CFA Level 1 - Equity Investments Session 14 - Reading 60 Equity Valuation: Concepts and Basic Tools-LOS k (Notes, Practice Questions, Sample Questions) 1. Regarding the estimates required in the constant growth dividend discount model, which of the following statements ismost accurate? A) Dividend forecasts are less reliable than estimates of otherinputs. B) The model is most inﬂuenced by the estimates of "k" and "g." C) The variables "k" and "g" are easy to forecast. [Explanation: B — The relationship between "k" and "g" iscritical - small changes in the di erence between these twovariables results in large value ﬂuctuations] 2. Which of the following is least likely an advantage of using price/sales (P/S) multiple? A) P/S multiples provide a meaningful framework for evaluatingdistressed ﬁrms. B) P/S multiples are more reliable because sales data cannot be distorted by management. C) P/S multiples are not as volatile as P/E multiples and hencemay be more reliable in valuation analysis.
[Explanation: B — Accounting data on sales is used to calculatethe P/S multiple. The P/S multiple is thought to be more reliablebecause sales ﬁgures are not as easy to manipulate as theearnings and book value, both of which are signiﬁcantlya ected by accounting conventions. However, it is not true that"sales data cannot be distorted by management" becauseaggressive revenue recognition practices can inﬂuence reportedsales] 3. Which of the following is NOT an advantage of using price-to-book value (PBV) multiples in stock valuation? A) Book values are very meaningful for ﬁrms in serviceindustries. B) Book value is often positive, even when earnings are negative. C) PBV ratios can be compared across similar ﬁrms if accountingstandards are consistent. [Explanation: B — Book values are NOT very meaningful forﬁrms in service industries] 4. One advantage of price/sales (P/S) multiples over price to earnings (P/E) and price-to-book value (PBV) multiples is that: A) P/S is easier to calculate. B) P/S can be used for distressed ﬁrms. C) Regression shows a strong relationship between stock pricesand sales. [Explanation: B — Unlike the PBV and P/E multiples, which canbecome negative and not meaningful, the price/sales multiple is
meaningful even for distressed ﬁrms (that may have negativeearnings or book value)] 5. An argument against using the price to cash ﬂow (P/CF) valuation approach is that: A) non-cash revenue and net changes in working capital are ignored when using earnings per share (EPS) plus non-cash chargesas an estimate. B) cash ﬂows are not as easy to manipulate or distort as EPS andbook value.C) price to cash ﬂow ratios are not as volatile asprice-to-earnings (P/E) multiples. [Explanation: A — Items a ecting actual cash ﬂow fromoperations are ignored when the EPS plus non-cash chargesestimate is used. For example, non-cash revenue and netchanges in working capital are ignored. Both remainingresponses are arguments in favor of using the price to cash ﬂowapproach] 6. An argument against using the price-to-earnings (P/E) valuation approach is that: A) research shows that P/E di erences are signiﬁcantly related tolong-run average stock returns.B) earnings power is the primary determinant of investmentvalue. C) earnings can be negative
[Explanation: C — Negative earnings render the P/E ratiouseless. Both remaining factors increase the usefulness of theP/E approach] 7. An argument against using the price-to-sales (P/S) valuation approach is that: A) P/S ratios are not as volatile as price-to-earnings (P/E)multiples.B) sales ﬁgures are not as easy to manipulate or distort asearnings per share (EPS) and book value. C) P/S ratios do not express di erences in cost structures across companies. [Explanation: C — P/S ratios do not express di erences in coststructures across companies. Both remaining responses areadvantages of the P/S ratios, not disadvantages] 8. Which of the following is a disadvantage of using the price-to-book value (PBV) ratio? A) Book value may not mean much for manufacturing ﬁrms withsigniﬁcant ﬁxed costs.B) Firms with negative earnings cannot be evaluated with thePBV ratios. C) Book values are a ected by accounting standards, which may vary across ﬁrms and countries. [Explanation: C — The disadvantages of using PBV ratios are:Book values are a ected by accounting standards, which mayvary across ﬁrms and countries.
Book value may not mean much for service ﬁrms withoutsigniﬁcant ﬁxed costs.Book value of equity can be made negative by a series ofnegative earnings, which limits the usefulness of the variable.] 9. One advantage to using the price/book value (P/B) ratio over using the price/earnings (P/E) ratio is that P/B can be used when: A) earnings or cash ﬂows are negative. B) stock markets are volatile.C) the ﬁrm is in a slow growth phase. [Explanation: A — When earnings are negative, P/E ratioscannot be used but P/B ratios can be used. The ﬁrm's rate ofgrowth and the volatility of markets do not suggest advantagesof using P/B ratios rather than P/E ratios]