Table of Contents
CFA Level 2 – Equity, Session 10 – Reading 35, Equity Valuation: Applications and Processes – LOS d
(Practice Questions, Sample Questions)
1. Which of the following is least likely one of the primary steps of the top-down valuation process?
A) Selecting a valuation model.
B) Assess corporate governance.
C) Decision making.
Explanation: B) The valuation process consists of 5 steps:
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Understanding the business.
Forecasting company performance.
Selecting a valuation model.
Complete a valuation.
Decision making.
Corporate governance is important, but is not one of the primary steps.
2. Financial Analyst Davey Jarvis, CFA, is evaluating Laura’s Chocolates, Inc., which processes nut-based toffee for world-wide distribution. Which of the following steps is Jarvis most likely to take as part of the top-down valuation process?
A) Perform momentum-based technical analysis.
B) Evaluate price performance on an ongoing basis.
C) Learn / understand the business.
Explanation: C) The valuation process consists of 5 steps:
Understanding the business.
Forecasting company performance.
Selecting a valuation model.
Complete the valuation.
Decision making.
3. When using a firm’s reported financial information as inputs into a security valuation model, it is important for the analyst to have confidence that the reported information accurately reflects the operations of the firm. This concern is referred to as:
A) the quality of earnings.
B) a confidence factor.
C) the transparency of earnings.
Explanation: A) The accuracy and level of detail disclosed in financial reports is referred to as the quality of earnings. Efforts of management to obscure the true operating performance of the firm can leave an analyst with little confidence in the security valuation.
4. Overestimating the growth rate of a firm in using a valuation model would result in a value that is likely to be:
A) can’t tell from this information.
B) too low.
C) too high.
Explanation: C) Using an estimate for a firm’s growth rate that is too high would overstate the amount of future returns, resulting in a present value that is too high.
5. Which of the following would cause an analyst to have concern about a firm’s quality of earnings?
A) A firm books sales when orders are shipped.
B) The firm took a write off for a recently impaired asset.
C) The gain on the sale of a plant was included in operating earnings.
Explanation: C) The inclusion of gains from the sale of assets as operating income would cause the analyst to question the quality of the firm’s earnings
6. Notes to financial statements contain:
A) little useful information for the analyst relative to the actual financial statements.
B) statements by auditors.
C) important information about the firm’s accounting practices and basis of presentation.
Explanation: C) A number of important disclosures regarding a firm’s accounting practices and the basis on which income and expense are recognized are contained in the footnotes to the financial statements
7. Disclosures of accounting practices and basis are often made in what part of a firm’s financial reports?
A) Cash flow statement.
B) Income statement.
C) Footnotes to the financial statements.
Explanation: C) A number of important disclosures regarding a firm’s accounting practices and the basis on which income and expense are recognized are contained in the footnotes to the financial statements.
8. What are three factors that would make a firm’s accounting earnings less of a gauge of future economic performance? Late filings, unusually:
A) high amounts of loans to company insiders, and short tenure of senior management.
B) low amounts of loans to company insiders, and short tenure of senior management.
C) high amounts of loans to company insiders, and long tenure of senior management.
Explanation: A) Quality of earnings looks at the relationship between accounting earnings and economic profit potential of the firm. An analyst is concerned about anything that would render accounting earnings less useful as a gauge of the firm’s future expected economic earnings. Warning signals include late filings, unusually high amounts of loans to company insiders, and short tenure of senior management.
9. An analyst should carefully review the footnotes to a firm’s financial statements to determine the:
A) future growth rate of the firm.
B) salaries of top executives.
C) accounting practices and basis utilized by the firm.
Explanation: C) A number of important disclosures regarding a firm’s accounting practices and the basis on which income and expense are recognized are contained in the footnotes to the financial statements
10.1 Joe Dentice has an opportunity to buy 5% of Gold Star Oil, Inc., a closely held oil company. He wants to value the company so as to be able to make a decision on the fair price to pay for the investment.
List the steps in the top down valuation approach as it is applicable for Gold Star investment. Forecast the growth of:
A) the overall economy, growth of the industry, and the growth rate of Gold Star.
B) Gold Star, the growth of each firm in the industry, and then the growth of the oil industry.
C) each firm in the oil industry, the growth rate of the oil industry, and the growth rate of the economy
Explanation: A) The top down model for valuation would begin with analysis of the overall economy and the expectation of the growth rate in the economy. Further, the impact of the expected growth rate of the economy on the oil industry needs to be ascertained. The second component is the analysis of the oil industry in which Gold Star operates. That involves the determination of the competitive forces in the industry and the future threats and opportunities faced by the industry. It also determines the variables that determine the future profitability of the entire oil industry. The analyst then forms future expectations of these variables given the expectations about the overall economy. The expectations of variables determining the growth and profitability of the oil industry are then used to determine the expectations of the overall growth of Gold Star. In the company analysis, the analyst reviews the quality of earnings, financial ratios, management and intangibles to ascertain the growth prospects for the company. The analyst then selects an appropriate model to value the company. Assumptions used in the valuation must be clearly spelled out and updated to reflect new information.
10.2 Which of the following models would be most suitable to value Gold Star?
A) Relative valuation.
B) Liquidation value.
C) Absolute valuation.
Explanation: C) Absolute valuation models or intrinsic value models such as the dividend growth rate model and the free cash flow model value a company independent of peer valuation. The valuation is based on the present value of cash-flows for the specific company. Relative valuation models such as P/E ratio compare the earnings multiple to that of similar companies to make a judgment about the valuation. If the P/E ratio is higher than peer company P/E ratio, it is said to be overvalued. Conversely, if the P/E ratio is lower than peer company P/E ratio, it is said to be undervalued. Caution should be taken to make sure that peer companies are indeed comparable. For the valuation of Gold Star, absolute valuation would be suitable since it is closely held and hence market valuation is not available.
10.3 Which discounts must be taken into account while valuing the investment opportunity? Joe should take into account the:
A) marketability, liquidity, and control premium in the valuation.
B) marketability, liquidity, and majority discounts in the valuation.
C) marketability, liquidity, and minority discounts in the valuation.
Explanation: C) Since Gold Star is closely held, the investment is not easily marketable. Closely linked is the fact that the investment cannot be easily liquidated and the cost of selling the investment needs to be discounted from the value. Finally, since only 5% of the stock is being invested in, the control of the operations of the company still remains with the majority shareholders. This lack of control needs to be quantified and discounted from Gold Star’s valuation
