Exam 11: Equity Analysis and Valuation

Problem Six: Adjusting Financial Statements You are examining the financial statements of ABC Corporation for Year 2. ABC Corporation manufactures widgets and has a unionized workforce. You are trying to assess the earnings persistence of the company. To aid you in this endeavor you are adjusting earnings for non-recurring, non-sustainable items. Below is a list of items you believe might affect earnings persistence. Indicate why the item may affect earnings persistence and how each item might affect net income. Company has: 1. LIFO Liquidation of $3M 2. Decreased the discount rate used to determine post-retirement health benefits 3. Accumulated Depreciation as a percentage of gross depreciable assets is ninety percent 4. Labor unions went on strike for one month during the year

Atypical horizon for measuring earnings power is 5 years.

A growing company with disappointing profitability would generally have

To produce a reliable forecast of earnings, an analyst must first separate the persistent components of earnings from the nonrecurring components.

Interim financial reports

When considering the determinants of the price to book value ratio (P/BV) which of the following statements are correct? I. The greater a company's return on common stockholders' equity the greater the P/BV ratio, all other things being equal II. The greater a company's cost of equity the greater the P/BV ratio, all other things being equal III. The greater a company's return on common stockholders' equity equals a company's cost of equity the P/BV ratio should equal 1.0 IV. The greater a company's current earnings the higher the P/BV ratio

If a company has a high price to book ratio (PB) and low price-earnings (PE) ratio, this suggests that:

Analysts' expected earnings for Alexas for next two years are: 2006: $2.00 2007: $2.23 Cost of equity is 15%. Return on equity is expected to equal cost of equity from 2008 onwards. Dividend payout ratio is expected to remain the same for 2006 and 2007. Price per share at the end of 2005 would be closest to:

If a company has a low price to book value and a high price earnings ratio this is an indicator that the stock is most likely under-priced.

Which of the following can affect earnings quality? I. Management's choice of accounting principle II. Management's choice of dividend policy III. Management's estimates IV. Management's discretionary expenditures

Alexas Corporation reports the following: Earnings per share \ 1.80 Dividends per share \ 0.72 Book Value per share-end of year \8 .62 -If Price to book value at the end of 2005 equals 1.00, and return on beginning of year equity is expected to remain constant, then cost of equity (to nearest percent) equals:

Problem Seven: Earnings Persistence/Future Earnings Consider each of the scenarios below independently. 1. Luxury Limos is in the business of renting limousines in New York City. It has a fleet of 200 limos. It owns the limousines that they rent, and keeps them on average for five years. In Year 3, Luxury Limos showed a loss on the sale of limos of $5,000. In Years 1 and 2 it recorded a loss on sale of $2,000 and $1,000, respectively. Should the gains and losses on the sale of limos be ignored when determining earnings persistence or not? 2. Turnaround Corporation has just hired new top management. In the new management's first year they take a huge restructuring charge (looks as though they are taking a "big bath"). Included in the restructuring charge are: ● Recognition of a contingent liability for probable environmental clean-up ● Write-down of assets (which amounted to a 50% write-down of all assets) ● A charge for a future upgrade of its computer system For each of the items included in the restructuring charge, and considering management's possible motivation for taking a "big bath", identify how these items might affect future recorded income.

When assessing earnings persistence it is important to analyze discretionary expenditures. Which of the following statements are correct? I. Research and Development is generally considered a discretionary expenditure II. Decreased discretionary expenditures should always be taken as a positive indicator that the company is getting costs under control III. Advertising expenditures can be considered discretionary expenditures, which often have implications for future sales IV. Absolute levels of discretionary expenditures are more important than the level of expenditures relative to sales

Which of the following is not a factor in producing earnings forecasts?

The quality of earnings is affected by the volatility of a company's sales.

If a company has a return on equity that is lower than its cost of equity capital it could be said to be destroying value.

Fristy Corporation has a book value of equity of $5,000 at the beginning of 2005, and net income of $1,000 for year ended 2005. It pays no dividends and its cost of equity capital is 10%. It expects return on beginning of year equity to remain constant for 2006 and 2007 and decrease to 10% thereafter. What should its price to book value be at the end of 2005 (pick closest number)?

Hupta Corporation Net income \ 6,000 Dividends \ 2,000 Total assets-12/31/05 \ 50,000 Total liabilities-12/31/05 \ 20,000 Number of shares outstanding 1,000 Cost of equity 10\% -Net income is expected to increase by 10% for the next year, and dividend payout ratio is expected to remain constant. After 2006, residual earnings are expected to decrease to zero. Using the earnings-based valuation method what is the value per share of Hupta stock as of 12/31/05?

a. What is meant by "earnings" persistence? b. Why might an analyst be interested in examining the earnings persistence of a company? c. How might managerial incentives affect the analysis of earnings persistence?

ABC Corporation and DEF Corporation operate in the same industry. ABC has a P/E ratio that is 50% higher than DEF Corporation. Which of the following account for some of the difference in the observed P/E ratios? I. ABC uses more conservative accounting principles II. ABC has a higher cost of equity capital III. ABC has higher expected future growth IV. DEF uses FIFO and ABC uses LIFO