate of return = 12.5%.
What will be the appropriate price-to-book value (PBV) ratio for the Garber Company based on return differential?
ᅞ A) 0.58.
ᅚ B) 1.73.
ᅞ C) 1.38.
Explanation
The estimated growth rate is 6.7% [0.1675 × (1 − 0.60)] and PBV ratio based on rate differential will be:
P0 / BV0 = (ROE1 − g) / (r − g) = (0.1675 − 0.067) / (0.125 − 0.067) = 1.73.

An analyst gathered the following data for TRK Construction [all amounts in Swiss francs (Sf)]:
Recent share price Sf 30.00
Shares outstanding Sf 40 million

Market value of debt Sf 120 million
Cash and marketable securities Sf 75 million
Investments Sf 200 million
Net income Sf 160 million
Interest expense Sf 9 million

Depreciation and amortization Sf 12 million
Taxes Sf 48 million
The EV/EBITDA multiple for TRK Construction is closest to:
ᅞ A) 3.47x.
ᅞ B) 5.21x.
ᅚ C) 4.56x.
Explanation
EBITDA = (net income + interest + taxes + depreciation / amortization)
EV = (market value of common stock + market value of debt - cash and investments)
EBITDA = 160 + 9 + 12 + 48 = Sf 229 million
EV = (30 × 40) + 120 - 75 - 200 = Sf 1045 million
EV / EBITDA = 4.56
Leslie Singer comments to Robert Chan that Dreamtime Industries' expected dividend growth rate is 5.0%, ROE is 14%, and required
return on equity (r) is 10%. Based on a justified P/B ratio compared to a P/B ratio (based on market price per share) of 1.60, Dreamtime
Industries is most likely:
ᅞ A) overvalued.
ᅚ B) undervalued.
ᅞ C) correctly valued.
Explanation
Justified P/B = (ROE − g) / (r − g). When the expected dividend growth is 5.0%, the justified P/B = (0.14 − 0.05) / (0.10 − 0.05) = 1.80.
This is greater than the market P/B of 1.60.
A firm has a payout ratio of 35%, a return on equity (ROE) of 18%, an estimated growth rate of 13%, and its shareholders require a return
of 17% on their investment. Based on these fundamentals, a reasonable estimate of the appropriate price-to-book value ratio for the firm
is:
ᅞ A) 1.58.
ᅚ B) 1.25.
ᅞ C) 2.42.
Explanation
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:
Mouse &
Massive Tech
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?
ᅞ A) Many stocks in the benchmark group are mispriced.
ᅚ B) Large stocks have an outsized effect on the benchmark data.
ᅞ C) She is using the mean rather than the median valuation as a benchmark.
Explanation
Capitalization weights are not an issue unless the benchmark is a cap-weighted index. Jenkins is using a basket of stocks in the same
industry, which can be assumed to be a simple arithmetic average. Average valuations reflect outliers; medians do not. P/Es can get very
high, but can never fall below zero. As such, the outliers are going to trend high, and the median is likely to be considerably lower than the
mean. A stock that looks cheap relative to the mean may look expensive relative to the median. Stocks of different sizes often have
different average or median valuations. Mispricing of stocks in the benchmark is always a risk. (Study Session 12, LOS 37.j)
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:
ᅞ A) price/sales ratio.
ᅚ B) price/book ratio.
ᅞ C) enterprise value/EBITDA ratio.
Explanation
Accounting issues are not relevant to this discussion. As such, we must consider the other characteristics of the market to choose the
best method. The P/E ratio is limited in value because many of the companies do not make money. The P/S ratio doesn't work well when
the companies have different cost structures, and the measure does not reflect differences in profit margins. EBITDA is less likely to be
negative than earnings, but it will fall prey to differences in cost structure just as the P/E and P/S ratios will. Like EBITDA, book value is
often positive even when profits are negative. The price/book ratio is best for valuing companies with small amounts of fixed assets, like
software makers. In addition, the fact that most of the companies are small eliminates one of the P/B ratio's weaknesses that it can be
misleading when compared firms have significantly different asset sizes. (Study Session 12, LOS 37.j)
Which valuation ratio is least appropriate for comparing Massive and Mouse?
ᅚ A) Price/book because Massive is larger than Mouse.
ᅞ B) Price/cash flow because cash flows for small companies can be extremely volatile.
ᅞ C) Enterprise value/EBITDA because Massive and Mouse have very different debt levels.
Explanation
The P/B ratio's can be misleading when used to compare companies with vastly different asset bases. A large semiconductor company is
likely to have lots of fixed assets, while a tiny software company may have very few assets. The P/CF ratio tends to be more stable than
the P/E ratio. The P/E ratio is useless for considering companies that lose money, but that does not mean the measure has no value
when earnings are positive. The EV/EBITDA ratio is effective at comparing stocks with different degrees of financial leverage. (Study
Session 12, LOS 37.j)
Mouse & Associates is cheaper than Massive Tech as measured by:
ᅞ A) the price/sales ratio and the price/earnings ratio.
ᅚ B) the earnings yield but not the price/book.
ᅞ C) the price/sales ratio and the dividend yield.
Explanation
To calculate the P/E, divide the market capitalization by the earnings. Lower is cheaper.
To calculate the P/B, divide the market capitalization by the equity. Lower is cheaper.
To calculate the P/S, determine sales by dividing the earnings by the net margin. Then divide the market capitalization by the sales.
Lower is cheaper.
To calculate the earnings yield, divide the earnings by the market capitalization. Higher is cheaper.
To calculate the dividend yield, divide the dividends by the price. Higher is cheaper.
Massive Tech Mouse & Associates
P/E 30.23 26.67
P/B 10.83 15.27
P/S 3.63 5.87
Earnings yield 3.31% 3.75%
Dividend yield 4.62% 0.17%

(Study Session 12, LOS 37.d)
The price/cash flow ratio of Massive Tech, where cash flow is defined as earnings plus noncash charges, is closest to:
ᅚ A) 9.65.
ᅞ B) 16.67.
ᅞ C) 7.89.
Explanation
Cash flow = net income plus depreciation plus amortization = ($4,300 + 3,500 + 5,675) = $13,475 million.
P/CF = market capitalization/cash flow = ($130,000/13,475) = 9.65. (Study Session 12, LOS 37.d)
If Jenkins wants to compare foreign stocks to U.S. stocks and is concerned about differences in accounting, she should start with the:
ᅞ A) price/FCFE ratio.
ᅚ B) dividend yield.
ᅞ C) price/book ratio.
Explanation
Of all the price ratios, the price/free cash flow to equity ratio is the least affected by international accounting differences. However, the
dividend yield is not affected by such accounting differences at all, and represents a good starting point. Residual-income models and
price/book ratios are very sensitive to accounting issues. (Study Session 12, LOS 37.o)
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% -- -- --
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?
ᅞ A) Decrease ROE.
ᅞ B) Increase r.
ᅚ C) A larger spread between ROE and the required rate of return (r).
Explanation
To increase the PBV do one of the following:
Increase ROE.
Decrease r.
Increase the spread between ROE and r.
Using the information from scenario one which of the following items would decrease Firm A's PBV?
ᅞ A) Increase ROE.
ᅞ B) Increase the spread between ROE and r.
ᅚ C) Increase r.
Explanation
To decrease the PBV do one of the following:
Decrease ROE.
Increase r.
Decrease the spread between ROE and r.
Using the information in scenario two, what is the cost of equity capital of Brown, Inc.?
ᅞ A) 10.5%.
ᅞ B) 12.0%.
ᅚ C) 15.5%.
Explanation
Use the capital asset pricing model (CAPM) to compute the cost of equity capital as follows:
Kequity = 5% + (1.5)(12% − 5%) = 15.5%.
Using the information in scenario two, what is the weighted-average cost of capital (WACC) of Brown, Inc.?
ᅞ A) 9.86%.
ᅚ B) 13.60%.
ᅞ C) 14.40%.
Explanation
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%.
Using the information in scenario three, what should Mansted observe about Donner's solvency and debt capitalization?
ᅞ A) Donner's solvency ratio is worse but its debt capitalization is better than the industry
average.
ᅞ B) Donner's solvency ratio is better but its debt capitalization is worse than the industry average.
ᅚ C) Both Donner's solvency and debt capitalization ratios are better than the industry average.
Explanation
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 51.c)
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:
ᅚ A) declining (worsening) over time but is still above the industry average.
ᅞ B) declining (worsening) over time and is below the industry average.
ᅞ C) rising (improving) over time and is above the industry average.
Explanation
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 51.d)
In interpreting the standardized unexpected earnings (SUE) momentum measure, it can be concluded that a given size forecast error is:
ᅚ A) more meaningful the smaller the historical size of forecast errors.
ᅞ B) more meaningful the larger the historical size of forecast errors.
ᅞ C) scaled by the earnings surprise.
Explanation
A given size forecast error is more (less) meaningful the smaller (larger) the historical size of forecast errors.
A common pitfall in interpreting earnings yields in valuation is:
ᅞ A) using underlying earnings.
ᅞ B) using negative earnings.
ᅚ C) look-ahead bias.
Explanation
A common pitfall is look-ahead bias, wherein the analyst uses information that was not available to the investor when calculating the
earnings yield.
An analyst has gathered the following fundamental data:
Firm A Firm B Firm C Firm D
Payout Ratio 75%
Return on Equity (ROE) 20% 15% 30% 14%
Price/Book Value (PBV) Ratio 3.00 0.70 3.50

What is the PBV ratio for Firm A?
ᅚ A) 2.14.
ᅞ B) 0.71.
ᅞ C) 1.25.
Explanation
The growth rate in dividends (g) = ROE(1 − payout ratio) = 0.20 × (1 − 0.75) = 0.05 or 5%. The PBV ratio = (ROE − g) / (r − g) = (0.20 −
0.05) / (0.12 − 0.05) = 2.14.
Which of the following valuation approaches is based on the rationale that stock values differ due to differences in the expected values of
variables such as sales, earnings, or related growth rates?
ᅚ A) Method of forecasted fundamentals.
ᅞ B) Free cash flow to the firm.
ᅞ C) Method of comparables.
Explanation
The method of forecasted fundamentals is based on the rationale that stock values differ due to differences in the expected values of
fundamentals such as sales, earnings, or related growth rates.
The net impact of an increase in payout ratio on price-to-book value (PBV) ratio cannot be determined because it might also:
ᅞ A) decrease the market value of the firm.
ᅚ B) decrease expected growth.
ᅞ C) decrease required rate of return.
Explanation
If payout increases, the growth of the firm may slow down, because internally generated funds are not being invested in new, profitable
projects. Hence, the net impact on the PBV ratio from change in payout ratio cannot be determined.
An argument against using the price-to-sales (P/S) valuation approach is that:
ᅞ A) P/S ratios are not as volatile as price-to-earnings (P/E) multiples.
ᅚ B) P/S ratios do not express differences in cost structures across companies.
ᅞ C) sales figures are not as easy to manipulate or distort as earnings per share (EPS) and book
value.
Explanation
P/S ratios do not express differences in cost structures across companies. Both remaining responses are advantages of the P/S ratios,
not disadvantages.
Which of the following price multiples is most severely damaged by international accounting differences?
ᅞ A) Price to free cash flow to equity (P/FCFE).
ᅞ B) Price to cash flow from operations (P/CFO).
ᅚ C) Enterprise value to earnings before interest, taxes, depreciation, and amortization

(EV/EBITDA).
Explanation
EV/EBITDA is the most seriously affect because it is most closely tied to accounting conventions.
An increase in growth will cause a price to cash flow multiple to:
ᅚ A) increase.
ᅞ B) there is insufficient information to tell.
ᅞ C) decrease.
Explanation
An increase in growth increases the price to cash flow ratio (CF), as indicated by the following expression:
P0 / CF0 = (1 + g) / (r - g)
A common justification for using earnings yields in valuation is that:
ᅞ A) earnings are more stable than dividends.
ᅞ B) earnings are usually greater than free cash flows.
ᅚ C) negative earnings render P/E ratios meaningless and prices are never negative.
Explanation
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.
Precision Tools is expected to have earnings per share (EPS) of $5.00 per share in five years, a dividend per share of $2.00, a cost of
equity of 12%, and a long-term expected growth rate of 5%. What is the terminal trailing price-to-earnings (P/E) ratio in five years?
ᅞ A) 7.14.
ᅚ B) 6.00.
ᅞ C) 9.00.
Explanation
P5/E5 = (0.40 × 1.05) / (0.12 - 0.05) = 6.00
The price-to-book value (PBV) ratio for a high-growth firm will:
ᅞ A) increase as the growth rate in either the high-growth or stable-growth period decreases.
ᅚ B) increase as the growth rate in either the high-growth or stable-growth period increases.
ᅞ C) increase as the growth rate in the high-growth period increases and decrease as the growth
rate in the stable-growth period increases.
Explanation
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.
A decrease in the earnings retention rate will cause a price-to-sales (P/S) multiple to:
ᅚ A) increase.
ᅞ B) remain the same.
ᅞ C) decrease.
Explanation
A decrease in the earnings retention rate will increase the following expression for P/S due to the implied increase in the payout ratio,
which is (1 - b):
P0 / S0 = [(E0 / S0)(1 - b)(1 + g)] / (r - g)
Note that the topic review does not allow for any interactive relationship between retention and growth. Thus, no explicit consideration is
given to whether the increase in the payout ratio will cause an offsetting decrease in growth.

A firm has a payout ratio of 40%, a profit margin of 7%, an estimated growth rate of 10%, and its shareholders require a return of 14% on
their investment. Based on these fundamentals, a reasonable estimate of the appropriate price-to-sales ratio for the firm (based on trailing
sales) is:
ᅚ A) 0.77.
ᅞ B) 0.56.
ᅞ C) 0.70.
Explanation
Alpha Software (AS) recently reported 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?
ᅞ A) 37.14.
ᅚ B) 31.86.
ᅞ C) 44.52.
Explanation
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.
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?
ᅞ A) Price/book.
ᅞ B) Price/cash flow.
ᅚ C) Price/sales.
Explanation
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.

An analyst is preparing a presentation on "Interpreting PE ratios" and has the following data:
Portfolio % Stock PE
Stock AAA 60% 10

Stock BBB 40% 15
Which of the following is closest to the weighted harmonic mean of these two PE ratios?
ᅞ A) 12.49.
ᅞ B) 11.98.
ᅚ C) 11.54.
Explanation
The weighted harmonic mean of the two PE ratios is a harmonic mean which is weighted by the portfolio weights.
1/[(0.60 × 1/10) + (0.40 × 1/15)] = 11.54
One disadvantage of using the price/sales (P/S) multiple for stock valuation is that:
ᅞ A) P/S multiple does not provide a framework to evaluate the effects of corporate policy
decisions and price changes.
ᅞ B) profit margins are not consistent across firms within an industry.
ᅚ C) sales are relatively stable and might not change even though earnings and value might
change significantly.
Explanation
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.
Which of the following is NOT an advantage of using price-to-book value (PBV) multiples in stock valuation?
ᅞ A) Book value is often positive, even when earnings are negative.
ᅞ B) PBV ratios can be compared across similar firms if accounting standards are consistent.
ᅚ C) Book values are very meaningful for firms in service industries.
Explanation
Book values are NOT very meaningful for firms in service industries.

Good Sports, Inc., (GSI) has a leading price-to-earnings (P/E) ratio of 12.75 and a 5-year consensus growth rate forecast of 8.5%. What is
the firm's P/E to growth (PEG) ratio?
ᅚ A) 1.50.
ᅞ B) 150.00.
ᅞ C) 0.67.
Explanation
The firm's PEG is 12.75 / 8.50 = 1.50.
An analyst is preparing a presentation on "Interpreting PE ratios" and has the following data:
Portfolio % Stock PE
Stock AAA 60% 10
Stock BBB 40% 15
Which of the following is the most appropriate measure for calculating the portfolio P/E?
ᅞ A) Geometric mean of the P/E's.
ᅞ B) Arithmetic average of the P/E's.
ᅚ C) Weighted harmonic mean of the P/E's.
Explanation
The weighted harmonic mean of the 10 and 15 will give the result closest to the portfolio earnings divided by the portfolio value.
An analyst is calculating the weighted harmonic mean P/E ratio of a 2-stock portfolio. Stocks AAA and BBB have prices of $12 and $15,
respectively, and EPS of $1 and $2, respectively. Which of the following is the weighted harmonic mean P/E of the portfolio closest to?
ᅚ A) 9.00
ᅞ B) 9.23
ᅞ C) 9.75
Explanation
The weighted harmonic mean is 1/[(12/27)(1/12) + (15/27)(2/15)] = 27/3 = 9.00 The weighted harmonic mean of the individual stocks P/Es
is the best measure of the P/E for a portfolio of stocks.
Shares of TKR Construction (TKR) are selling for $50. Earnings for the last 12 months were $4.00 per share. The average trailing P/E ratio
for firms in TKR's industry is 15. The appropriate WACC is 12%, and the risk-free rate is 8%. Assume a growth rate of 0%. Using the
method of comparables, what price is indicated for TKR?
ᅞ A) $50.00.
ᅞ B) $33.33.
ᅚ C) $60.00.
Explanation
Using the method of comparables, TKR should be priced as (15 × 4) = $60.00.
The Lewis Corp. had revenue per share of $300 in 2001, earnings per share of $4.50, and paid out 60% of its earnings as dividends. If the
return on equity (ROE) and required rate of return of Lewis are 20% and 13% respectively, what is the appropriate price/sales (P/S)
multiple for Lewis?
ᅞ A) 0.18.
ᅞ B) 0.12.
ᅚ C) 0.19.
Explanation
Profit Margin = EPS / Sales per share = 4.50 / 300 = 0.015 or 1.5%.
Expected growth in dividends and earnings = ROE × (1 − payout ratio) = 0.20 × 0.40 = 0.08 or 8%.
P0/S0 = [profit margin × payout ratio × (1 + g)] / (r − g) = [0.015 × 0.60 × (1.08)] / (0.13 − 0.08) = 0.1944.
Which of the following statements about the method of forecasted fundamentals in price multiple valuation is most accurate?
ᅞ A) It relies on the Law of One Price.
ᅚ B) It relates multiples to company fundamentals using a discounted cash flow (DCF) model.
ᅞ C) It values an asset relative to a benchmark value of the multiple.
Explanation
The method of forecasted fundamentals relates multiples to company fundamentals using a DCF method. It does not explicitly rely on the
Law of One Price. Further, it does not typically focus on benchmarks.
Which of the following is a disadvantage to using EV/EBITDA?

ᅞ A) EBITDA is useful for valuing capital-intensive businesses with high levels of
depreciation and amortization.
ᅞ B) EBITDA is usually positive even when EPS is not.
ᅚ C) Since FCFF captures the amount of capital expenditures, it is more strongly linked with
valuation theory than EBITDA.
Explanation
Since FCFF captures the amount of capital expenditures, it is more strongly linked with valuation theory than EBITDA. The other
statements are advantages.
All other variables held constant, the justified price-to-book multiple will decrease with a decrease in:
ᅚ A) expected growth rate.
ᅞ B) required rate of return.
ᅞ C) payout ratio.
Explanation
All other variables held constant, a decrease in expected growth rate will result in a decrease in the justified price-to-book multiple.
ᅞ A) 11.39.
ᅚ B) 10.35.
ᅞ C) 7.65.
Explanation
Predicted P/E = 7.65 + (3.75 × 0.65) + (15.35 × 0.05) − (0.70 × 0.72) = 10.35
Underlying earnings may be defined as earnings:
ᅞ A) net of capital expenditures needed to keep the business productive.
ᅚ B) that exclude non-recurring components.
ᅞ C) that include non-recurring components.

Explanation
Underlying earnings are earnings that exclude non-recurring items. They are also known as persistent, continuing, or core earnings.
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?
ᅚ A) No, ZEI's P/E ratio will increase by approximately 14.32%.
ᅞ B) No, ZEI's P/E ratio will decrease by approximately 14.32%.
ᅞ C) Yes, ZEI's P/E ratio will increase by approximately 0.5%.
Explanation
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.
Which of the following statements regarding the P/E to growth (PEG) valuation approach is least accurate? The P/E to growth (PEG)
valuation approach assumes that:
ᅚ A) stocks with higher PEGs are more attractive than stocks with lower PEGs.
ᅞ B) there is a linear relationship between price to earnings (P/E) and growth.
ᅞ C) there are no risk differences among stocks.
Explanation
The PEG valuation approach implicitly assumes there is a linear relationship between price to earnings (P/E) and growth, even though
there is not a "real world" linear relationship. The analyst must be cautious when using the PEG ratio for valuation or comparison purposes
especially if the growth rate is very small or very large. If earnings or the growth rate is negative the PEG ratio is meaningless. The PEG
ratio does not adjust for varying levels of risk among stocks and views stocks with lower PEG ratios to be more attractive than stocks
with higher PEG ratios.
Which of the following are advantages of using EV/EBITDA?
ᅞ A) EV/EBITDA ignores how different revenue recognition policies affect CFO.
ᅞ B) If working capital is growing, EBITDA will be larger than CFO.

ᅚ C) EBITDA is useful for valuing capital-intensive businesses with high levels of depreciation and
amortization.
Explanation
EBITDA is useful for valuing capital-intensive businesses with high levels of depreciation and amortization. The other statements are
disadvantages to using EV/EBITDA.
If cash flow from operations (CFO) embeds financing-related flows, it should be adjusted by:
ᅞ A) subtracting capital expenditures.
ᅚ B) adding (net interest outflow) × (1 - tax rate).
ᅞ C) subtracting (net interest outflow) × (1 - tax rate).
Explanation
Cash flow from operations CFO should be adjusted to CFO + (net cash interest outflow) × (1 - tax rate), if CFO embeds financing-related
flows.

Shares outstanding 40 million

Taxes Sf 52 million
The EV/EBITDA multiple for TRK Construction is closest to:
ᅚ A) 3.69x.
ᅞ B) 4.12x.
ᅞ C) 2.47x.
Explanation

EV = (25 × 40) + 130 - 65 - 250 = Sf 815 million
EV / EBITDA = 3.69
At a CFA society function, Robert Chan comments to Li Chiao that Xanedu Industries' expected dividend growth rate is 5.5%, dividend
payout ratio (g) is 40%, and required return on equity (r) is 12%. Based on a justified leading P/E ratio compared to an actual P/E ratio of
8.0, Xanedu Industries is most likely:
ᅞ A) correctly valued.
ᅞ B) undervalued.
ᅚ C) overvalued.
Explanation
Justified Leading P/E = payout ratio / (r − g). When the expected dividend growth is 5.5%, the justified leading P/E = 0.40 / (0.12 − 0.055)
= 6.15. This is less than the actual (based on current market price) P/E of 8.0.
ᅞ A) 7.65.
ᅞ B) 11.43.
ᅚ C) 10.14.
Explanation
Predicted P/E = 7.65 + (3.75 × 0.55) + (15.35 × 0.07) − (0.70 × 0.92) = 10.14
P/E multiples are often computed using the average of the multiples of comparable firms, because:
ᅚ A) it is conceptually very straightforward.
ᅞ B) it provides the most accurate results.
ᅞ C) it is very easy to find comparable firms that have the same business mix and risk and growth
profiles.
Explanation
The use of comparable firms is quite common, because it is conceptually very straightforward. Also, it does not require the analyst to
make specific assumptions regarding growth, risk, and other variables. However, it is often difficult to find comparable firms, since even
within the same industry different firms can have different business mixes and risk and growth profiles.
An argument for using the price-to-earnings (P/E) valuation approach is that:
ᅞ A) earnings can be negative.
ᅚ B) research shows that P/E differences are significantly related to long-run average stock
returns.
ᅞ C) earnings volatility facilitates interpretation.
Explanation
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.
Herb McClain tells Cammy Oren that Kline Industries' expected dividend growth rate is 4.0%, ROE is 14%, and required return on equity
(r) is 10%. Based on a justified P/B ratio compared to a P/B ratio (based on market price per share) of 1.55, Kline Industries is most
likely:
ᅞ A) overvalued.
ᅞ B) correctly valued.
ᅚ C) undervalued.
Explanation
Justified P/B = (ROE − g) / (r − g). When the expected dividend growth is 4.0%, the justified P/B = (0.14 − 0.04) / (0.10 − 0.04) = 1.67.
This is greater than the P/B (at market) of 1.55.
Enhanced Systems, Inc., (ESI) has a leading price to sales (P/S) of 0.18 while the median leading P/S of a peer group of companies
within the industry is 0.10. Based on the method of comparables, an analyst would most likely conclude that ESI should be:
ᅚ A) sold or sold short as an overvalued stock.
ᅞ B) bought on margin as an undervalued stock.
ᅞ C) bought as an undervalued stock.
Explanation
The price per dollar of sales is considerably higher than that for the median of the peer group, which implies that it may well be
overvalued.
Which of the following is a disadvantage of using price-to-sales (P/S) multiples in stock valuations?
ᅞ A) P/S multiples are more volatile than price-to-earnings (P/E) multiples.
ᅞ B) It is difficult to capture the effects of changes in pricing policies using P/S ratios.
ᅚ C) The use of P/S multiples can miss problems associated with cost control.
Explanation
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.
Which of the following is a disadvantage of using the price-to-book value (PBV) ratio?
ᅞ A) Book value may not mean much for manufacturing firms with significant fixed costs.
ᅞ B) Firms with negative earnings cannot be evaluated with the PBV ratios.
ᅚ C) Book values are affected by accounting standards, which may vary across firms and
countries.
Explanation
The disadvantages of using PBV ratios are:
1. Book values are affected by accounting standards, which may vary across firms and countries.
2. Book value may not mean much for service firms without significant fixed costs.
3. Book value of equity can be made negative by a series of negative earnings, which limits the usefulness of the variable.
A justified price multiple is the:
ᅞ A) multiple implied by the market price.
ᅚ B) warranted or intrinsic price multiple.
ᅞ C) multiple implied by historical growth.
Explanation
A justified price multiple is the warranted or intrinsic price multiple. It is the estimated fair value of that multiple.
The observation that negative price to earnings (P/E) ratios are meaningless and prices are never negative is used to justify which
valuation approach?
ᅚ A) Earnings yield.
ᅞ B) Dividend yield.
ᅞ C) Dividend discount model.
Explanation
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.
An increase in financial leverage will cause the trailing price-to-earnings (P/E) multiple to:
ᅚ A) decrease.
ᅞ B) increase.
Explanation
An increase in financial leverage will cause the required rate of return to increase, thereby decreasing the P/E. This is clear in the
expression for trailing P/E:
P0 / E0 = [(1 - b)(1 + g)] / (r - g)
(Note: the topic review does not allow for any interactive relationship between leverage, return on equity (ROE), and growth. Thus, no
explicit consideration is given to whether the increase in leverage would increase ROE and therefore growth through the g = (ROE ×
retention) relationship.)
The relative valuation model known as the PEG ratio is equal to:
ᅞ A) earnings per share growth rate / price-to-earnings.
ᅞ B) P/E × earnings.
ᅚ C) price-to-earnings (P/E) / earnings per share (EPS) growth rate.
Explanation
The PEG ratio is equal to the price-to-earnings ratio divided by the EPS growth rate.
Which of the following factors is NOT a source of differences in cross-border valuation comparisons?
ᅞ A) Growth opportunities.
ᅚ B) Intra-country market indicators.
ᅞ C) Cultures.
Explanation
Intra-country market indicators are not, by definition, cross-border.
Which of the following statements about the method of comparables in price multiple valuation is CORRECT?
ᅞ A) It assumes that cash flows are related to fundamentals.
ᅚ B) It values an asset relative to a benchmark value of the multiple.
ᅞ C) It relates multiples to company fundamentals using a discounted cash flow (DCF) model.
Explanation
The method of comparables involves using a price multiple to evaluate whether an asset is valued properly relative to a benchmark value
of the multiple. It makes no explicit assumptions about fundamentals and does not rely on a DCF model.
A firm's return on equity (ROE) is 14%, its required rate of return is 10%, and its expected growth rate is 8%. What is the firm's justified
price-to-book value (P/B) based on these fundamentals?
ᅚ A) 3.00.
ᅞ B) 2.75.
ᅞ C) 2.00.
Explanation
The firm's justified price-to-book value = (ROE - g) / (r - g) = (0.14 - 0.08) / (0.10 - 0.08) = 3.00
An increase in return on equity (ROE) will cause a price-to-book (P/B) multiple to:
ᅚ A) increase.
ᅞ B) decrease.
Explanation
An increase in ROE should increase the price to book (P/B) ratio:
P0 / B0 = (ROE - g) / (r - g)
Lucas Davenport, CFA, has been assigned the task of doing a valuation analysis of Sanford Systems Inc. Sanford is currently trading at
$15 per share. Exhibits 1 and 2 present a summary of Sanford's financial statements for 2007 and 2008.
Davenport has previously completed a FCFE valuation, which yielded a value of $11.18 per share based on FCFE per common share in
2008 of $0.85.
Exhibit 1: Sanford Systems Balance Sheets as of 12/31/2008 (in US$ millions)
2007 2008
Cash and equivalents $325 450
Accounts receivable 850 870
Inventory 1,000 1,050
Total current assets $2,175 $2,370
Gross fixed assets 13,600 15,900
Accumulated depreciation 2,300 2,900
Net fixed assets 11,300 13,000
Total assets $13,475 $15,370
Accounts payable $1,500 $1,520
Notes payable 300 550
Accrued taxes and expenses -------- --------
Total current liabilities $1,800 $2,070
Long-term debt $5,575 $6,111
Common stock 100 100
Additional paid-in capital -------- --------
Retained earnings 6,000 7,089
Total shareholders' equity $6,100 $7,189
Total liabilities and shareholders' equity $13,475 $15,370
Exhibit 2: Sanford Systems Income Statements for 2007 and 2008 (in US$ millions)
2007 2008
Total revenues $12,000 $13,100
Operating costs and expenses 9,400 9,600
EBITDA $2,600 $3,500
Depreciation and amortization 500 600
EBIT $2,100 $2,900
Interest expense 500 585
Income before taxes $1,600 $2,315
Taxes (40%) 640 926
Net income $960 $1,389
Dividends $280 $300
Change in retained earnings $680 $1,089
EPS $1.92 $2.78
DPS $0.56 $0.60
# of shares outstanding (millions) 500 500
Davenport determines that the company follows IFRS rules, and compiles the following industry price-to-adjusted (per share) CFO data,
where adjusted CFO is equal to cash flow from operations from the statement of cash flows plus after-tax cash interest expense.
Exhibit 3: Industry Data

Trailing Beta Consensus 5-Year
P/Adjusted CFO per share Earnings Growth
Industry Median 2.0x 1.20 9.9%
Sanford 1.25 9.2%
Davenport would also like to make international price multiple comparisons and is contemplating using one or more of the following ratios:
price-to-sales, price-to-earnings, price-to-book, price-to-adjusted cash flow from operations, and enterprise value-to-EBITDA.
Davenport decides to use a single-stage residual income model to estimate the value of Sanford, in addition to the FCFE framework he
used earlier. He estimates Sanford's long-term perpetual growth rate in residual income at 5 percent, its return on new investments to be
20 percent, weighted average cost of capital to be 10.4 percent based on the target debt-to-asset ratio, and the required return on equity to
be 14 percent.
Finally, Davenport solves the following equation for T, given the other inputs (where the index is the S&P 500), and determines that T =
3.6.
Sanford's economic value added (EVA®) for 2008 is closest to:
ᅚ A) $356.80
ᅞ B) $567.80
ᅞ C) $1,383.20
Explanation
EVA is equal to net operating profit after tax (NOPAT) minus the dollar weighted average cost of capital ($WACC).
NOPAT = EBIT(1 + t) = $2,900(1 − 0.4) = $1,740

Invested capital = LTD + SH equity = $6,111 + $7,189 = $13,300
$WACC = $13,300 × 0.104 = $1,383.20
EVA = $1,740 − $1,383.20 = $356.80
(Study Session 12, LOS 38.a)
Based on a comparison of the actual trailing P/FCFE ratio compared to the justified trailing P/FCFE ratio (based on Davenport's FCFE
valuation model) for 2008, Sanford is:
ᅚ A) overvalued because the actual P/FCFE ratio is greater than the justified P/FCFE ratio for
2008.
ᅞ B) undervalued because the actual P/FCFE ratio is less than the justified P/FCFE ratio for 2008.
ᅞ C) correctly valued because the actual P/FCFE ratio is equal to the justified P/FCFE ratio for
2008.
Explanation
Sanford's actual P/FCFE ratio is the current market price of $15 divided by FCFE for 2008:
The justified P/FCFE ratio is the value derived from the FCFE valuation model ($11.18) divided by FCFE for 2008:
Based on this analysis, Sanford is overvalued on an absolute basis (NOT relative to the industry benchmark) because the actual P/FCFE
ratio is greater than the justified P/FCFE ratio. (Study Session 10, LOS 31.b)
Based on a comparison of the actual trailing P/adjusted CFO ratio compared to the industry median trailing P/adjusted CFO per share
ratio for 2008, Sanford:
ᅚ A) is overvalued relative to the industry benchmark because Sanford's P/adjusted CFO
ratio is higher than the industry median, despite slightly higher systematic risk and
lower 5-year earnings growth.
ᅞ B) may be undervalued relative to the industry benchmark because Sanford's P/adjusted CFO
ratio is higher than the industry median, despite slightly higher systematic risk and lower 5-
year earnings growth.
ᅞ C) is correctly valued relative to the industry benchmark because Sanford's P/adjusted CFO ratio
is equal to the industry median, despite slightly higher systematic risk and lower 5-year
earnings growth.
Explanation
Sanford's adjusted CFO is equal to net income plus depreciation minus the increase in net working capital (excluding cash and notes
payable) plus after-tax interest expense:
Sanford is overvalued relative to the industry benchmark because its P/adjusted CFO ratio is higher than the industry median of 2.0,
despite slightly higher systematic risk (as measured by beta) and a lower 5-year earnings growth forecast. (Study Session 12, LOS 37.m)
Which of the following market multiples is most appropriate for Davenport to use in international valuation comparisons?
ᅚ A) Price-to-adjusted CFO.
ᅞ B) Price-to-sales.
ᅞ C) Enterprise value-to-EBITDA.
Explanation
Using relative valuation methods that require the use of comparable firms is challenging in an international context due to differences in
accounting methods, cultures, risk, and growth opportunities. Further, benchmarking is difficult because price multiples for individual firms
in the same industry vary widely internationally, and country market price multiples can vary significantly. Common differences in
international accounting treatment fall into several categories: goodwill, deferred income taxes, foreign exchange adjustments, R&D,
pension expense, and tangible asset revaluations.
The usefulness of all price multiples is affected to some degree by differences in international accounting standards. The least affected
are price-to-cash flow ratios (including P/adjusted CFO), while P/B, P/E, P/S, P/EBITDA, and EV/EBITDA will be more seriously affected
because they are more affected by management's choice of accounting methods and estimates. (Study Session 12, LOS 35.o)
The value per share of Sanford's common equity, based on a single-stage residual income model, is closest to:
ᅚ A) $23.96.
ᅞ B) $21.24.
ᅞ C) $22.44.
Explanation
Book value per share for 2008 is:
The value of the common equity according to the single-stage residual income model is:
(Study Session 12, LOS 38.f)
For purposes of this question only, assume Sanford's ROE is 20%, its current market price is $25, and the cost of equity is 14%.
Sanford's implied growth rate in residual income is closest to:
ᅞ A) 5.23%.
ᅞ B) 5.11%.
ᅚ C) 5.88%.
Explanation
BVPS = 7,189 / 500 = $14.38
The implied growth rate can be calculated as:
(Study Session 12, LOS 38.g)
What is the justified leading price-to-earnings (P/E) multiple of a stock that has a retention ratio of 60% if the shareholders require a return
of 16% on their investment and the expected growth rate in dividends is 6%?
ᅞ A) 6.36.
ᅚ B) 4.00.
ᅞ C) 4.24.
Explanation
Justified Leading P/E = P0/E1 = 1 − b / r − g = Payout ratio / r − g = 0.40 / (0.16 − 0.06) = 4.00
The goal of normalizing earnings is to adjust for:
ᅞ A) non-cash charges.
ᅚ B) cyclical elements.
ᅞ C) seasonal elements.
Explanation
The goal of normalizing earnings is to adjust for cyclical elements.
An increase in profit margin will cause a price-to-sales (P/S) multiple to increase if:
ᅚ A) the growth rate in sales does not decrease proportionately.
ᅞ B) the required rate of return increases.
Explanation
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)
The trailing price-to-earnings (P/E) ratio is defined as:
ᅞ A) price to next period's expected earnings.
ᅞ B) the average P/E over the last five years.
ᅚ C) price to most recent earnings.
Explanation
The trailing P/E ratio is price to most recent realized earnings.
The average return on equity (ROE) earnings normalization method relies on:
ᅞ A) average earnings per share (EPS) over the most recent cycle.
ᅚ B) average ROE over the most recent cycle.
ᅞ C) the earnings yield.

Explanation
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.
An analyst begins an equity analysis of Company A by noting the following ratios from three companies in the same industry:
EPS PE
Company A $1.60 10.0

Company B $2.10 12.5
Company C $5.80 13.0
This analyst is most likely using:
ᅞ A) the method of forecasted fundamentals.
ᅚ B) the method of comparables.
ᅞ C) technical analysis.
Explanation
The analysis is comparing ratios of three companies in the same industry. The Law of One Price states that similar assets should have
comparable prices.
Beachwood Builders merged with Country Point Homes on December 31, 2003. Both companies were builders of mid-scale and luxury
homes in their respective markets. On December 31, 2013, 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, 2013.
Beachwood paid no dividends and has no preferred shareholders.
Country Point's free cash flow (FCF) is expected to grow 7% after 2017.
The current risk-free rate is 6%. The market risk premium is 11%.
Beachwood Builders had 5 million common shares as of December 31, 2013.
Country Point's cost of capital is equal to its return on equity at year-end (rounded to the nearest percentage point).
Country Point did not have any long-term debt allocated from Beachwood.
The following data for Country Point is also available for analysis
$ (in millions) 2013 2014(E) 2015(E) 2016(E) 2017(E)

Net Income 10 15 20 25 30
Depreciation 5 6 5 6 5
Change in Capital Expenditures 7 8 9 10 12

Change in Working Capital 0 0 0 0 0
There are three comparable companies in Country Point's peer group: Upscale Homes, Custom Estates and Chateau One.
Five-Year EPS
Company Forward P/E Forward PEG
Growth Forecast
Upscale Homes 10.0 12.5% 0.80
Custom
15.0 15.0% 1.00
Estates
Chateau One 20.0 17.5% 1.14
Bernheim's investment bankers have determined the value of Country Point to be $162.6 million. As part of the spin-off, Beachwood
issued to its common shareholders two shares in Country Point for each Beachwood share that its current shareholders held. The
appropriate initial offering price per share of the shares that Beachwood's shareholders receive is closest to:
ᅞ A) $32.50.
ᅞ B) $14.45.
ᅚ C) $16.26.
Explanation
Since the shareholders receive two shares for every share they currently hold, each Beachwood common shareholder will receive two
common shares of Country Point. At December 31, 2013, Beachwood had 5 million shares. Therefore, 10 million common shares were
issued for the spin-off. The spin-off was valued at $162.6 million; dividing by 10 million, we arrive at a spin-off value per share of $16.26 (=
$162.6 million / 10 million).
(LOS 29.k)
Immediately after the spin-off, Country Point's book value per share is closest to:
ᅞ A) $11.12.
ᅚ B) $5.56.
ᅞ C) $16.25.
Explanation
The allocated common equity or book value of Country Point was $55.6 million at year-end 2013 and 10 million shares were allocated for
the spin-off. The book value would be $55.6 million / 10 million = $5.56 per share.
(LOS 37.d)

Assume for this question that the initial offering price per share of the Country Point shares is $16.26. Based on this initial offering price of
the spin-off, the estimated price-to-book (P/B) ratio of Country Point is closest to:
ᅞ A) 2.00 times.
ᅚ B) 2.92 times.
ᅞ C) 1.46 times.
Explanation
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 $16.26 per
share spin-off price / $5.56 BVPS = 2.92 × book.
(LOS 37.d)
Based on Bernheim's careful analysis, firms comparable to Country Point trade at a P/B ratio of 3.5 times. The expected price per share
of the spin-off based on this P/B ratio and assuming a liquid and efficient market for Country Point's common shares is closest to:
ᅞ A) $38.92.
ᅞ B) $56.88.
ᅚ C) $19.46.
Explanation
Based on the comparable P/B ratio of 3.5 times, we can simply multiply the book value of $5.56 by 3.5 to arrive at $19.46.
(LOS 37.d)
Imagine that the current market price of Country Point at December 31, 2013 is $20.00 per share. If the average trailing P/E for luxury
home builders is 15x, Country Point is most accurately described as:
ᅞ A) undervalued.
ᅚ B) overvalued.
ᅞ C) fairly valued.
Explanation
The earnings per share is $10 million/10 million shares = $1.00 per share. The trailing P/E for Country Point is $20.00 per share divided by
$1.00 EPS which equals 20x. Relative to the industry the Country Point's trailing P/E is higher. Assuming no differences in fundamentals
among Country Point's peers, this comparison suggests that Country Point is overvalued at a market price of $20.00.
(LOS 37.r)
Imagine that the current market price for Country Point is $20.00 and the firm's estimated five-year earnings growth rate is 15.0%. The two
most attractive companies among the four peer companies based on price-earnings-growth ratio (PEG) as of December 31, 2013 are:
ᅞ A) Chateau One and Country Point.
ᅞ B) Custom Estates and Chateau One.
ᅚ C) Upscale Homes and Country Point.
Explanation
Country Point's forward earnings per share is $15 million/10 million shares = $1.50 per share. The forward P/E for Country Point is $20.00
per share divided by $1.50 EPS which equals 13.3x. The forward PEG is 13.3x divided by 15 which equals 0.89. PEG ratios less than one
are an indicator of an attractive company. The two companies with the lowest PEG ratios are Upscale Homes and Country Point, both
company's ratios are less than 1.
(LOS 35.k)
Which of the following is NOT a common momentum valuation indicator?
ᅚ A) Dividend yield.
ᅞ B) Earnings surprise.
ᅞ C) Relative strength.
Explanation
Dividend yield is not generally considered a momentum valuation indicator.
What is the appropriate justified trailing price-to-earnings (P/E) multiple of a stock that has a payout ratio of 40% if shareholders require a
return of 15% on their investment and the expected growth rate in dividends is 5%?
ᅚ A) 4.20.
ᅞ B) 3.80.
ᅞ C) 6.30.
Explanation
P0/E0 = (0.40 × 1.05) / (0.15 - 0.05) = 4.20
A firm's return on equity (ROE) is 15%, its required rate of return is 12%, and its expected growth rate is 7%. What is the firm's justified
price to book value (P/B) based on these fundamentals?
ᅞ A) 1.71.
ᅞ B) 0.63.
ᅚ C) 1.60.
Explanation
P0/B0 = (ROE - g) / (r - g) = (0.15 - 0.07) / (0.12 - 0.07) = 1.60
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 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?
ᅞ A) Yes, Xanedu's justified leading P/E ratio will increase by approximately 0.5%.
ᅞ B) No, Xanedu's justified leading P/E ratio will increase by approximately 7.8%.
ᅚ C) No, Xanedu's justified leading P/E ratio will decrease by approximately 7.8%.
Explanation
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.
The value of a firm, calculated using the discounted cash flow (DCF) method, will be closest to the valuation using P/E multiples when
P/E multiples are estimated using:
ᅞ A) historical P/E multiples.
ᅚ B) fundamental data.
ᅞ C) P/E multiples of comparable firms.
Explanation
In the DCF valuation method, an analyst makes specific assumptions about each variable, such as growth, risk, payout, etc. The
valuation using P/E multiples will be closest to the one obtained using the DCF approach when fundamental data -- for growth, risk,
payout, etc. -- is used to estimate P/E multiples.
ᅞ A) sold or sold short as an overvalued stock.
ᅞ B) bought as an undervalued stock.
ᅚ C) viewed as a properly valued stock.

Explanation
The price per dollar of earnings is the same as that for the median of the peer group, which implies that it is likely properly valued.
For which of the following firms is the Price/Earnings to Growth (PEG) ratio most appropriate for identifying undervalued or overvalued
equities?
Firm A: Expected dividend growth = 6%; Cost of equity = 12%; price-to-earnings (P/E) = 12.
Firm B: Expected dividend growth = −6%; Cost of equity = 12%; price-to-earnings (P/E) = 12.
Firm C: Expected dividend growth = 1%; Cost of equity = 12%; price-to-earnings (P/E) = 12.
ᅞ A) Firm B.
ᅞ B) Firm C.
ᅚ C) Firm A.
Explanation
The formula for the PEG ratio is: PEG = (P/E) / g. It measures the tradeoff between P/E and expected dividend growth (g). For traditional
growth firms, PEG ratios fall between 1 and 2. The general rule is that PEG ratios above 2 are indicative of overvalued firms (expensive),
and PEG ratios below 1 are indicative of firms that are undervalued (cheap).
Firm A: PEG = 2, indicating a stock that is appropriately priced.
Firm B: The PEG ratio of firms with negative expected dividend growth is negative, which is
meaningless. For Firm B, PEG = -2.
Firm C: Firms with very low expected dividend growth are likely to have PEG ratios that
unrealistically indicate overvalued stocks. For Firm C, PEG = 12.
An increase in return on equity (ROE) will cause a price-to-earnings (P/E) multiple to:
ᅞ A) decrease.
ᅞ B) there is insufficient information to tell.
ᅚ C) increase.
Explanation
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.
Robert Chan comments to Leslie Singer that Converted Industries' expected dividend growth rate is 5.0%, dividend payout ratio (g) is
45%, and required return on equity (r) is 10%. Based on a justified trailing P/E ratio compared to the stock's trailing P/E ratio at market of
9.0, Converted Industries is most likely:
ᅚ A) undervalued.
ᅞ B) overvalued.
ᅞ C) correctly valued.
Explanation
Justified trailing P/E = payout ratio * (1 + g) / (r − g). When the expected dividend growth is 5.0%, the justified trailing P/E = 0.45 * (1 +
0.05) / (0.10 − 0.05) = 9.45. This is greater than the market P/E of 9.0.
The multiple indicated by applying the discounted cash flow (DCF) model to a firm's fundamentals is necessarily the:
ᅞ A) result of calculating retention/(required rate of return - growth) for the overall market.
ᅞ B) same as the average industry multiple.
ᅚ C) justified price multiple.
Explanation
A justified price multiple is the warranted or intrinsic price multiple. It is the estimated fair value of that multiple. The question is limited to
an individual firm and does not necessarily apply to the market or an industry.
A method commonly used to normalize earnings is the method of:
ᅚ A) historical average earnings per share (EPS).
ᅞ B) average return on assets.
ᅞ C) comparables.
Explanation
A common method in normalizing earnings uses the historical average EPS.
Glad Tidings Gifts (GTG) recently reported 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?
ᅚ A) 19.69.
ᅞ B) 25.51.
ᅞ C) 22.22.
Explanation
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.
A common price to earnings (P/E) based method for estimating terminal value in multi-stage models is the:
ᅞ A) dividend yield approach.
ᅚ B) fundamentals approach.
ᅞ C) P/E to growth (PEG) approach.
Explanation
It is common to restate the Gordon growth model price as a multiple of expected future book value per share or earnings per share (EPS).
What is the appropriate leading price-to-earnings (P/E) multiple of a stock that has a projected payout ratio of 40% if shareholders require
a return of 15% on their investment and the expected growth rate in dividends is 5%?
ᅞ A) 13.20.
ᅞ B) 6.30.
ᅚ C) 4.00.
Explanation
P0/E0 = 0.40 / (0.15 - 0.05) = 4.00
Note that the leading P/E omits (1 + g) in the numerator, which is present in the formula for the trailing P/E.
The following data was available for Morris, Inc., for the year ending December 31, 2001:
Sales per share = $150.
Earnings per share = $1.75.
Return on Equity (ROE) = 16%.
Required rate of return = 12%.
If the expected growth rate in dividends and earning is 4%, what will the appropriate price-to-sales (P/S) multiple be for Morris?
ᅞ A) 0.109.
ᅞ B) 0.037.
ᅚ C) 0.114.
Explanation
Profit Margin = EPS / Sales per share = 1.75 / 150 = 0.01167 or 1.167%.
Payout ratio = 1 − (g / ROE) = 1 − (0.04 / 0.16) = 0.75 or 75%.
P0 / S0 = [profit margin × payout ratio × (1 + g)] / (r − g) = [0.01167 × 0.75 × 1.04] / (0.12 − 0.04) = 0.11375.

Shares outstanding 40 million

Taxes Sf 56 million
The EV/EBITDA ratio for TRK Construction is closest to:
ᅚ A) 3.12x.
ᅞ B) 2.52x.
ᅞ C) 3.49x.
Explanation
EV = (22 × 40) + 140 - 55 - 300 = Sf 665 million
EV / EBITDA = 3.12

05 Market-Based Valuation - P... Nterprise Value Multiples

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Market-Based Valuation: Price and Enterprise Value Multiples

Test ID: 7441438

Question #1 of 140 Question ID: 463339

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

ᅞ A) management discretion increases the reliability of the ratio.

ᅞ B) earnings can be negative.

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

Question #2 of 140 Question ID: 463406

An analyst has gathered the following data about Jackson, Inc.:

Return on equity (ROE) = g / (1 − payout ratio) = 0.067 / 0.40 = 0.1675 or 16.75%.

Question #3 of 140 Question ID: 463438

ᅚ C) No, because the PEG ratio is undefined for zero-growth companies.

Question #4 of 140 Question ID: 463330

ᅚ A) the method of forecasted fundamentals.

Question #5 of 140 Question ID: 463433

ᅞ A) Yes, because the expected earnings-growth rate is cancelled out in the

Question #6 of 140 Question ID: 463397

Question #7 of 140 Question ID: 463420

ᅚ A) bought as an undervalued stock.

ᅞ B) sold short as an overvalued stock.

ᅞ C) sold as an overvalued stock.

Question #8 of 140 Question ID: 463441

ᅚ A) total company value.

Question #9 of 140 Question ID: 463413

P5 / E5 = (0.50 × 1.05) / (0.12 − 0.05) = 7.50

Whelan: "People can't even agree how to calculate your ratio."

Which valuation metric do the analysts most likely prefer?

ᅞ B) Price/cash flow Price/book

ᅚ C) Price/sales Price/cash flow

Question #11 of 140 Question ID: 463410

CVR, Inc. High Margin / Low Volume 20% 8% 1.25

CVR, Inc. Low Margin / High Volume 20% 2% 4.00

If profit margin is based on the expected earnings next period,

Question #12 of 140 Question ID: 463337

The warranted or intrinsic price multiple is called the:

ᅞ A) multiple implied by historical growth.

ᅚ B) justified price multiple.

ᅞ C) multiple implied by the market price.

Question #13 of 140 Question ID: 463407

CVR, Inc. High Margin / Low Volume 20% 8% 1.25

CVR, Inc. Low Margin / High Volume 20% 2% 4.00

If profit margin is based on the expected earnings next period,

Question #14 of 140 Question ID: 463445

An analyst gathers the following information for ABC Industries:

Market Value of Debt $110 million

Market Value of Equity $90 million

Book Value of Debt $100 million

The EV/EBITDA is closest to:

Question #15 of 140 Question ID: 463400

Question #16 of 140 Question ID: 463371

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

Question #17 of 140 Question ID: 463418

ᅞ A) bought as an undervalued stock.

ᅞ B) viewed as a properly valued stock.

ᅚ C) sold or sold short as an overvalued stock.

Questions #18-23 of 140

Question #18 of 140 Question ID: 463347

Which analyst's quote is least accurate?

Question #19 of 140 Question ID: 463348