Topic 6: Financial Statement Analysis & Equity Valuation

Question 1

What are economic earnings?

Answer 1

• sustainable cash flow that can be paid out to stock holders without impairing the productive capacity of the firm

Question 2

What are accounting earnings?

Answer 2

• affected by some conventions (inventories, depreciation); business cycles

Question 3

What does total asset turnover measure?

Answer 3

• measures how efficient a firm uses its assets (for every dollar of assets, how many sales the firm generates)

Question 4

What does a high interest coverage ratio indicate?

Answer 4

• shows the likelihood of bankruptcy is low because annual earnings are significantly greater than annual interest obligations

Question 5

What determines the intrinsic value of a firm’s stock?

Answer 5

• Expectations of future dividends and earnings

Question 6

What happens if ROA is greater than borrowing rate?

Answer 6

• a firm earns more on its money than it pays out to creditors the surplus earnings are available to the firm’s owners (shareholders), which increases ROE

Question 7

What happens if ROA is less than borrowing rate?

Answer 7

• ROE will decline

by an amount that depends on the debt-to equity ratio

Question 8

What is the compound leverage factor made of?

Answer 8

= Interest burden * Leverage

Question 9

What does a low P/B ratio mean?

Answer 9

• A low P/B ratio stock can be a safer investment, since the book value can be a floor supporting the market price

Question 10

What does a high P/B ratio indicate?

Answer 10

• A high P/B ratio is an indication that investors think a firm has chance of earning a return on investment > market capitalization rate (K)

Question 11

What does a low P/E ratio indicate?

Answer 11

• Low P/E ratio stocks may be good bargains since you can acquire a claim on a dollar of earnings more cheaply if the P/E ratio is low

Question 12

What does a high P/E ratio indicate?

Answer 12

• Current earnings may differ from future earnings, so high P/E stocks may still be bargain if their earnings and dividends are expected to grow faster

Question 13

What is the difference between LIFO & FIFO?

Answer 13

• LIFO- assumes goods are valued at todays cost

- FIFO- assumes goods are valued at original cost

Question 14

• LIFO: cost of goods sold (COGS) of $1.1 million,
  the end-of-year balance sheet value of the 1
  million units in inventory remains $1 million
• FIFO: COGS of $1 million, the end-of-year
  balance sheet value of the inventory would be
  $1.1 million
  Which is the preferred way of presenting inventory and why?

Answer 14

• LIFO firm has both a lower reported profit and a lower balance sheet value of inventories than the FIFO firm
• LIFO is preferred in computing economic earnings since it uses up-to-date prices to evaluate the COGS

Question 15

Trading Signal

- IV (Intrinsic value) > MP (Market Price)

Answer 15

• Buy or long

Question 16

Trading Signal

IV < MP

Answer 16

• Sell or short

Question 17

Trading Signal

IV = MP

Answer 17

• Hold or fairly priced

Question 18

Intrinsic value $50 is higher than current price $48, so ABC is what?

Answer 18

• Underpriced and we should buy

Question 19

Constant dividend model is only valid if?

Answer 19

g < k