Chapter 15

COMPANY ANALYSIS

Multiple Choice Questions

Overview

1. The last step in fundamental analysis is:

a. economic analysis
b. industry analysis
c. company analysis
d. technical analysis

(c, easy)

Fundamental Analysis

2. Which of the following is not one of the relative valuation multipliers

used in fundamental analysis?

a. P/E ratio
b. P/S ratio
c. P/M ratio
d. P/B ratio

(c, easy)

3. When analyzing stocks, the major variable of interest to a majority of

investors is:

a. sales.
b. profit margins.
c. dividend yield.
d. earnings per share.

(d, moderate)

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 The Accounting Aspects of Earnings

4. EPS are of higher quality if:

a. the company is a blue chip.

b. the auditor's reputation is high.
c. they were derived using conservative principles.
d. FASB has approved them.

(c, moderate)

5. Which of the following are shown on the balance sheet on a cost or

market value?

a. cash
b. stockholders equity
c. marketable securities
d. fixed assets

(d, moderate)

6. Which of the following statements regarding retained earnings is not true?

a. It is part of stockholders equity.

b. It represents spendable funds for a company.
c. It designates that part of previous earnings not paid out as dividends.
d. All of the above statements are true.

(b, moderate)

7. The auditor's report:

a. guarantees accuracy.
b. guarantees the quality of the earnings.
c. attests that the statements are a fair presentation of financial position.
d. all of the above are true

(c, moderate)

8. Which of the following terms best describes the shareholder's equity item
of the balance sheet?

a. Book value
b. Market value
c. Current value
d. Stock value

(a, moderate)

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 9. In which of the following sections of a balance sheet are "Inventories"
listed?

a. Current assets
b. Property, plant and equipment, at cost
c. Current liabilities
d. Shareholders' Equity

(a, easy)

10. How is EPS computed? After-tax net income divided by

a. current common shares outstanding.

b. previous years common shares outstanding.
c. treasury shares outstanding.
d. average common shares outstanding.

(d, moderate)

11. The generally accepted accounting principles (GAAP) require that the
EPS be calculated using a

a. conservative treatment.
b. liberal treatment.
c. standard set of rules developed by the accounting profession.
d. standard set of rules developed by the SEC.

(c, easy)

12. The key item for investors on the income statement is:

a. sales.
b. gross profit.
c. operating expenses.
d. after-tax net income.

(d, moderate)

13. Earnings derived under GAAP and shown on the income statement is
known as:

a. reported earnings.
b. certified earnings.
c. audited earnings.
d. verified earnings.

(a, moderate)

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 14. Which of the following is not one of the parts of the cashflow statement?

a. cashflow from operating activities.

b. cashflow from sales activities.
c. cashflow from investing activities.
e. cashflow from financing activities.

(b, moderate)

15. Which of the following mandated that companies, starting in 2004, must
submit an annual report to the SEC outlining the effectiveness of their
internal accounting controls?

a. SEC Amendments Act

b. SIPC
c. Glass-Stegall Act
d. Sarbanes-Oxley Act

(d, easy)

16. Which of the following represents the rate at which a company can grow
from internal sources?

a. return on assets
b. sustainable growth rate
c. adjusted EPS
d. return on equity

(b, moderate)

17. Which statement about the quality of reported EPS is FALSE?

a. Earnings quality assessments are difficult to make and require

considerable expertise in accounting and financial analysis.
b. Reported EPS is not the precise figure that it first appears to be.
c. It is necessary to make adjustments to reported EPS figures when
making cross-sectional comparisons.
d. Quality of earnings is generally consistent among companies in the same
industry.

(d, difficult)

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 Analyzing a Companys Profitability

18. One way to calculate EPS is:

a. ROA x Book value per share.

b. ROE x Book value per share.
c. ROA/ Book value per share.
d. ROE/ Book value per share.

(b, moderate)

19. The two components of EPS are

a. ROA and leverage.

b. book value per share and leverage.
c. ROE and book value per share.
d. leverage and profit margin.

(c, difficult)

20. The two components of ROE are

a. ROA and book value per share.

b. ROA and leverage.
c. ROA and profit margin.
d. leverage and book value.

(b, moderate)

21. ROA is the product of

a. net income margin and turnover.

b. book value and turnover.
c. leverage and book value.
d. net income margin and leverage.

(a, moderate)

22. Which of the following statements is true?

a. Turnover is not related to ROA.

b. Leverage affects EPS.
c. ROA is a function of turnover and leverage.
d. EPS is solely a function of ROE

(b, difficult)

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 23. The sustainable growth rate of a firm can be calculated as the product of
the

a. return on assets and the return on equity.

b. dividend payout ratio and leverage.
c. retention rate and the return on equity.
d. net profit margin and total sales.

(c, difficult)

24. If a firm's ROA and ROE are equal, it can be concluded that the firm is

a. losing money.
b. liquid enough to pay some extra dividends.
c. financed by all equity.
d. financed by a high proportion of debt.

(c, moderate)

Earnings Estimate

25. One way to obtain earnings forecasts is the mechanical procedure known
as:

a. cross-reference analysis.
b. exponential trending.
c. time series analysis.
d. data mining.

(c, moderate)

26. Which of the following is true regarding earnings forecasts made by

analysts versus forecasts made by statistical models?

a. The evidence tends to support analysts' forecasts in terms of accuracy over

statistical models.
b. The evidence tends to support statistical models' forecasts in terms of
accuracy over statistical models.
c. The evidence tends to support both types of forecasts equally.
d. The evidence does not support either type of forecast in terms of accuracy.

(a, difficult)

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 27. Which of the following is not true regarding earnings estimates?

a. Some companies provide guidance on forthcoming earnings

announcements.
b. The guidance number plays a major role in the consensus estimate.
c. The variance of actual reported earnings from the consensus had typically
constituted the "whisper" forecast.
d. All of the above are true.

(c, difficult)

The P/E Ratio

28. If the dividend growth rate increases for a firm, its P/E will ---------, other
things the same.

a. increase
b. stay the same
c. decrease
d. increase or decrease but not stay the same

(a, moderate)

29. How would you explain P/E ratio differences among companies? By
investor

a. expectations about the future growth of the market.

b. estimates of the recent growth of earnings.
c. expectations about the future growth of earnings.
d. estimates about the recent growth of dividends.

(c, moderate)

30. If business risk decreases for Megabucks, Inc., the P/E will __________,
other things the same.

a. increase
b. stay the same
c. decrease
d. increase or decrease but not stay the same

(a, difficult)

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 31. Other things equal, if the

a. required rate of return increases, the P/E ratio will rise.

b. risk premium increases, the P/E ratio will rise.
c. risk-free rate rises, the P/E ratio will fall.
d. dividend payout increases, the P/E ratio will fall.

(c, difficult)

32. Other things equal,

a. the higher the expected growth rate, the lower the P/E ratio.
b. if the risk-free rate rises, the required rate will decline.
c. as the required rate rises, the P/E ratio declines.
d. if the risk premium rises, the required rate will fall.

(c, difficult)

33. High P/E stocks are generally associated with

a. mature companies.
b. cyclical companies.
c. young fast-growing companies.
d. defensive companies.

(c, moderate)

Fundamental Security Analysis in Practice

34. In modern investment analysis, the risk for a stock is related to its:

a. leverage factor.
b. standard deviation.
c. beta coefficient.
d. coefficient of variation.

(c, moderate)

35. The largest investment advisory service in the United States is:

a. Standard & Poor's

b. Moody's Industrial Manuals
c. Morningstar
d. Value Line Investment Survey

(d, easy)

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 36. _______ use a computer program in an attempt to imitate the brain in
analyzing securities.

a. Decision trees
b. Program trading
c. Day traders
d. Neural networks

(d, moderate)

True/False Questions

Fundamental Analysis

1. It is not necessary to determine a point estimate of the intrinsic value of a

stock when using relative valuation techniques.

(T, moderate)

The Accounting Aspects of Earnings

2. Accounting adjustments are often called nonrecurring gains or losses or

extraordinary items.

(T, moderate)

3. The auditor's report guarantees the accuracy of the earnings reported in the
financial statements.

(F, moderate)

4. The Securities Investor Protection Act was passed by Congress largely in

response to the accounting scandals involving Enron, WorldCom, Global
Crossing and others.

(F, easy)

5. EBITDA, sometimes called operating profit, is often emphasized by

telecommunications companies because of their lack of real profitability.

(T, moderate)

6. Current plans call for the International Accounting Standards to replace

local accounting rules in European Union countries.

(T, moderate)

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 7. Free cash flow represents money left after all the bill are paid and dividend
payments are made.

(T, easy)

Analyzing a Company's Profitability

8. Leverage can magnify the returns to the stockholders and also reduce the
losses to the stockholders.

(F, moderate)

9. A company may maintain its ROA if the net income margin decreases by
increasing its asset turnover.

(T, moderate)

Earnings Estimates

10. Investors interested in buying stocks which report bad news and suffer a
sharp decline should buy the first day bad news is reported.

(F, difficult)

11. One earnings surprise tends to lead to another earnings surprise.

(T, easy)

12. A favorable earnings surprise occurs when the forecasted earnings are
greater than the actual earnings of a company.

(F, easy)

The P/E Ratio

13. The P/E ratio can be expected to change as the expected dividend payout
ratio changes.

(T, moderate)

14. Other things being equal, as k rises, the P/E ratio will also rise.

(F, moderate)

15. According to Peter Lynch, the P/E ratio of a company that is fairly valued
will equal its expected growth rate.

(T, moderate)

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 Short-Answer Questions

The Accounting Aspects of Earnings

1. What is the relationship of the Financial Accounting Standards Board and

the Securities and Exchange Commission?

(moderate)

Answer: The FASB and the SEC are separate organizations. The FASB is a
self-regulatory body of the accounting profession that sets
accounting standards. The SEC is part of the federal government
that requires companies to disclose financial data presented under
FASBs standards.

2. When an investor buys a share of common stock he/she buys a claim of

ownership. How is this claim represented on the balance sheet?

(moderate)

Answer: The claim is represented by the entire common equity section. The
three most common accounts are common stock, capital paid in
excess of par, and retained earnings. The book value of equity is
calculated from the entire common equity section.

Analyzing A Company's Profitability

3. What is the internal (sustainable) growth rate? How is it calculated?

(moderate)

Answer: The internal growth rate is the growth rate depending on earnings
retention as the only source of new capital. It is calculated as g =
br = (1 payout rate)(ROE).

Earnings Estimates

4. How accurate are professional earnings estimates? Do purely mechanical

models give better results than analysts who add subjective assessment to
the data?

(difficult)

Answer: According to a study by Dreman and Berry, the average annual

error in earnings estimates was 44 percent during the period
studied (1974-1990). Only 25 percent of the consensus estimates
came within plus or minus 5 percent of reported earnings.

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 Analysts consistently beat purely mechanical models. Subjective
assessment of the future is required.

5. What are earnings surprises? How do they affect stock prices?

(moderate)

Answer: Any new information that affects projected earnings creates an

earnings surprise. The SUE model formalizes the surprise factor.
Stock prices react up or down to the surprise.

6. Can an investor that wants to use the approach of projected earnings and
P/Es find help in Value Line?

(easy)

Answer: Yes. In fact Value Line projects EPS, dividends, dividend payout,
growth rates and prices.

The P/E Ratio

7. What three variables affect the P/E ratio? How does each affect it?

(moderate)

Answer: Using the model P/E = (D1/E1)/(k g), the variables are the
dividend payout rate, D1/E1, the required rate of return, k, and the
dividend growth rate, g. If the dividend payout rate increases
(decreases), the P/E increases (decreases), other things the same.
If the required rate of return increases (decreases), the P/E
decreases (increases). If the growth rate increases (decreases), the
P/E increases (decreases).

8. Should an investor seek companies with low P/Es or high P/Es?

(moderate)

Answer: Investors differ in their philosophies. Investors who seek low P/E
companies are value investors. They think that the stocks are
undervalued and will eventually gain full valuation. On the other
hand, growth investors seek high P/E stocks as ones with high
growth prospects.

9. How could unexpected inflation affect the P/E ratio?

(moderate)

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 Answer: Unexpected inflation would increase the risk-free rate of return,
RF, which would increase the required return, k, on stocks. This
would reduce P/E ratios.

Critical Thinking/Essay Questions

1. What is meant by quality of earnings, and how does it affect the equity
analysts job?

(difficult)

Answer: Quality of earnings generally has to do with the accounting

standards applied. Generally speaking, conservative standards
result in a higher quality of earnings than liberal standards.
Conservative methods often produce higher expenses and lower
EPS. An analyst has a hard time comparing the earnings of
companies prepared under differing methods. An analyst might be
willing to apply a higher P/E to higher quality earnings in
projecting a future stock price.

2. In the model P/E = (D1/E1)/(k g), the P/E should increase if the
dividend payout rate increases, other things the same. If the payout rate
was intentionally increased by the board of directors, other things are
likely not to stay the same. What is likely to happen to the dividend
growth rate and the required return?

(moderate)

Answer: If more earnings are paid out, then there is less to retain. If there is
less earnings retention, then there is a relatively smaller equity
base to support earning assets. This would reduce growth. The
effect of a higher payout on the required return is the center of
considerable controversy, but one scenario would suggest less risk
and slower grow growth, and a reduced required return.

Problems

1. Don Jorge Shipping Inc. has net income of $40 million, total assets of
$300 million, and sales of $800 million. Its equity is $190 million.

(a) Calculate ROA.

(b) Calculate ROE.
(c) If the book value per share is $7.00, what is EPS?

(moderate)

Solution: (a) ROA = net income margin x turnover

= 40/800 x 800/300
= 0.05 x 2.67

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 = 0.1335 or 13.35 percent

(b) ROE = ROA x Leverage

= 0.1335 x 1.579
= 0.2101 or 21.01 percent

(c) EPS = ROE x book value per share

= $7.00 x .2101
= $1.47

2. Internet Industries expects to earn $5.00 for the coming year, and pay a
$2.00 dividend. Its ROA is 13 percent, while its leverage factor is 1.7.

(a) Calculate the expected growth rate in dividends.

(b) Given a required rate of return of 17 percent, determine the estimated
price for High Tech, Inc., common stock.
(c) Calculate the expected dollar dividend two periods from now.

(moderate)

Solution: (a) g = br
b = 1 - payout ratio = 1 - .4 = .6
ROE = ROA x Leverage = .13 x 1.7 = .221
g = .6 x .221 = .1326 or 13.26
percent

(b) P0 = D1/(k - g)
= 2.00/(0.17 - .1326) = $53.48

(c) D2 = D1(1 + g)
= $2.00 (1.1326) = $2.265

3. The risk-free rate of return is 10 percent, and the expected return for the
stock market is 16 percent. Evergreen Industries has a beta of 1.1, and
investors expect dividends and earnings to grow at an 8 percent rate per
year. The current dividend is $1.20, and the payout ratio is 50 percent.

(a) Calculate the P/E ratio for Evergreen Industries.

(b) Estimate the price of the stock for the next year using the multiplier
model.

(moderate)

Solution: (a) k = RF + B(RM - RF)

= .10 + 1.1(.16 - .10) = 0.166

P/E = (D1/E1)/(k g)
= ($1.30/$2.59)/(0.166 - .08) = 5.81

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 (b) P1 = P/E x E1
= 5.81 x $2.59 = $15.05

4. Calculate the required rate of return on DCM Corporation's stock if its

current price is $35 per share, next year's expected dividend is $2.00 per
share, its return on equity is 12 percent, and its dividend payout ratio is 55
percent.

(moderate)

Solution: g = retention rate x ROE= (1 - dividend payout ratio) x ROE

= (1 - 0.55) x 12 = .45 x 12 = .054

P0 = D1/(k g) or
k = D1/P0 + g
= 2/35 + .054 = 0.1111 or 11.11
percent

5. A company has sales of $220 million. These are expected to increase by

15 percent next year and 12 percent in the year after that. Over each of the
next two years, the company expects to have a net profit margin of 8
percent, a payout ratio of 60 percent, and a constant 3 million shares of
common stock outstanding. If the stock is expected to trade at a P/E ratio
of 14 at the end of the second year and if the investor requires a 14 percent
rate of return, what should the justified price of the stock be today?

(difficult)

Solution:
Current Year 1 Year 2
Growth rate + 15 % + 12%
Sales $253m $283.36m
Net Profit (8% of sales)$20.24m $22.67m
Number of shares out 3m 3m
EPS $6.75 $7.56
DPS (60% of EPS) $4.05 $4.54

Stock price in year 2 = EPS in year 2 x P/E at end of year 2

P2 = 7.56 x 14
= $105.84

Stock price today = Present value of D1 + Present value

of D2 + Present value of P2
P0 = [$4.05/(1.14)] + [4.54/(1.14)2] + [105.84/(1.14)2]
= $3.55 + $3.49 + $81.44
= $88.48

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 6. Upon analyzing the financial statements of Jain Industries, you discover
that it is currently retaining 60 percent of its earnings (which were $6 this
past year), and is experiencing a ROE of almost 20 percent. Assuming a
risk-free rate of 4 percent and a risk-premium of 8 percent, how much
would you be willing to pay for Jain Industries stock on the basis of the
P/E ratio approach?

(difficult)

Solution: k = RF + RP= 6+8 = 14 percent

7. = retention rate x ROE = 0.6 x 20 = 12 percent
D1/E1 = (1 retention rate)= (1 0.6)= 0.4
P/E = (D1/E1)/(k g) =0.4/(0.14 0.12) = 20
EPS1 = EPS0(1 + g) = 6(1 + 0.12) = $6.72
Intrinsic value = Justified P/E x Expected EPS
= (20)(6.72) = $134.40

8. Given the following for Mighty Manufacturing Company:

Operating efficiency = 0.1

Net income = $50,000,000
Net income margin = 0.05
Total asset turnover = 3
Leverage = 1.5
Retention rate = 0.3

(a) Calculate ROA.

(b) Calculate ROE.
(c) Find the growth rate of dividends.

(moderate)

Solution: The letter m is used to denote millions.

(a) Net income margin = Net income/Sales

0.05 = $50m/sales
Sales = $1,000m

Total asset turnover = Sales/Total assets

3 = $1,000m/TA
TA = $333.333m

ROA = Net income/Total assets

= $50m/$333.333m
= 0.15 or 15 percent

(b) Leverage = Total assets/Equity

1.5 = $333.333m/Equity
Equity = $222.222m

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 ROE = Net income/Equity
= $50m/$222.222m
= 0.225 or 22.5 percent

(c) g = br
= Retention rate x ROE
= 0.3(0.225)
= 0.0675 or 6.75 percent

9. Find the P/E ratio of a stock with a ROE of 30 percent, a book value per
share of $5.00, and a current stock price of $30.00.

(moderate)

Solution: EPS = ROE(Book value)

= 0.30($5) = $1.50 per share

P/E = $30/$1.50 = 20

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