Question

1. Which of the following statements is most likely to be correct about price multiples based on fundamentals?

A. Price multiples are sensitive to the inputs.

B. A stock may be overvalued using the price multiple method but undervalued using the discounted cash flow models.

C. Price multiples are most reliable when the firm has assets with ready market values.

2. A firm has a required rate of return that is higher than its ROE. Assuming all other factors remain unchanged, which of the following would reduce a firm's price-to-earnings ratio?

A. The dividend payout ratio increases.

B. The yield on Treasury bills increases.

C. The level of inflation is expected to decline.

3. Asset based valuation is least useful when the firm has:

A. High levels of debt.

B. High levels of current assets and current liabilities.

C. Subsidiaries that operate in hyper-inflation economies.

Answer 1

Answer 1:

a) All price multiples, whether based on market values or based on fundamentals, are sensitive to the inputs. The sensitivity of each multiple may be diferent based on the multiple and the method used to calculate it(market values base approach or based on fundamentals) but all multiples are sentitive to inputs. SO THIS IS CORRECT OPTION

b) Price multple being referred to in this question is base on fundamental value. These multiples are calculated from the fundamental values for a stock such as discounted cash flow technique or gordon growth model. So if a stock is over/undervalued using the price multiple method it will be over/undervalued using the discounted cash flow model as well. The difference can exist if we use multiples based on market values and value of stock calculated from fundamental valuation techniques such as discounted cash flow. SO THIS OPTION IS INCORRECT

c) Here again we are talking about price multiples based on fundamentals. So the reliability of answer when the firm has assets with ready market values is not of consequence. Again this option would have made sense had we calculated price multiples based on market values. SO THIS OPTION IS INCORRECT

Answer 2: The formula of justified leading P/E ratio is given as

where b :- retention ratio (the amount of money company retains with itself after distibuting dividends)

r :- required return on equity (the amount of return investors expect in order to invest in the stock)

g :- growth of equity (the projected growth rate of the company in the long run)

Now we can compute the effect of each option on the formula to arrive at the answer

a) The dividend payout ratio increases: this would reduce the value of "b" and thus increase the P/E ratio. SO THIS OPTION IS INCORRECT

b) The yield on Treasury bills increases: This would increase the value of "r" becauses required return on equity is calculated by adding risk premium to yield on treasury bills. This would increase the denominator and reduce the value of P/E ratio. SO THIS OPTION IS CORRECT

c) The level of inflation is expected to decline: The value of P/E depends of price and earnings both. In case of higher inflation levels the earnings of the company will increase since the purchasing power of the currency goes down but people will not be willing to purchase the stock at proportionately higher prices because fundamentally there has been no positive change in the company. As a result in case of rising inflation, prices will not increase as much as the earning would increase which would in turn lead to a fall in P/E ratio. Similarly in case of falling infation levels, price of stock will fall but the fall will be proportionately lesser than the fall in earnings of the company which would lead to increasing P/E of the company.SO THIS OPTION IS INCORRECT

Answer 3:

A) High levels of debt: This does not make the asset base valuation approach inefficient as long as the value of debt can be ascertained accurately. SO THIS OPTION IS INCORRECT

b) High levels of current assets and current liabilities: Again This does not make the asset base valuation approach inefficient as long as the values can be computed accurately. Most of the problems arise when there are intangible assets (non-current asset) involved because in that case the valuation becomes tricky and there are higher chances of error in calculation and thus the value of the firm might be incorrect. SO THIS OPTION IS INCORRECT

c) Subsidiaries that operate in hyper-inflation economies: This can pose a challenge to using the asset base valuation approach because it is tough to value assets in a hyper-inflationary invironment. SO THIS OPTION IS CORRECT