Financial 

Statement Analysis 
Some Practice Questions and answers 
1. What explains differences between firm’s price-to-sales ratios?

1. Investors are interested in profits from sales, not sales. So price-to-sales ratios vary
according to the profitability of sales, that is, the profit margin on sales. Also, investors
are interested in future sales (and the profitability of future sales) not just current sales.
So a firm will have a higher price-to-sales ratio, the higher the expected growth in sales
and the higher the expected future profit margin on sales. Note that the price-to-
sales ratio should be calculated on an unlevered basis.

2 It is common to compare firms on their price-to-EBIT ratios. What are the merits of
using this measure? What are the problems with it? Hint: EBIT leaves something out.

2. The price-to-EBIT ratio is calculated as price of operations divided by EBIT. The numerator
and denominator are:
Numerator: Price of operations (firm) = price of equity + price of debt
Denominator: EBIT is earnings before interest and taxes.

Merits:
The ratio focuses on the earnings from the operations. The price-to-EBIT ratio prices the
earnings from a firm’s operations independently of how the firm is financed (and thus how
much interest expense it incurs). Note that, as the measure prices operating earnings, the
numerator should not be the price of the equity but the price of the operations, that is, price of
the equity plus the price of the net debt. In other words, the unlevered price-to-EBIT ratio
should be used.

Problems:
As the measure ignores taxes, it ignores the multiple that firms can generate in operations by
minimizing taxes.
A better measure is
Unlevered Price/Earnings before Interest
MarketValue of Equity  Net Debt

Earnings Before Interest
where
Earnings Before Interest = Earnings + Interest (1 – tax rate). After tax interest is
added back to earnings because interest expense is a tax deduction, and so reduces
taxes.
3 It is also common to compare firms on their price-to-EBITDA ratios. What are the
merits of using this measure? What are the dangers? Hint: EBITDA leaves something
out.

The price-to-EBITDA ratio has the same merits as the price-to-EBITDA ratio. But,
by adding back depreciation and amortization to EBITDA, it rids the calculation of an
accounting measurement that can vary over firms and, for a given firm, is sometimes seen as
suspect. It thus can make firms more comparable.

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Problems:
This multiple suffers from the same problems as the price-to-EBIT ratio. In addition, it ignores
the fact that depreciation and amortization are real costs. Factories depreciate (lose value) and
this is a cost of operations, just as labor costs are. Copyrights and patents expire. And goodwill
on a purchase of another firm is a cost of the purchase that has to be amortized against the
benefits (income) from the purchase, just as depreciation amortizes the cost of physical assets
acquired. The accounting measures of these economic costs may be doubtful, but costs they
are. Price-to-EBITDA for a firm that is “capital intensive” (with a lot of plant and depreciation
on plant) is different from that of a “labor intensive” firm where labor costs are substituted for
plant depreciation costs. So adding back depreciation and amortization may reduce
comparability. During the telecom bubble, analysts priced firms based on ebitda. The
telecoms over-invested in networks, producing excess capacity. The cost of this excess capacity
does not affect EBITDA, so is not counted.

4. Why do trailing P/E ratios vary with dividend pay-out?

Share price drops when a firm pays dividends because value is taken out of the firm. But current
earnings are not affected by dividends (paid at the end of the year). Future earnings will be
affected because there are less assets in the firm to earn, but current earnings will not. A trailing
P/E ratio that does not adjust for dividend prices earnings incorrectly. A P/E ratio that adjusts
for the dividend is:
Price per share  Annual Dps
Adjusted trailing P/E =
Eps

5. If a firm has a P/E ratio of 12 and a profit margin on sales of 6 percent, what is its price-
to-sales (P/S) ratio likely to be?
P E
P/S    12  0.06  0.72
E S

6. If a firm is expected to have a profit margin of 8 percent but trades at a price-to-sales

ratio of 25, what inferences would you make?

6. By historical standards, a multiple of 25 is high for a P/E ratio, and is an extremely high
price-to-sales ratio if only 8% of each dollar of sales ends up in earnings. Either the market is
expecting exceptional sales growth (and thus exceptional earnings despite the margin of 8%),
or the stock is overvalued.

7.What do traders mean when they refer to stocks as "glamour stocks" and "value
stocks?"

7. Traders refer to firms with high P/E and/or high P/B ratios as growth stocks, for they see
these firms as yielding a lot of earnings growth. They see prices increasing in the future as the
growth materializes. The name, value stocks is reserved for firms with low multiples, for low
multiples are seen as indicating that price is low relative to value. A glamour stock is one that
is very popular due to high sales and earnings growth (and usually trades at high P/S and P/E
ratios). A contrarian stock is once that is said to be out of favor and trades at a low multiple.

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8. Why would you expect asset-based valuation to be more difficult to apply to a
technology firm, like Dell Inc., than to a forest products company, like Weyerhaeuser?

8. Yes. In an asset-based company (like Weyerhaueser) most of the assets (like timberlands)
are identified on the balance sheet and could be marked to market to estimate a value. For a
technology firm (like Dell), value is in intangible assets (like its direct-to-customer marketing
system) that are not on the balance sheet. Indeed, they are nebulous items that are not only hard
to measure but also hard to define. How would one define Dell’s direct-to-customer marketing
system? How would one measure its value?

9. The yield on a bond is independent of the coupon rate. Is this true?

9.Yes. The value of a bond depends on the coupon rate because the value of the bond is the
present value of the cash flows (including coupon payments) that the bond pays. But the yield
is the rate at which the cash flows are discounted and this depends on the riskiness of the bond,
not the coupon rate. Consider a zero coupon bond – it has no coupon payment, but a yield that
depends on the risk of not receiving payment of principal.

10. It is sometimes said that firms prefer to make stock repurchases rather than pay
dividends because stock repurchases yield a higher eps. Do they?

10. Yes. Dividends reduce future eps: with fewer assets in the firm, earnings are lower but
shares outstanding do not change. A stock repurchase for the same amount as the dividend
reduces future earnings by the same amount as the dividend, but also reduces shares
outstanding. But firms should not prefer stock purchases for these reasons because the change
in eps does not amount to a change in value. See the next question. Shareholders may prefer
stock repurchases if capital gains are taxed at a lower rate than dividend income.

11. If share repurchases increase eps more than dividends, do share repurchases also
create more value than dividends?

11. No. Dividends reduce the price of a firm (and the per-share price). But shareholder wealth
is not changed (at least before the taxes they might have to pay on the dividends) because they
have the dividend in hand to compensate them for the drop in the share price. In a stock
repurchase, total equity value drops by the amount of the share repurchase, as with the dividend.
Shareholders who tender shares in the repurchase are just as well off (as with a dividend)
because they get the cash value of their shares. The wealth of shareholders who did not
participate in the repurchase is also not affected: share repurchases at market price do not affect
the per-share price. So share repurchases do not create value for any shareholders. Subsequent
eps are higher with a stock repurchase than with a dividend. Shareholders who tendered their
shares in the repurchase earn from reinvesting the cash received, as they would had they
received a dividend. Shareholders who did not tender have lower earnings (because assets are
taken out of the firm) but higher earnings per share to compensate them from not getting the
dividend to reinvest.

12. Should a firm that pays higher dividends have a higher share value?
12. No. Paying a dividend actually reduces share value by the amount of the dividend (but
does not affect the cum-dividend value). Shareholders are no better off, cum-dividend. Of
course, it could be that firms that pay higher dividends are also more profitable (and so have
higher prices), but that is due to the profitability, not the dividend.

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1 Investors receive dividends as payoffs for investing in equity shares. Thus the value of
a share should be calculated by discounting expected dividends. True or False?

1. The first sentence is true: dividends are the payoff to equity investing. The second sentence
is true in theory but not in practice. Equity value is the present value of the infinite stream of
expected dividends that a going concern generates. But, in practice, one can’t forecast to
infinity. Dividends paid over practical, finite forecast horizons are not relevant to value. This
is this dividend conundrum.

2.Some analysts trumpet the saying "Cash is King." They mean that cash is the primary
fundamental that the equity analyst should focus on. Is cash king?

2. If cash is king, his subjects are not well served. Free cash flow does not incorporate
accrual aspects of value added. Free cash flow is reduced by investments, yet investment
(typically) adds value. Free cash flow is a liquidation concept, not a value-added concept.

3.Should firm that has higher free cash flows have a higher value?

3. Not necessarily. A firm can generate higher free cash flow by liquidating its investments.
A highly profitable (and highly valuable) firm can have low (or even negative) free cash
flows because it is investing heavily to capitalize on its investment opportunities.

4.After years of negative free cash flow, General Electric reported a positive free cash
flow of $7,386 million in 2003. Would you interpret the 2003 free cash flow as good
news?

4.Not necessarily. Cash flow from operations increased in 2003 over 2002, but the 2003 free
cash flow was generated partially by a reduction in investment. This drop in investment can
be seen as bad news: Will the drop in investment harm future profits and cash flows?

5. Which of the following two measures gives a better indication of the value added
from selling inventory: (a) cash received from customer’s minus cash paid for
inventory, or (b) accrual revenue minus cost of goods sold? Why?

5. The answer is (b). Matching cash received from sales with cash spent on inventory does
not match value received with value given up to earn the cash, because it recognizes the cost
of unsold good against the receipts from goods sold. Accrual accounting accomplishes the
matching because only the cost of goods sold is recognized against the revenue from goods
sold.

6.What explains the difference between cash flow from operations and earnings?

6. The difference is explained by net (after-tax) interest payments and the total accruals in
earnings – the amount of earnings that does not involve cash flows:
Earnings = Cash from operations – net interest payments + accruals

7.What explains the difference between free cash flow and earnings?

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7. Free cash flow is earnings (before after-tax interest) minus operating accruals minus cash
investment in operations:
C – I (free cash flow) = Earnings + net interest payments – accruals – cash investment
Earnings = C – I - net interest payments + accruals + cash investment

8. Why is an investment in a T-bill not an investment in operations?

8. Because investment in T bills is an investment to store cash that temporarily is not needed
in operations. The investment in operations only comes when the T-bill is sold and the cash
from the sale is invested in operating assets.

9. Explain the difference between levered cash flow and unlevered cash flow.

9. Levered cash flow is after net interest payments; as it involves interest from financing
activities, it is called a levered measure. Unlevered cash flow is cash from operations without
the any consideration of interest from financing activities.

10 Why must the interest component of cash flow or earnings be calculated on an after-
tax basis?

10. Interest draws taxes; interest income incurs tax and interest expense yields a tax deduction.
So, to understand the effect of interest on earnings or cash flows, interest must be attached to
the interest to put it on an after‐tax basis.  
 

1 Information indicates that a firm will earn a return on common equity above its cost of
equity capital in all years in the future, but its shares trade below book value. Those
shares must be mispriced. True or false? ꞏ

1. True. A firm with positive expected residual earnings (produced by an ROCE above the
cost of capital) must be valued at a premium.

2. Jetform Corporation traded at a price-to-book ratio of 1.01 in May 1999. Its most
recently reported ROCE was 10.1 percent, and it is deemed to have a required equity
return of 10 percent. What is your best guess as to the ROCE expected for the next fiscal
year?

2.To trade at book value, we expect the ROCE to be equal to the cost of capital, 10%. (The
current ROCE is not relevant here: P/B is based on expected future ROCE.)

3 Telesoft Corp. traded at a price-to-book ratio of 0.98 in May 1999 after reporting an
ROCE of 52.2 percent. Does the market regard this ROCE as normal, unusually high, or
unusually low?

3.A P/B of 1.0 implies a future ROCE equal to the cost of capital. An ROCE of 52.2 % is high
relative to the cost of capital, so the P/B implies the ROCE is unusually high and will drop in
the future.

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4 A share trades at a price-to-book ratio of 0.7. An analyst who forecasts an ROCE of 12
percent each year in the future, and sets the required equity return at 10 percent,
recommends a hold position. Does his recommendation agree with his forecast?

4.No. If the firm is expected to earn an ROCE in excess of the required return, it should sell at
a premium over book value. Given the forecast, the firm is a BUY if it trades below book value.

5. A firm cannot maintain an ROCE less than the required return and stay in business
indefinitely. True or false?

5.False.If the firm maintains a low ROCE it will be valued at a discount on book value. But it
can survive: it has a positive going-concern value.

6. Look at the Case 3 valuation of Dell, inc., in the chapter. Why are residual earnings
increasing after 2002, even though return on common equity (ROCE) is fairly constant?

6.Firms create residual earnings through ROCE and growth in net assets. The ROCE for Dell
are level (and declining in 2005), but the book values are increasing. With constant ROCE and
growing book values, residual earnings increase.

7. An advocate of discounted cash flow analysis says, "Residual earnings valuation does
not work well for companies like Coca-Cola, Cisco Systems, or Merck, which have
substantial assets, like brands, R&D assets, and entrepreneurial know-how off the books.
A low book value must give you a low valuation." True or false?

7. False. Book value may be low relative to total value, but the residual earnings methods
estimate the missing value in the balance sheet to add to book value. It does so by forecasting
the earnings that will be added to book value in the future. Those earnings include earnings
from assets that are not on the balance sheet, like brands and knowledge assets: Even though
value is missing from the balance sheet, it can be calculated from earnings that will come
through the income statement.

8. When an analyst forecasts earnings, it must be comprehensive earnings. Why?

8. If the analyst does not forecast all sources of earnings (that is, comprehensive earnings)
then she will ignore some part of the payoff to shareholders, and will lose some value in her
calculation of a value from the forecast.

9. Comment on the following: "ABC Company is generating negative free cash flow and
is likely to do so for the foreseeable future. Anyone willing to pay more than book value
needs their head read."

9. The price-to-book valuation has nothing to do with free cash flow. Look at the General
Electric has negative free cash flows (2004), but a large P/B ratio . Growth in investment
determines the P/B ratio (along with return on investment), but investment reduces free cash
flow.

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1. Explain why analysts' forecasts of earnings-per-share growth typically underestimate
the growth that an investor values if a firm pays dividend.

1. Analysts typically forecast eps and eps growth without consideration for how earnings are
affected by payout. That is, they forecast ex-dividend growth, not cum-dividend growth.
Investors value ex-dividend earnings growth, but they also value additional earnings to be
earned from the reinvestment of dividends.

2. The historical earnings growth rate for the S&P 500 companies has been about 8.5
percent. Yet the required growth rate for equity investors is considered to be about 12
percent. Can you explain the inconsistency?

2. The historical 8.5% growth rate that is often quoted is the ex-dividend growth rate. It
ignores the fact that earnings were also earned by investors from reinvesting dividends (in the
S&P 500 stocks, for example) that were typically 40% of earnings. The cum-dividend rate is
about 12%.

3 The following formula is often used to value shares, where Earn1 is forward earnings,
r is the cost of capital, and g is the expected earnings growth rate.
Value of equity = Earn 1 / r — g
Explain why this formula can lead to errors.

3. This formula capitalizes earnings at the ex-dividend earnings growth rate, g. This ignores
growth that comes from reinvesting dividends. Further, if earnings are expected to grow at a
rate equal to the required return, r, then the growth should not be valued, and forward
earnings should be capitalized at the rate, r, not r – g. Only growth in excess on the required
rate should be recognized. The formula also has mathematical problems. If g = r, then the
denominator is zero and the value is infinite. If g is greater than r (which is necessary for
growth to have value), the denominator is negative.

4. A firm's earnings are expected to grow at a rate equal to the required rate of return
for its equity, 12 percent. What is the trailing P/E ratio? What is the forward P/E ratio?

4. The trailing P/E is normal: 1.12/0.12 = 9.33. The forward P/E is also normal: 1/0.12 =
8.33.

5. The normal forward P/E and the normal trailing P/E always differ by 1.0. Explain
the difference.

5. The difference is that, for the trailing P/E, one more years of earnings are involved (the
current year). The trailing P/E can be interpreted as paying for the value of forward earnings
(at the multiple for forward earnings) plus a dollar for every dollar of current earnings.

6. Explain why, for purposes of equity valuation, earnings growth forecasts must be for
cum-dividend earnings growth, yet neither cum-dividend growth rates nor valuation
are affected by expected dividends.

6. Cum-dividend earnings growth incorporates earnings that are earned from the
reinvestment of dividends, and investors value those earnings. Ex-dividend growth rates are

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affected by dividends: dividends reduce assets which then earn lower earnings. As cum-
dividend growth rates reflect the earnings from dividends, they are not affected by dividends.
Cum-dividend growth rates are effectively the rates that firms would have if they did not pay
dividends.

7. Abnormal earnings growth is always equal to growth of (change in) residual earnings.
Correct?

7. Correct.

8. A P/E ratio for a bond is always less than that for a stock. Correct?

8. Incorrect. As the normal (forward) P/E ratio is the inverse of the required return and the
required return for a bond is (usually) lower than that for a stock, the normal P/E ratio for a
bond is greater than that for a stock. However, a bond cannot deliver growth, so the P/E ratio
for a growth stock might well be greater than that for a bond.

9. In an equity research report, an analyst calculates forward earnings yield of 12 per-

cent. Noting that this yield is considerably higher than the 7 percent yield on a 10-year
Treasury, she heads her report with a buy recommendation. Could she be making a
mistake?

9. Yes, she could. One expects the earnings yield on a stock to be greater than the bond
yield because a stock is riskier and thus has a higher required return.

10. How do you interpret a PEG ratio?

10. A PEG ratio is the ratio of the P/E to one-year-ahead expected earnings growth (in
percentage terms). As the P/E anticipates earnings growth, the PEG ratio should be 1.0 if the
market is anticipating growth appropriately. However, more than one year of growth is
involved in assessing P/E ratios, so the measure should only be used as a first-pass check on
the P/E ratio.

11. Why might an analyst refer to a leading (forward) P/E ratio rather than a trailing
P/E ratio?

11. The trailing P/E, based on current earnings, is affected by transitory earnings. The
forward P/E based on next years' forecasted earnings is less likely to be so affected, and so is
a better base for growth. (But the analyst does have to forecast next year's earnings).

12. Can a firm increase its earnings growth yet not affect the value of its equity?

12. Yes; eps growth can be increased with investment, but the investment may earn only the
required return, and thus not add value. A firm can also increase its expected earnings growth
through accounting methods, but not add value.

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1. Why can free cash flow be regarded as a dividend, that is, as a distribution of value rather
than the value created?

1. Free cash flow is a dividend from the operating activities to the financing activities; that is, it
is the net cash payoff from operations that is disposed of in the financing activities. The
operations generate value then “distribute” some of the value in the free cash flow dividend,
leaving the remainder of the value generated reinvested in net operating assets. Think of a firm
without any debt; in this case, C – I = d, that is, the free cash flow is the dividend to shareholders.

2. A firm has positive free cash flow and a net dividend to shareholders that is less than free
cash flow. What must it do with the excess of the free cash flow over the dividend?

2. The firm must buy debt, by buying down to its own financial obligations or by buying others’ debt
as a financial asset.

3. How can a firm pay a dividend with zero free cash flow?

3.The firm borrows: C - I = d + F. So, if C - I = 0, then the firm borrows to pay the dividend such that
d + F = 0.

4. Distinguish an operating asset from a financial asset.

4. An operating asset is used to produce goods or services to sell to customers in operations. A

financing asset is used for storing excess cash to be reinvested in operations, pay off debt, or pay
dividends.

5. Distinguish an operating liability from a financial liability.

5.An operating liability is an obligation incurred in producing goods and services for customers. A
financial liability is an obligation incurred in raising cash to finance operations.

6. If an analyst has reformulated balance sheets and income statements, she does not need a
cash flow statement to calculate free cash flow. True or false?

6.True. From the reformulated balance sheets and income statement,

C-I = OI -NOA. So, with operating income identified in a reformulated income statement and
successive net operating assets identified in a reformulated balance sheet, free cash flow drops out.

7 What drives free cash flow?

7.Operations drive free cash flow. Specifically, value is added in operations through operating
earnings, and free cash flow is the residual after some of this value is reinvested in net operating
assets.

8 What drives dividends?

8.Free cash flow (driven by operations) drives dividends. But dividends are the residual of free cash
flow after servicing the interest and principal claims of debt or investing in net financial assets.

9 What drives net operating assets?

9.Net operating assets are increased by earnings from operations and reduced by free cash flow.
Expanding, net operating assets are increased by operating revenues and cash investment and reduced
by operating expenses and cash from operations.

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10 What drives net financial obligations?

10.Net financial obligations are increased by the obligation to pay interest, and by dividends, and are
reduced by free cash flow.

11 Free cash flow does not affect common shareholders' equity. True, or false?

11.True. Free cash flow is a dividend from the net operating assets to the net financial obligations.
So, as CSE = NOA - NFO, free cash flow does not affect CSE.

1. Why are reformulated statements necessary to discover operating profitability?

1.Without the reformulation, operating profitability is confused with financing profitability,
and the return on financial assets (and borrowing cost for financial obligations) is typically
different from operating profitability. Operations add value whereas financing typically does
not, so financing activities need to be separated out to uncover the operating profitability.

2. From the point of view of the common shareholders, minority interest is a financial
obligation. Correct?
2.Not correct. In a sense, minority interest is an obligation for common shareholders to give
the minority in a subsidiary a share of profits. But it is not, like debt, an obligation that is
satisfied by free cash flow from operations. Rather, it is equity that shares in a portion of profits
after net financing costs.

3. What is meant by saying that debt provides a tax shield?

3.Interest is deductible for taxes so issuing debt shields the firm from taxes.

4. When can a firm lose the tax benefit of debt?

4 A firm loss the tax benefit of debt when it cannot reduce taxable income with interest on debt.
This can happen if a firm has losses in operations (and thus has no income to reduce with the
interest deduction). In the U. S. this situation is unlikely because firms can carry losses forward
or backward against future or past income.

5. What does an operating profit margin reveal?

5.The operating profit margin is the profitability of sales, the percentage of a dollar of sales
that ends up in operating income after operating expenses.
 

1. Why might cash flow analysis be important for valuing firms?

1. If the analyst uses discounted cash flow analysis, he must analyse the source of the cash
flows, in order to forecast the cash flows.

2. For what purpose might forecasting cash flows be an analysis tool?

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2. 1. For discounted cash flow valuation.
2. For forecasting liquidity, to see if debt payments can be covered by cash flow.
3. More generally for financial planning, to ensure enough cash is raised to meet debt
repayments, dividends and investment requirements.
3. For a pure equity firm (with no net debt), how is free cash flow disposed of?

3. Free cash flow must be paid out in dividends as there are no debt financing flows.
For a pure equity firm, C - I = d

4. By investing in short-term securities to absorb excess cash, a firm reduces its cash flow
after investing activities in its published cash flow statement. What is wrong with this
picture?

4 Excess cash can result from operations generating cash. Yet the GAAP statement
presentation reduces net cash from operations (free cash flow) by the amount of the excess cash
that operations generate. The generation and disposition of free cash flow are confused.

5. Do you consider the direct method to be more informative than the indirect method of
presenting cash flow from operations?

5.The direct method gives considerably more detail on the sources of cash from operations.
But the indirect method gives the accruals for the period.

6. GAAP cash flow statements treat interest capitalized during construction as investment
in plant. Do you agree with this practice?

6.No. This interest is a cost of financing construction, not investment in the construction. It
should be in the financing section of the statement, not the investing section

7. Why is free cash flow sometimes referred to as a liquidation concept?

7. Because a firm increases its free cash flow by selling off assets (and reduces free cash flow
by acquiring assets).

8. Why might an analyst not put much weight on a firm's current free cash flow as an
indication of future free cash flow?

8.Current free cash flow is reduced by investment that generates future cash flow. So the lower
the current free cash flow (because of investment), the higher future free cash flow is likely to
be.

9. What factors produce growth in free cash flow?

9. As C - I = OI - NOA, free cash flow grows with growth in operating profits, but declines
with growth in investment in net operating assets.

10. Consider the following quote: "Sales of receivables and operating cash flows are
entirely separate events. We see sales of receivables as a low-cost financing method; it
shouldn't generate operating cash flow." Do you agree?

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10. Yes, agree. Receiving cash from customers is a from a firm’s primary source of value.
Cash from selling receivables is not cash from additional customers – it’s just the acceleration
of cash that the firm would eventually get from existing customers when they pay.

1. Under what conditions would a firm's return on common equity (ROCE) be equal to
its return on net operating assets (RNOA)?
1. The two rates of return will be the same in either of the following conditions:
(a) The SPREAD is zero, that is, return on net operating assets equals net
borrowing cost.
(b) Financial leverage (FLEV) is zero, that is, financial assets equal financial
obligations.
2. Under what conditions would a firm's return on net operating assets (RNOA) be
equal to its return on operating assets (ROOA)?
2 The two rates of return will be the same in either of the following conditions:
(a) The operating liability leverage spread (OLSPREAD) is zero, that is, ROOA
equals the implicit borrowing rate for operating liabilities.
(b) Operating liability leverage is zero, that is, the firm has no operating liabilities.

3. State whether the following measures drive return on common equity (ROCE) positively,
negatively, or depending on the circumstances:
a. Gross margin.
b. Advertising expense ratio.
c. Net borrowing cost.
d. Operating liability leverage.
e. Operating liability leverage spread.
f. Financial leverage.
g. Inventory turnover.
3. (a) Positive
(b) Negative
(c) Negative
(d) It depends on whether the operating liability leverage spread is positive or
negative
(e) Positive
(f) It depends on whether the operating spread is positive or negative
(g) Positive
Note: the advertising expense ratio (advertising/sales) might be high in the current period,
producing a negative effect on ROCE. But the large amount of advertising might produce
higher future sales, so could be regarded as a positive value driver (and a positive driver of
future ROCE).

4. Explain why borrowing might lever up the return on common equity.

4.If the assets in which the cash from issuing debt is invested earn at a rate greater than the
borrowing cost of the debt, ROCE increases: shareholders earn from the SPREAD.

5. Explain why operating liabilities might lever up the return on net operating assets.
5.If a firm can generate income using the liabilities that are higher than the implicit cost that
creditors charge for the credit, it increases its RNOA.

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6. A firm should always purchase inventory and supplies on credit rather than paying
cash. Correct?
6.Not necessarily. If the supplier charges a higher price for the goods to compensate him for
financing the credit, buying on credit may not be favorable. The operating liability leverage
created by buying on credit will be favorable if the return earned on the inventory is greater
than the implicit cost the supplier charges for the credit.

7. A reduction in the advertising expense ratio increases return on common equity and
share value. Correct?
7.The first part of the statement is correct: A drop in the advertising expense ratio increases
current ROCE. But a drop in advertising might damage share value as future ROCE might
drop because of reduced sales.

8. A firm states that one of its goals is to earn a return on common equity of 17-20
percent. What is wrong with setting a goal in terms of return on common equity?
8.Return on common equity (ROCE) is affected by leverage. If a firm borrows, pays
dividends, or makes a stock repurchase, it can increase its ROCE. But its return on
operations (RNOA) may not change, or even decline. Always examine increases in ROCE to
see if they are due to leverage.

9. Why might operating losses increase after-tax borrowing cost?

9.If the firm loses the ability to deduct interest expense for tax purposes, it does not get the
tax benefit of debt and so increases its after-tax borrowing cost. Of course the firm also may
find that creditors will charge a higher before-tax borrowing rate if it is making losses.

10. Some retail analysts use a measure called "inventory yield," calculated as gross
profit-to-inventory. What does this measure tell you?
10.The inventory yield is a measure of the profitability of inventory, the profit from selling
inventory relative to the inventory carried. If gross profit falls or inventories increase, the
ratio will fall.

11. Return on total assets (ROA) is a common measure of profitability. The historical
average is about 7.0 percent. The historical yield on corporate bonds is about 6.6
percent. Why is the ROA so low? Would not investors expect more than a 0.4 percent
higher return on risky operations?
11.ROA mixes operating and financial activities. Financial assets are in the denominator and
operating liabilities are missing from the denominator. Interest income is in the numerator.
This calculation yields a low profitability measure, as the return on financial assets is
typically lower than operating profitability and the effect of operating liabilities --- to lever up
operating profitability --- is not included.

12. Low profit margins always imply low return on net operating assets. True or false?
12. False. A firm can have a low profit margin (PM) but compensate with a high asset
turnover (ATO).
 

1. What is a growth firm?

1 A growth firm is one that is expected to grow residual earnings. As changes in residual
earnings are equal to abnormal earnings growth, a growth firm can also be defined as
one that can generate abnormal earnings growth, that is, earnings growth (cum-

13 
 
 dividend) at a rate greater than the required rate. As residual earnings is driven by return
on common equity (ROCE) and growth in equity, a growth firm is one that can increase
ROCE and/or grow investment that is expected to earn at an ROCE that is greater than
the equity cost of capital.
2. In analysing growth, should the analyst focus on residual earnings, abnormal earnings
growth, or both?
2 Abnormal earnings growth is the same as growth in residual earnings, so it doesn’t matter.
Abnormal growth in earnings – growth above the required rate of growth – is a simpler
concept, but residual earnings growth helps to lead the analyst into the drivers of growth
– investment and the profitability of investment.
3. What measure tells you that a firm is a no-growth firm?
3 A no-growth firm has zero or negative residual earnings growth or, equivalently, has growth
in cum-dividend earnings at a rate equal or less than the required return.

4 What features in financial statements would you look for to identify a firm as a growth
company?
4.A growth company would have the following features:
 An ROCE greater than the cost of capital
 Increasing residual earnings (that amounts to abnormal earnings growth) due
to
 Sales growth (with positive profit margins)
 Increasing profit margins
 Increasing asset turnover
 Growing net investment (earning a ROCE greater than the cost of
capital)
A growth company is one that is expected to have these attributes in the future. It
is possible that a firm may have had these attributes in the past but is not expected
to have them in the future. And it is possible that a firm may not have these features
currently (a start-up, for example), but is expected to have them in the future.

5. Why would an analyst wish to distinguish the part of earnings that is sustainable?
5.The analyst is interested in the future because value is based on future earnings (or strictly,
on future residual earnings). So she analyses current earnings for indications of what
future earnings might be. To the extent that current earnings is not sustainable (that is,
will not be a part of future earnings), the analyst wants to identify those earnings.

6. What are transitory earnings? Give some examples.

6.Transitory earnings are aspects of current earnings that have no bearing on future earnings.
Examples are earnings from a one-time contract, a write-off on unusually large bad
debt, a write-down of obsolescent inventory, a one-time uninsured loss of property, a
restructuring charge, and profit from an asset sale or a discontinued line of business.
Note that write-offs and restructurings do have an effect on future income in a
technical, accounting sense because, if the charge is not taken now, it will have to be taken
in the future. But, provided the charge is a "fair" one that does not over or underestimate
the restructuring cost, its effect on earnings will be completed in the current period.

7. Are unrealized gains and losses on financial assets persistent or transitory income?
7.In one sense, these gains and losses are persistent because they occur every period. But a
gain or loss in the current period gives no indication of whether there will be a gain or

14 
 
 loss in the future. That is, the expected future gain or loss is zero, irrespective of the
current gain or loss. So these gains and losses are treated as transitory.

8. Distinguish operating leverage from operating liability leverage.

8 Operating leverage is the proportion of fixed and variable costs in a firm's cost structure;
it is an income statement concept.
Operating liability leverage is the proportion of operating liabilities in net
operating assets; it is a balance sheet concept. Both create leverage. Operating leverage
levers the operating income from sales. Operating liability leverage levers operating
income from net operating assets (RNOA).

9. The higher a firm's contribution margin ratio, the more leverage it gets from increasing
sales. Correct?
9.This is correct. A higher contribution margin means lower variable costs. So more
of each dollar of sales "goes to the bottom line."

10. Would you see a high profit margin of, say, 6 percent for a grocery retailer as sustainable?
10 Profit margins in retailing tend to be low because the business is very competitive. The
median profit margin for food stores is 1.7%. If a firm were reporting a 6.0% profit
margin, we'd guess that it is temporary: Competition will probably erode this margin.

11. What determines growth in equity investment in a firm?

11 Common equity grows through earnings and new share issues, and declines through stock
repurchases and dividends. But more fundamental factors underlie this growth. Equity
grows because of increases in sales (revenues) that require more net operating assets
(to service the sales). The amount of net operating assets to service additional sales
1
depends on , that is, on the NOA required for each dollar of sales. The amount of
ATO

equity growth to finance the NOA growth depends on the extent of net debt financing
used. If firms issue debt to finance the growth or liquidate financial assets, no growth
in equity occurs.

12. A firm can have a high trailing P/E ratio, yet have an expected cum-dividend earnings
growth rate after the forward year that is less than the required rate. Is this so?
12 Yes, this is correct. A trailing P/E can be high because current earnings are
temporarily low, even though expected future growth would indicate that the
P/E should otherwise be low.

13. For a firm with a normal trailing P/E ratio, expected future residual earnings must be the
same as current residual earnings. Correct?
13 This is correct. A normal P/E implies that residual earnings are expected to
continue at the current level (and, equivalently, earnings are expected to grow,
cum-dividend, at the required rate of return).

15 
 
14. Can a firm have a high P/E ratio yet a low P/B ratio? How would you characterize the
growth expectations for this firm?
14 Yes. A firm with a high P/E and a low P/B is one where residual earnings are expected to
increase from their current level but are expected to be lower than zero.
15. Firms with high unsustainable earnings should have low (trailing) P/E ratios. Is this
correct?
15 Yes, correct. Temporarily high earnings are expected to decline, so should have
a low P/E ratio.

1. If assets are at fair market value in the balance sheet, the income reported from those assets
in the income statement does not give any information about the value of the assets. Is this
correct?
1 Yes: for assets marked to market, income is just the change in market value plus any
dividend. Changes in market value do not say anything about the value of the assets.
And dividends (in principle) are not related to value. Details of the income are not
needed, however, as the balance sheet gives the value (provided the market value is an
efficient price).

2. If assets are measured at their fair (intrinsic) value, the analyst must forecast that residual
earnings from those assets will be zero. Is this correct?
2 This is correct. The assets are expected to earn at their required return. Therefore,
expected residual income is zero.

3. Why might the market value of the assets of a pure investment fund that holds only equity
securities not be an indication of the funds (intrinsic) value?
3 The shares held may not be priced efficiently. If the fund is an actively managed
fund, the fund managers are investing in shares that they think are under-priced. So
the fund might trade at a premium.

4. What drives growth in residual operating income?

4 Residual operating income growth is driven by

1. Increases in the return on net operating assets

2. Growth in net operating assets
3. Decline in the cost of capital for operations

5. Can residual operating income increase while, for the same period, residual earnings
decrease?
5.Yes. ROCE and residual earnings may decrease because of a drop in financial
leverage, even though RNOA and residual operating income increase.

6. Explain what is meant by a financing risk premium in the equity cost of capital. When will
a financing risk premium be negative?
6.A financing risk premium is the additional risk that equity holders have of losing value
because the firm cannot meet obligations on its net debt. The premium will be
negative if the firm has net financial assets rather than net financial obligations.

7. A firm with positive net financial assets will typically have a required return for equity that
is greater than the required return for its operations. Is this correct?

16 
 
7 This statement is incorrect. The required return for equity is a weighted average of
the required return for operations and that for net financial assets. As the required
return on net financial assets is typically less than that for operations, the required
return for equity is greater than that for operations. (The relationship is reversed if the
firm has net financial obligations.)

8. What is wrong with tying management bonuses to earnings per share? What measure
would you propose as a management performance metric?
8 Earnings per share can be increased by increasing leverage. Although leverage
increases eps, leverage does not increase value (apart from tax effects, if they exist).
So management can increase their bonuses without creating value for shareholders
by increasing leverage. They increase risk, but not value.   Residual operating income 
is a more desirable metric.  It focuses on operations (where value is created) and is not 
affected by financing. 

9. The management of a firm that ties employee bonuses to return on common equity
repurchases some of the firm's outstanding shares. What is the effect of this transaction on
shareholders' wealth?
9.Shareholders’ wealth declines. A share repurchases increases ROCE so, in this case,
increases management’s bonus pay. But a change in ROCE does not create value for
shareholders – unless the repurchase is at a price that is less than fair value.

10. An increase in financial leverage increases return on common equity (if the operating
spread is positive), and thus increases residual earnings. The value of equity is based on
forecasted residual earnings, yet it is claimed that the value of equity is not affected by a
change in financial leverage. How is this seeming paradox explained?
10.ROCE and residual earnings are indeed affected by a change financial leverage. But,
following the argument through, the required return for equity also changes with
leverage such that the present value of forecasted residual earnings (and thus the
equity value) is unchanged.

11. Levered price-to-book ratios are always higher than unlevered price-to-book ratios. Is this
correct?
11. No. This statement is only correct for a firm with positive financial leverage (FLEV
greater than zero which implies financial obligations are greater than financial assets)
and unlevered price-to-book ratios greater than 1.0.

12. During the 1990s and 2000s, many firms repurchased stock and borrowed to do so. What
is the typical effect of stock repurchases on earnings-per-share growth and return on common
equity? Predict how a firm that excessively engaged in these practices would have fared in
the downturn in 2008.
12 The effect of these repurchases and borrowings was to increase earnings per share growth
and ROCE for the time that the leverage remained favorable (that is, operations were
profitable). In the downturn, leverage turned unfavorable, damaging the equity of
highly leveraged firms, for operating income was not sufficient to cover debt service.

13. If an investor wants to buy a stock with high earnings growth but with low risk, she must
pay a high multiple of earnings for it. Correct?

17 
 
13 Correct. The P/E is determined by the required rate of growth and earnings growth in
excess of the required rate. Lower required rates of return mean higher P/E ratios, and higher
growth means higher P/E ratio. The required rate of growth is related to risk. So the P/E is
higher if risk is low, but even higher if a lot of growth is forecast.

14. Does an increase in financial leverage increase or decrease the (levered) P/E ratio?
14 An increase in financial leverage increases equity risk and the required return for
equity. The levered P/E declines, provided the operating income yield is higher
than the net borrowing cost, NBC (or, equivalently, the enterprise P/E is less than
1/NBC). As the enterprise P/E also incorporates growth expectations, this means
that the P/E decreases provided that growth is not particularly high (as to swamp
the leverage effect).

15. Established firms, like General Electric, have low beta risk, low earnings volatility, but
consistently high earnings growth rates. These firms should have particularly high P/E ratios.
Correct?
15 Correct. Low risk and high growth translate into a high P/E. (The reference to GE
became a little dated in 2008 as the firm ran into trouble in its finance division, GE Capital,
during the credit crisis.)
__________________________________________________________________________ 

1. Why is a simple forecast of operating income based on book value usually not a good
forecast? When might such a forecast be a good forecast?
1.Book values give a good forecast when they are reviewed at their fair value: applying the
required return to book value gives a good forecast of earnings from the net assets. So, for a
bond measured at market value, one gets a good forecast of the expected name from the bond
by applying the expected return on the bond to the book value. But net operating assets are
seldom carried at their fair value; indeed many operating assets (like knowledge assets) are
not on the balance sheet.

2. A valuation that simply capitalizes a forecast of operating income for the next year
implicitly assumes that residual operating income will continue as a perpetuity. Is this
correct?
2.Yes, this is correct. The following two valuations are equivalent (using a 10% required
return for operations):
ReOI1
Value of Operations0 = NOA0 +
0.10
OI1
Value of Operations0 =
0.10
If there is no growth in residual operating, abnormal operating income growth must be
zero. The valuation here is for the case of abnormal operating income growth of zero.

3. What is the difference between an SF2 and an SF3 forecast?

3.An SF2 forecast projects that new investment will earn at the required rate of return. An
SF3 forecast forecasts that new investment will earn at the same rate of return (RNOA) as the
investments in the current period.

4. An analyst forecasts that next year's core operating income for a firm will be the same as
the current year's core operating income. Under what conditions is this a good forecast?

18 
 
4.If current core operating income is appropriately purged of transitory items the forecast is a
good forecast if:
(1) Profitability of the net operating assets (RNOA) will be the same, and
(2) There is no growth in net operating assets.
A forecast should adjust for growth. So a sound forecast based on current operating
income (an SF2 forecast) is:
Core OI1, = Core OI0 + (Required return × NOA)

5. When is the forecasted growth rate in residual operating income the same as the forecasted
growth rate in sales?
5.The growth rate for sales is the same as the growth rate in residual operating income when
RNOA is constant, the required return is constant, and asset turnovers are constant. (if
RNOA is constant and ATO is constant, profit margins (PM) must also be constant.)

6. Would you call a firm that is expected to have a high sales growth rate a growth firm?
6.A firm with high expected growth in sales is probably a firm that can grow residual
earnings. But sales have to be profitable: a firm might grow sales, but with declining profit
margins and increasing asset turnovers, that is, with rising expenses per dollar of sales and
increasing investment to get a dollar of sales.

7. The higher the anticipated return on net operating assets (RNOA) relative to the anticipated
growth in net operating assets, the higher will be the unlevered price-to-book ratio. Is this
correct?
7.This statement is generally correct. But RNOA must be greater than the required return on
operations for it to be correct.

1. Why is it important to understand the “business concept” before valuing a firm?  

1To forecast future financial statements, the analyst must know where the business is going.
He must also have an idea of the key drivers that will determine the future financial
statements, and these key drivers are determined by the business concept and by customers’
acceptance to the concept. Firms gain an edge over their competition by innovative business
concepts.
2. Explain why a fade diagram is helpful for forecasting
2 Fade diagrams give the typical patterns (within industries) of changes in drivers over
time. The forecaster takes these patterns as a starting point and asks how the individual
firm in question might be different from the average firm.

3 What factors determine the rate at which high operational profitability declines over time?
3. Competition is the primary determinant. But the ability of a firm to challenge the
competition slows the fade rate.

4. What is meant by the “integrity” of a pro forma?

4. Pro forma financial statements have integrity if the various parts tie together
according to the accounting relations that govern the statements.

5. Forecasted dividends affect forecasted shareholders’ equity but do not affect the value
calculated from forecasted financial statements. Why?

19 
 
 5 Values are calculated from forecasts of operations, and dividends do not affect
operations. Dividends, rather, are a disposition of the free cash flow from operations.

6. What is a red-flag indicator?

6 A red flag indicator is a feature within or outside the financial statements that
indicates deterioration in profitability in the future.

7. What is an unarticulated strategy?

7 An unarticulated strategy is a business idea that is not developed enough to quantify it
into pro forma statements. A strategy to research into a cure for cancer does not lend
itself readily to financial valuation.

8. Why must the effect of a merger or acquisition on shareholder value be calculated on a per-
share basis?
8 When shares are issued in a merger or acquisition, the analyst must be concerned with
the division of the value of the merged company between the shareholders of the two firms
in the merger. That division is determined by the terms under which shares are issued in
the merger (and thus how much each shareholder receives per share).

9. When might management of a firm consider a leveraged buyout?

9 A firm generates value for shareholders when it buys the firm’s shares at less than
intrinsic value. If management considers the shares to be undervalued in the market, buying
them generates value. It is also argued that leveraged buyouts incentivize management –
because they have to service the high debt load.

10. Why might the shares of the acquiring firm in an acquisition decline on announcement of
the acquisition?
10 The acquirer’s shares will decline if the market thinks the acquirer is overpaying for
the acquisition. This may be because the acquiree’s shares are over-priced – possibly
driven up by bidding from a number of potential acquirers – or because the acquirer
offers unfavorable terms (to itself) in a share exchange. The acquirer’s share price might
also decline if the market views the merger as one where the acquirer is using its
overvalued shares to make and acquisition, and thus views the merger announcement as a
signal of that overvaluation.

1. Firms with a return on net operating assets (RNOA) that is higher than the required return
on operations are adding value with their investments and so should trade at a premium over
their book value. Is this statement correct?

1.The first half of the statement is not correct. A firm can have a high RNOA because of the
accounting it uses, not because it is investing in value-added projects. But the second part of
the statement is correct. If a firm has high RNOA because of the accounting – or because of
economic profitability – it must trade at a premium.

2. Why are LIFO accounting and the expensing of R&D expenditures referred to as
conservative accounting policies?

2.Both policies understate the book value of assets relative to alternatives, and conservative
accounting involves understatement of assets.

20 
 
3. Explain how intrinsic price-to-book (P/B) ratios are affected by conservative accounting
(such as expensing R&D expenditures).
3.Conservative accounting means that the carrying value of net assets is lower than otherwise.
So, as accounting does not affect intrinsic prices, conservative accounting yields higher
intrinsic P/B ratios.

4. Does conservative accounting result in higher or lower accounting rates of return?

4.Conservative accounting produces higher return on net operating assets (RNOA) and return
on common equity (ROCE). When first implemented, it may produce lower measures (as net
assets are written off) but the write off results in higher rates of return subsequently.

5. Explain how intrinsic P/E ratios are affected by conservative accounting (such as
expensing R&D expenditures).
5.Conservative accounting does not affect the intrinsic P/E ratio if net operating assets are
constant, for earnings are not affected by the accounting and neither is value. But if net
operating assets are increasing, earnings are lower with conservative accounting, so the P/E is
higher. And P/E ratios are lower if net operating assets are declining.

6. Consultants talk of “economic profit” or “economic value added”. What is it? Can it be
observed?
6.The concept of “economic profit” refers to value added by an investment over the opportunity
cost of the investment. But it cannot be observed, without measurement, and measurement
involves choices of accounting rules (which may or may not capture economic profit). All
measures of “economic profit” are accounting measures. Economic profit or economic value
added can, however, be estimated ex ante (before the fact) with residual earnings techniques.

7. How is it that accounting policies affect the measurement of residual income but the value
calculated using residual income methods may not be affected by accounting policies?
7.Accounting policies determine residual income by changing book values. So, if book values
are added to the present value of residual earnings, the calculated value is not affected, provided
steady state residual income is forecasted.

8. A firm that uses LIFO accounting for inventory in times of rising inventory costs will
always report lower profit margins than if it used FIFO. Is this correct?
8.No, this is not always correct. If inventories are constant, income and margins will be the
same under LIFO and FIFO. If inventories decline, LIFO liquidation will yield higher income
and profit margins.

9. A firm using LIFO accounting for inventory is likely to have a lower inventory turnover
ratio than one using FIFO. Is this correct?
9.No, this is not correct. LIFO yields lower inventory values (if inventory costs are rising) so
a higher inventory turnover.

10. Firms with anticipated earnings-per-share growth are worth more. Is this statement
always correct?
10.No. Growth in eps can be created by leverage and stock repurchases. And growth can be
created by conservative accounting.

11. What is a “hidden reserve”? What does it mean to “release hidden reserves”?

21 
 
11.A hidden reserve is an asset that would otherwise be on the balance sheet if it were not for
conservative accounting. It can also be created by an overstated liability. Hidden reserves are
created by reducing earnings (and so recording lower net assets). Releasing hidden reserves
refers to the practice of slowing investment that has generated the reserve (along with
conservative accounting) so as to increase income. Hidden reserves are also released by
reducing an overstated liability. The LIFO reserve is an example of a hidden reserve (for
inventories). A decrease in the LIFO reserve is a release of the reserve (that increases income
through lower cost of goods sold).

12. What is meant by “steady state”?

12.Steady-state is a point in the evolution of a firm (usually in the future) where residual income
subsequent to that point can be summarized by residual earnings at the point in time and a
growth rate.

13. In the United Kingdom, firms revalue tangible assets upward and recognize the value of
brands on the balance sheet. In the United States, this accounting is not permitted. In which
country would you expect the average return on common equity for firms to be higher?
13. Return on common equity should be higher, on average, in the U.S. Accounting in the
U.S. is more conservative, producing higher ROCE.

14. The Wall Street Journal reported: “Sears, Roebuck & Co. is moving toward more
conservative accounting methods used by competing credit- card issuers, which will boost its
loan losses by about $200 million during the next 5 quarters”. What effect should this new
policy have had on future return on net operating assets?
14.The return on net operating assets (RNOA) will be lower in the first year as the new write-
off of credit-card receivables hits the income statement, but thereafter the change will increase
RNOA.

15. Expensing research and development costs raises accounting quality issues similar to
those raised in cash accounting. Explain.

15. R&D expensing is cash accounting: investment is expensed immediately. Like free cash
flows, this can give low or negative income when the firm is in fact generating value through
the R&D. Accordingly, when forecasting for valuation, the forecast horizon often must be
pushed far into the future (as with cash accounting) to capture the earnings from R&D
investment. Capitalizing R&D and matching expenses for it against future revenue rectifies the
problem. (But one then has to ask about the quality of the asset and its amortization: will the
R&D really be successful?)
 
1. A firm can create future income by temporarily increasing its bad debt allowance. Is this
correct?
1.This is correct. By overestimating bad debts currently, and reversing the overestimate in the
future, a firm reports higher income in the future.

2. Low depreciation charges forecast losses in future income statements. Is this correct?
2.This is correct. If a firm under depreciates assets, it will recognize a loss or restructuring
charge later as the asset is sold or is deemed to be “impaired.”

3. A decrease in warranty liabilities increases net sales. Is this correct?

22 
 
3.This is correct. Holding all else constant, an increase in a warranty liability means more
warranty expense to charge against sales (to yield lower net sales), and a decrease in a warranty
liability has the opposite effect.

4. Increasing profit margins by underestimating expenses creates net operating assets. Is this
correct?
4.This statement is correct. To reduce expenses, an operating asset has to increase or an
operating liability has to decrease.

5. Why is a change in the asset turnover an indicator of future profitability?

5.If assets (such as inventory and receivables) rise relative to sales it may be that the firm is
having more difficulty generating sales from its investment, so future sales and profits might
decrease. But also, if the firm is increasing accruals to report higher profits per dollar of sales,
it will increase net operating assets and lower its asset turnover. The accruals will reverse in
future periods, reducing (future) profitability.

6. Why do analysts compare cash flow from operations with earnings to assess the quality of
the earnings?
6.The difference between earnings and cash flow from operations is explained by the accruals,
and the accruals are the “soft” part of earnings that can be manipulated.

7. Why should an analyst view a large merger charge suspiciously?

7. Merger charges are estimated and sometimes can include costs that would otherwise be
part of operating income. If a firm has a large, overestimated merger charge, it can “bleed
back” the charge to income in the future, and so reduce the effect of goodwill amortizations
from the merger.

8. Why should an analyst view an increase in deferred taxes from bad debt allowances
suspiciously?
8.Bad debts are charged against income on the tax return when the debts actually go bad, that
is, when the debtor defaults. If the firm is reducing its bad debt allowance (and so creating
income for its financial reports) it will increase its deferred taxes, that is, taxes on the difference
between income on the tax return and income in the financial reports.

9. IBM reported a 3 percent increase in income for its first quarter of 2000, beating analysts’
estimates. But it also reported a decline in revenue. Its stock price dropped in response to the
report. What explanations would you give for the drop in stock price on an earnings increase?
What is your prediction for the change in IBM’s asset turnover over the quarter?
9.The market saw the increase in earnings as low quality. The higher profit margins on sales
might have been generated by cost efficiencies, but might also be a result of the accounting. In
any case, an earnings increase on declining revenues is seen as lower quality than an earnings
increase on increasing revenues. The quality of the earnings may be suspect, and the decline
in revenue may also have implications for a slowing of revenue growth in the future.
The asset turnover is expected to decline for two reasons:
(i) Sales are lower, so if investments have not declined, ATO will be lower.
(ii) Net operating assets may be higher because of “soft” accruals that resulted
in the earnings increase, reducing the ATO.

23 
 
10. Excite signed a pact with Netscape in 1999 under which it paid $86.1 million to share
revenues from co-branded search-and-directory services. It wrote off two thirds of the cost- or
$56.8 million-against income immediately. Analysts objected. Why should they?
10.The objecting analysts see the cost as an investment that should be written off over the life
of the revenues from the contract. Expensing the cost immediately means lower expenses later
and a false picture of the profitability of later revenues from the contract.

11. Shares of Pitney Bowes dropped 10 percent after it announced earnings per share from
continuing operations of $0.70 for its September quarter of 1999, up from $0.49 in the same
quarter in the year before. Revenues also increased 8 percent.
Analysts raised concerns about the quality of the earnings, citing a decrease in the firm’s
effective tax rate. Why might the effective tax rate be of concern to analysts?
11.Tax rates tend to converge to statutory rates over time as credits and other tax concessions
expire. So analysts may expect taxes to be higher in the future (and earnings lower). A
decrease below the statutory rate is likely to be temporary.

12. If you saw a deferred tax liability from depreciation increase significantly over a year, what
might you conclude?
12.The deferred tax liability from depreciation (reported in the deferred tax footnote) can
increase because
(a) There is a large increase in capital expenditures producing more depreciation
and a greater difference between book and tax depreciation, or
(b) The firm increases its estimate of useful lives for depreciation expense on the
books, thus decreasing depreciation expense and increasing the difference
between book and tax depreciation.

13. A firm has a capital expenditure-to-depreciation ratio of 1.6 over three years. What might
you infer from this ratio?
13.Capital expenditures must be depreciated to income over the life of the assets purchased.
So capital expenditures are an indication of future depreciation. If capital expenditure-to-
depreciation is high, the indications are that future depreciation will be higher than current
depreciation. This may be because of growth in capital expenditures (that will result in more
sales and profits) or because the firm is under depreciating its assets. The latter explanation is
an earnings quality concern, and a ratio of 1.6 would have to be investigated to see if this
concern is justified. Over time the ratio of capital expenditures to depreciation should be 1.0.
14. Some firms suggest that investors focus on “pro forma” earnings rather than reported
earnings. Their pro forma earnings usually exclude amortizations of goodwill and shares of
losses in subsidiaries. Is this good advice?
14.Ignoring these elements of earnings gives a higher “pro forma” earnings than reported
earnings. Shares in losses of minority subsidiaries are just as legitimate as shares in profits,
although both might be distinguished from profits and losses from sales. Amortizations of
goodwill are legitimate if the value of goodwill purchased in an acquisition declines: the firm
is reporting revenues from the acquisition and should match against those revenues the
“depreciated” cost of the acquisition, just as it depreciates plant. But if the value of the
goodwill has not declined, amortization charges are inappropriate. A firm would justify a pro
forma number by reasoning that the value of the goodwill has not been impaired.

15. Federal Reserve Chairman Alan Greenspan stated that corporate profits in the United States
were understated, particularly in the technology sector. To what do you think he was referring?

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15.He was referring to the expensing of investment in research and development and brand
building in the technology sector. These expenditures depress profits, but are really
investments in assets. (On the other hand, the technology sector overstates profits by not
recognizing employee compensation from stock options.)

16. The realization principle, which recognizes revenues at point of sale, is said to be an
accounting principle that improves the quality of reporting. Companies cannot estimate their
future revenues; rather they must have a firm customer before they can recognize revenue. Do
you see the realization principle as a desirable accounting principle?
16.Booking revenue on sale of goods or services to customers improves the quality of
reporting, for the reasons given in the question. But it also means that revenues that can be
forecasted are not booked. So, for example, and analyst might forecast considerable value from
an R&D breakthrough, but the accounting will not recognize that value until the product from
the innovation is sold.

17. Matching costs to revenue-the matching principle-is seen as producing “good quality”
earnings numbers. Why?
17.Matching costs to the revenues they generate gives a measure of the profitability of
products. Value received is compared to value surrendered to generate the value. The
measured profitability is then a good basis to forecast future profitability.

1. Why might the normal distribution of returns not characterize the risk of investing in a
business?
1The history of stock returns shows that an investor has a higher chance of getting large
negative or positive returns than is predicted by the normal distribution. With a normal
distribution, the whole distribution is summarized by the mean and the standard deviation, but
the standard deviation understates the probability of getting extreme returns. Investors are
particularly worried by the chance of getting large negative returns and the normal distribution
understates this chance.
2. Comment on the following statement. The challenge in measuring the required return for
investing is to measure the size of the risk premium over the risk-free rate, but the capital asset
pricing model largely leaves this measurement as a guessing game.
2.The market risk premium in the Capital Asset Pricing Model (CAPM) is the expected return
on the market portfolio minus the risk-free rate. Expected returns are hard to measure, so beta
analysts turn to historical returns to get a sense of the risk premium. The size of the historical
premium varies significantly over the periods in which it is measured, and from country to
country. Research gives estimates varying from 3.0% to 9.5%. With this lack of precision,
one does not have a lot of confidence in the cost of capital estimated using the CAPM.
3. Can you explain why diversification lowers risk?
3.With a number of securities in a portfolio, returns on the securities tend to off-set each other.
So, if one stock has a negative return, another stock might have a positive return (or a less
negative return), reducing the variation in returns for the portfolio. The only situation where
diversification does not reduce risk is where returns on securities in the portfolio are perfectly
correlated.

4. Why does operating liability leverage increase operating risk?

4.Refer to the operating liability leverage formula :
RNOA = ROOA + (OLLEV × OLSPREAD).
Operating liability leverage (OLLEV) is favorable if the operating liability leverage spread
(OLSPREAD) is positive, that is, return on operating assets (ROOA) is greater than the after-

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tax short-term borrowing rate. But the leverage can turn unfavorable if OLSPREAD turns
negative. This chance of OLSPREAD turning negative (with its effect of reducing RNOA and
residual income) is the risk of operating liability leverage. The OLSPREAD turns negative if
ROOA falls but also if trade creditors increase the implicit borrowing cost in the prices of the
goods and services they charge. And, if operational profitability declined enough, they might
deny credit altogether, taking away the benefit of operating liabilities.

5. Why are growth stocks often seen as high risk?

5.Growth stocks can be riskier because growth firms invest and make commitments in
anticipation of growth. If that growth does not materialize, their asset turnovers decline (they
have asset turnover risk) and their operating risk (fixed to variable costs) also increases (they
have higher profit margin risk). To the extent that growth is sustainable, however, growth
stocks are less risky.

6. Explain asset turnover risk.

6.Asset turnover is sales-to-net operating assets. Return on net operating assets (RNOA) and
residual operating income (ReOI) increase if asset turnover increases, but RNOA and ReOI
decrease if asset turnover decreases. Asset turnover risk is the chance that asset turnover will
decrease. Asset turnover will decrease if net operating assets do not drop proportionally with
a drop in sales because net assets are inflexible. So, for example, the chance of having idle
capacity in plants is asset turnover risk.

7. Airlines are said to have high operating risk. Why?

7.Airlines have high fixed expenses relative to variable expenses so, if sales fall, operating
profits fall more in percentage terms. They have high asset turnover risk because facilities and
equipment usually cannot be reduced when sales fall. And their sales are riskier: airlines are
particularly susceptible to drops in revenue when the economy turns down.

8. Why might stock returns have greater risk than is justified by the fundamentals of the firm’s
business activities?
8.Stock prices are driven by fundamentals but might also deviate from fundamentals. The
investor can thus face the risk of prices moving in ways not related to fundamentals. This is
price risk. Like all risk, it has its reward if the mispricing can be exploited.

9. Should firms manage risk on behalf of their shareholders?

9.Theory says that, if all the opportunities that firms have to manage risk are available to the
shareholders, the firm should not presume to manage risk on behalf of the shareholders. Rather
each shareholder should manage risk to yield his own chosen risk exposure. Indeed, if a firm
manages risk, it may deny the shareholder the ability to expose himself to this risk. But the
same opportunities for risk management may not be available to firm and shareholder alike, or
the firm may be able to do it more cheaply. In this case, the shareholder might want some risk
management by the firm.

10. Suppose one calculated the intrinsic value of two firms using residual earnings techniques
with the risk-free rate as a discount rate. The price-to-value (P/V) ratio of these two firms, so
calculated, should be the same if they have the same risk characteristics. Is this so?
10.Yes. If price is the risk-adjusted value and the firms are in the same risk class, then the P/V
ratio of the two firms are the same.

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11. Explain the difference between Scenario A and Scenario B investing and the risks involved
in each.
11. Scenario A involves investing in a firm whose price (currently) has “deviated from
fundamental value.” One hopes to earn an abnormal return as the price “gravitates to
fundamentals.” Scenario B involves investing in a firm that is currently appropriately priced,
but with the expectation that the price will deviate from fundamental value in the future. Both
strategies bear risk. In both cases, new information might arrive that changes the fundamental
value in such a way to go against the position that the trader has taken. Scenario A also has the
risk of price deviating from fundamentals even more (at least in the short run), as Scenario B,
that caused the mispricing, perpetuates. (Traders who shorted stocks during the bubble got into
very uncomfortable positions as prices rose more and more.)

1. Why is income in the equity portion of the balance sheet called "dirty-surplus" income?
1.Because the accounting is not representatively faithful in measuring additions to “surplus”.
“Surplus” is an old-fashioned word meaning shareholder’s equity – the surplus of assets over
liabilities. An effect on equity from operations – that creates additional “surplus” -- bypasses
the income statement (which is supposed to give the results of operations), and thus is “dirty.”
Clean-surplus accounting books all income in the income statement.

2. Why can "value be lost" if an analyst works with reported net income rather than
comprehensive income?
2.If a valuation is made on the basis of income that is missing some element (of the value added
in operations), the valuation is wrong. For example, if sales or depreciation expense were put
in the equity statement rather than the income statement, we would see the income statement
as missing something that is value-relevant.
3. Are currency translation gains and losses real gains and losses to shareholders? Aren't they
just an accounting effect that is necessary to consolidate financial statements prepared in
different currencies?
3.Currency translation gains and losses are real. If a U.S. firm holds net assets in another
country and the dollar equivalent of those asset falls, the shareholder has lost value.
Many of the net assets behind the Nike’s shareholders’ equity are in countries other than the
U.S. If the value of the dollar were to fall against those currencies, the firm would have more
dollar value to repatriate to ultimately pay dividends to shareholders. Nike’s 2008 equity
statement reports a currency translation gain of $211.9 million. This means that the dollar value
of net assets in other countries – in which the shareholders are investing – appreciated by
$211.9 over 2008. The shareholders gained in dollar terms.

4. In accounting for the conversion of convertible bonds to common stock, most firms record
the issue of shares at the amount of the book value of the bonds. The issue of the shares could
be recorded at their market value, with the difference between the market value of the shares
and the book value of the bonds recorded as a loss on the conversion. Which treatment best
reflects the effect of the transactions on the wealth of the existing shareholders.
4.Existing shareholders lose when shares are issued to new shareholders at less than the market
price. They give up a share worth the market price, but receive in return a cancellation of a
liability valued at its book value. The new shareholders buying into the firm through the
conversion gain: they receive shares worth more than they paid for the bonds. The accounting
treatment (the “market value method”) that records the issue of the shares in the conversion at
market value, along with a loss on conversion, reflects the effect on existing shareholders’
wealth. See the web page for the chapter for journal entries.
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