Module 15

Market-Based Valuation

Learning Objectives – Coverage by question

True/False Multiple Choice

LO1 – Explain company valuation using balance sheet

1-3, 5, 7, 9
multiples.

LO2 – Explain company valuation using income

6, 8, 10
statement multiples.

LO3 – Identify comparable to derive market multiples. 4, 11-22

LO4 – Interpret and reverse-engineer market multiples

23-25
to assess the reliability of market expectations.

These questions are available to assign in myBusinessCourse.

©Cambridge Business Publishers, 2021

15-1 Financial Statement Analysis & Valuation, 6th Edition
Module 15: Market-Based Valuation

Multiple Choice

Topic: Market Multiples

LO: 1
1. Valuation using market multiples is popular because it simply multiplies a market multiple by what
variable to determine value?
A) Stock price
B) Weighted average cost of capital
C) Summary performance measure
D) Working capital

Answer: C
Rationale: Using market multiples values the firm as the summary performance measure multiplied
by the market multiple.

Topic: Market Multiples

LO: 1
2. Which of the following would not be used as a summary performance measure when using market
multiples to determine value?
A)
B) Net operating assets
C) Net operating profit after tax
D) Book value

Answer: A
Rationale: Summary performance measures include earnings, book value, NOA, and NOPAT.

Topic: Market Multiples

LO: 1
3. Which of the following is an inconsistency of using market multiples to determine value?
A) Using a market multiple assumes that the target company is correctly priced, while comparable
companies are mispriced.
B) Using a market multiple assumes that the target company is mispriced, while comparable
companies are correctly priced.
C) Using a market multiple assumes that all companies are mispriced.
D) Using a market multiple assumes that the target company can be fully described by its summary
performance measure.

Answer: B
Rationale: Using market multiples values the firm as the summary performance measure multiplied
by the market multiple, which implicitly assumes that other firms from which the market multiple is
obtained are correctly valued.

©Cambridge Business Publishers, 2021

Test Bank, Module 15 15-2
Topic: Residual Operating Income Model
LO: 3
4. When considering the residual operating income model, a company value to net operating assets
ratio equal to 1 would suggest:
A) Future ROPI is equal to 0
B) Future ROPI is equal to 1
C) Present value of expected ROPI is equal to 0
D) Present value of expected ROPI is equal to 1

Answer: C
Rationale: When using market multiples and the residual operating income model if company value
equals 1 then future ROPI must be zero.

Topic: Valuation Using Balance Sheet Multiple

LO: 1
5. Foraker Products is a manufacturer and distributor of numerous food products. The company has a
book value of $20.68 per share. Foraker Products is part of the food processing industry which has
an industry PB ratio of 2.15.

Using industry information, estimate the intrinsic value of Foraker Products’ equity per share?
A) $ 9.62
B) $20.68
C) $44.46
D) $22.83

Answer: C
Rationale: Intrinsic value equals book value per share multiplied by the industry PB ratio, ($20.68 x
2.15 = $44.46).

Topic: Valuation Using Income Statement Multiple

LO: 2
6. Foraker Products is a manufacturer and distributor numerous food products. The company recently
reported earnings per share of $5.90. Based on its recent price of $110.48, the company has a PE
ratio of 18.72542373. Foraker Products is part of the food processing industry which has an industry
PE ratio of 19.75.

Using industry information, estimate the intrinsic value of Foraker Products’ earnings per share?
A) $ 5.90
B) $ 62.68
C) $104.75
D) $116.53

Answer: D
Rationale: Intrinsic value equals earnings per share multiplied by the industry PE ratio, ($5.90 x
19.75 = $116.53).

©Cambridge Business Publishers, 2021

15-3 Financial Statement Analysis & Valuation, 6th Edition
Topic: Valuation Using Balance Sheet Multiple
LO: 1
7. Nova Components is a manufacturer of computer parts. The company has a book value of
$2,175,986. In addition the company has 402,500 common shares issued and outstanding. Nova
Components is part of the computing industry which has an industry PB ratio of 6.10.

Using industry information, estimate the intrinsic value of Nova Components’ equity per share?
A) $32.98
B) $ 5.41
C) $11.51
D) None of these are correct.

Answer: A
Rationale: Intrinsic value equals book value multiplied by the industry PB ratio, ($2,175,986 x 6.10 =
$13,273,514.60). Dividing the intrinsic value by the number of shares outstanding provides an
intrinsic value per share, ($13,273,514.60 / 402,500 = $32.98).

Topic: Valuation Using Income Statement Multiple

LO: 2
8. Nova Components is a manufacturer of computer parts. The company recently reported earnings of
$2,175,986. In addition, Nova Components has 402,500 shares issued and outstanding. The
company has a PE ratio of 24.6. Nova Components is part of the computer parts industry which has
an industry PE ratio of 25.6.

Using industry information, estimate the intrinsic value of Nova Components’ equity per share?
A) $ 31.01
B) $132.99
C) $ 5.63
D) $138.40

Answer: D
Rationale: Intrinsic value equals earnings multiplied by the industry PE ratio. Dividing the intrinsic
value by the number of shares outstanding provides an intrinsic value per share, (($2,175,986 /
402,500) x 25.6 = $138.40).

Topic: Valuation Using Balance Sheet Multiple

LO: 1
9. Oliver Learning is a retailer focused on education supplies. The company has a book value of $39.58
per share. Oliver Learning has a PB ratio of 8.80 and the education supplies industry PB ratio is 6.46.

Assuming that comparable industry companies are priced correctly the intrinsic value of Oliver
Learning’s equity per share is:
A) Undervalued $92.62 per share
B) Overvalued $39.58 per share
C) Overvalued by $92.62 per share
D) Priced correctly

Answer: C
Rationale: Intrinsic value equals book value per share multiplied by the industry PB ratio. To
determine the amount of mispricing, the intrinsic value would be compared to the current price.
($39.58 x 8.80) – ($39.58 x 6.46) = $92.62

©Cambridge Business Publishers, 2021

Test Bank, Module 15 15-4
Topic: Valuation Using Income Statement Multiple
LO: 2
10. Fergeson Learning is a retailer focused on education supplies. The company recently reported
earnings per share of $3.93. Based on its recent price of $44.78 the company has a PE ratio of 11.39.
The educational supplies industry PE ratio is 19.25.

Assuming that comparable industry companies are priced correctly the intrinsic value of Fergeson
Learning’s equity per share is:
A) Undervalued $30.89 per share
B) Overvalued $3.93 per share
C) Overvalued by $30.89 per share
D) Priced correctly

Answer: A
Rationale: Intrinsic value equals earnings per share multiplied by the industry PE ratio. To determine
the amount of mispricing the intrinsic value would be compared to the current price. ($3.93 x 11.39) –
($3.93 x 19.25) = ($30.89)

Topic: Selecting Comparables for Market Multiples

LO: 3
11. Which of the following factors should not be considered when choosing comparable companies and
using net operating assets as the summary performance measure?
A) Expected future profitability
B) Expected future growth
C) Capital structure
D) Expected operating risk

Answer: C
Rationale: RNOA, growth in NOA and the variance of operating income are the three factors that
need to be considered when choosing comparables when net operating assets is the summary
performance measure.

Topic: Selecting Comparables for Market Multiples

LO: 3
12. Which of the following factors should not be considered when choosing comparable companies and
using book value as the summary performance measure?
A) Expected future profitability
B) Expected future growth
C) Expected equity growth
D) Capital structure

Answer: C
Rationale: RNOA, growth in NOA and the variance of operating income and capital structure are the
four factors that need to be considered when choosing comparable companies when book value is
the summary performance measure.

©Cambridge Business Publishers, 2021

15-5 Financial Statement Analysis & Valuation, 6th Edition
Topic: Residual Operating Income Model
LO: 3
13. The correct version of the residual operating income model is:
A) ROPI = NOPAT – (NOABEG x re )
B) ROPI = NOPAT – (NOAEND x re )
C) ROPI = NOPAT + (NOABEG x rw )
D) ROPI = NOPAT – (NOABEG x rw )

Answer: D
Rationale: The residual operating income model is operating income in excess of a fair rate of return
on beginning net operating assets.

Topic: Residual Operating Income Model

LO: 3
14. Under which circumstance will Company A not sell at a higher PB ratio than Company B?
A) Company A has higher profitability than Company B.
B) Company A has higher expected growth than Company B.
C) Company A has a higher discount rate than Company B.
D) Company A has higher leverage than Company B.

Answer: C
Rationale: When deriving the PB ratio using the residual operating income model it can be shown
that companies with lower discount rates will sell at a higher PB ratio.

Topic: PB Ratio
LO: 3
15. Given the following information for Hopkins Company, determine the company’s theoretically correct
PB ratio:

Net Operating Assets $266

Owners’ Equity $266
RNOA 14%
ROE 14%
WACC 8%
Expected Growth rate in ROPI 4%

A) 2.0
B) 1.0
C) 1.67
D) 2.5

Answer: D
Rationale:
HOPKINS CO.
ROPI $16 ($266 x 14%) – ($266 x 8%)
PV of ROPI $399 16 / (8% – 4%)
Value of Equity $665 $266 + $399
PB ratio 2.5 1 + ($399 / $266)

In this circumstance, we would obtain a value for equity of $665, resulting in a PB ratio of 2.5.

©Cambridge Business Publishers, 2021

Test Bank, Module 15 15-6
Topic: PB Ratios in Relation to Profitability
LO: 3
16. Given the following information for Max Company and Moritz Company determine the difference in
the entities’ theoretical value of equity:

Max Co. Moritz Co.

Net Operating Assets $266 $266
Owners’ Equity $266 $266
RNOA 14% 12%
ROE 14% 12%
WACC 8% 8%
Expected Growth rate in ROPI 4% 4%

A) $-0-
B) $226.0
C) $665.0
D) $133.0

Answer: D
Rationale:
Max Co. Moritz Co.
ROPI $16 ($266 x 14%) – ($266 x 8%) $10.60 ($266 x 12%) – ($266 x 8%)
PV of ROPI $399 16.0 / (8% - 4%) $266 10.6 / (8% - 4%)
Value of Equity $665 $266 + $399 $532 $266 + $266
PB ratio 2.5 1 + ($399 / $266) 2.0 1 + ($266 / $266)

Value of Equity Difference = ($665 - $532) = $133

Topic: PB Ratios in Relation to Profitability

LO: 3
17. Given the following information for Max Company and Moritz Company determine the difference in
the entities’ theoretically correct PB ratio:

Max Co. Moritz Co.

Net Operating Assets $266 $266
Owners’ Equity $266 $266
RNOA 14% 12%
ROE 14% 12%
WACC 8% 8%
Expected Growth rate in ROPI 4% 4%

A) 0.50
B) 0.75
C) 2.60
D) There would be no expected difference

©Cambridge Business Publishers, 2021

15-7 Financial Statement Analysis & Valuation, 6th Edition
 Answer: A
Rationale:
Max Co. Moritz Co.
ROPI $16 ($266 x 14%) – ($266 x 8%) $10.6 ($266 x 12%) – ($266 x 8%)
PV of ROPI $399 16.0 / (8% - 4%) $266 10.6 / (8% - 4%)
Value of Equity $665 $266 + $399 $532 $266 + $266
PB ratio 2.5 1 + ($399 / $266) 2.0 1 + ($266 / $266)

PB Ratio Difference = (2.5 – 2.0) = 0.5

Topic: PB Ratios in Relation to Growth

LO: 3
18. Given the following information for Mary Company and Scott Company determine the difference in
the entities’ theoretical value of equity:

Mary Co. Scott Co.

Net Operating Assets $540 $540
Owners’ Equity $540 $540
RNOA 14% 14%
ROE 14% 14%
WACC 12% 12%
Expected Growth rate in ROPI 8% 2%

A) $162
B) $108
C) $-0-
D) $810

Answer: A
Rationale:
Mary Co. Scott Co.
ROPI $10.80 ($540 x 14%) – ($540 x 12%) $10.80 ($540 x 14%) – ($540 x 12%)
PV of ROPI $270 10.8 / (12% - 8%) $108 10.80 / (12% - 2%)
Value of Equity $810 $540 + $270 $648 $540 + $108
PB ratio 1.5 1 + ($270 / $540) 1.2 1 + ($108 / $540)

Value of Equity Difference = ($810 – $648) = $162

©Cambridge Business Publishers, 2021

Test Bank, Module 15 15-8
Topic: PB Ratios in Relation to Growth
LO: 3
19. Given the following information for Mary Company and Scott Company, determine the difference in
the entities’ theoretically correct PB ratio:

Mary Co. Scott Co.

Net Operating Assets $540 $540
Owners’ Equity $540 $540
RNOA 13% 14%
ROE 13% 14%
WACC 12% 12%
Expected Growth rate in ROPI 8% 2%

A) 0.26
B) 0.08
C) 0.05
D) There would be no expected difference

Answer: C
Rationale:
Mary Co. Scott Co.
ROPI $5.40 ($540 x 13%) – ($540 x 12%) $10.80 ($540 x 14%) – ($540 x 12%)
PV of ROPI $135 5.40 / (12% - 8%) $108 10.80 / (12% - 2%)
Value of Equity $675 $540 + $135 $648 $540 + $108
PB ratio 1.25 1 + ($135 / $540) 1.2 1 + ($108 / $540)

PB Ratio Difference = (1.25 – 1.2) = 0.05

Topic: PB Ratios in Relation to Risk

LO: 3
20. Given the following information for Kailey Company and Cisco Company, determine the difference in
the entities’ theoretical value of equity:

Kailey Cisco
Net Operating Assets $450 $450
Owners’ Equity $450 $450
RNOA 15% 15%
ROE 15% 15%
WACC 10% 13%
Expected Growth rate in ROPI 8% 8%

A) $180
B) $945
C) $1,575
D) $-0-

©Cambridge Business Publishers, 2021

15-9 Financial Statement Analysis & Valuation, 6th Edition
 Answer: B
Rationale:
Kailey Cisco
ROPI $22.50 ($450 x 15%) – ($450 x 10%) $9 ($450 x 15%) – ($450 x 13%)
PV of ROPI $1,125 22.50 / (10% - 8%) $180 9 / (13% - 8%)
Value of Equity $1,575 $450 + $1,125 $630 $450 + $180
PB ratio 3.5 1 + ($1,125 / $450) 1.4 1 + ($180 / $450)

Value of Equity Difference = ($1,575 – $630) = $945

Topic: PB Ratios in Relation to Risk

LO: 3
21. Given the following information for Kailey Company and Cisco Company, determine the difference in
the entities’ theoretically correct PB ratio:

Kailey Co. Cisco Co.

Net Operating Assets $450 $450
Owners’ Equity $450 $450
RNOA 14% 15%
ROE 14% 15%
WACC 10% 13%
Expected Growth rate in ROPI 8% 8%

A) 1.60
B) 2.40
C) 8.32
D) There would be no expected difference

Answer: A
Rationale:
Kailey Cisco
ROPI $18 ($450 x 14%) – ($450 x 10%) $9 ($450 x 15%) – ($450 x 13%)
PV of ROPI $900 18 / (10% - 8%) $180 9 / (13% - 8%)
Value of Equity $1,350 $450 + $900 $630 $450 + $180
PB ratio 3.0 1 + ($900 / $450) 1.4 1 + ($180 / $450)

PB Ratio Difference = (3.0 – 1.4) = 1.60

©Cambridge Business Publishers, 2021

Test Bank, Module 15 15-10
Topic: Balance Sheet Market Multiples
LO: 3
22. PB ratios are higher than __________________ when companies carry debt.
A) Price-to-NNO ratios
B) Price-to-NOA ratios
C) Residual Operating Income
D) Price to Sales ratios

Answer: B
Rationale: Levered PB ratios are higher than unlevered PB ratios.

Topic: Reverse Engineering of PB Ratio – Implied Growth Rate

LO: 4
23. The following information is for Mountain Lion Corp. an appliance manufacturer. Given this
information determine Mountain Lion's implied rate of growth.

Market value of equity $38,400

Book value of equity $19,200
ROE 15.3%
EPS growth 8.8%
Market's expectation of ROE 15.3%
Market's expectation of discount rate (re) 9.0%

A) 2.5%
B) 8.8%
C) 2.7%
D) 1.0%

Answer: C
Rationale:
PB = 38,400 / 19,200 = 2
PB* = PB – 1 = 2 – 1 = 1.00

Solve for implied growth rate (g) = (re + [PB* x re] – ROE) / PB*
= (0.09 + [1.00 x .0.09] - 0.153] / 1.00
= 2.7%

©Cambridge Business Publishers, 2021

15-11 Financial Statement Analysis & Valuation, 6th Edition
Topic: Reverse Engineering of PB Ratio – Implied Discount Rate
LO: 4
24. The following information is for Mountain Lion Corp. an appliance manufacturer. Given this
information determine Mountain Lion's implied discount rate.

Market value of equity $38,400

Book value of equity $19,200
ROE 15.3%
EPS growth 8.8%
Market's expectation of ROE 15.3%
Market's expectation of growth rate (g) 6.0%

A) 8.8%
B) 2.8%
C) 12.1%
D) 10.7%

Answer: D
Rationale:
PB = 38,400 / $19,200 = 2
PB* = PB – 1 = 2 – 1 = 1.00

Solve for implied discount rate (re) = (ROE + [PB* x g] / (1 + PB*) =

15.3% + (1.00 x 0.06) / (1 + 1.00)
= 10.7%

Topic: Reverse Engineering of PB Ratio – Implied Future ROE

LO: 4
25. The following information is for Mountain Lion Corp. an appliance manufacturer. Given this
information determine Mountain Lion's implied future ROE.

Market value of equity $42,200

Book value of equity $19,200
ROE (past 4 quarters) 15.3%
EPS growth (past 4 quarters) 8.8%
Market’s expectation of discount rate ( re ) 9.0%
Market’s expectation of growth rate (g) 6.0%

A) 3.0%
B) 12.3%
C) 9.3%
D) 12.8%

Answer: D
Rationale:
PB = 43,200 / $19,200 = 2.25
PB* = PB – 1 = 2.25 – 1 = 1.25

Solve for implied future ROE = [PB* x (re – g)] + re

= [1.25 x (0.09 – 0.06)] + 0.09
= 12.8%

©Cambridge Business Publishers, 2021

Test Bank, Module 15 15-12
Exercises

Topic: Valuation using Price-to-NOA Multiple

LO: 1
1. The following table provides summary information for Alpha Corp. and its competitors Beta, Inc. and
Gamma Company. Use the information to compute the price to net operating assets ratio for Beta
and Gamma. In addition, using Beta and Gamma as comparables, compute Alpha’s intrinsic value,
equity intrinsic value and equity intrinsic value per share.

(All amounts in millions) Alpha Beta Gamma

Company assumed value $47,252 $35,368
Equity assumed value 42,865 35,024
Net operating assets $3,766 11,164 5,719
Book value of equity 2,922 6,777 5,375
Net nonoperating obligations 844 4,387 344
Common shares outstanding 92.4 325.8 185.4

Answer:
In this case use a simple average of the two comparable companies’ price to NOA ratio.

Beta Gamma
Price to Net Operating Assets
(NOA market multiple) $47,252 / $11,164 = 4.23 $35,368 / $5,719 = 6.18

Average of two ratios = 5.21

Alpha
Company intrinsic value (5.21 x $3,766) $19,621 million
Equity intrinsic value ($19,621 –$844) $18,777 million
Equity intrinsic value per share ($18,777 / 92.4) $203.21

Topic: Valuation Using the PB Multiple

LO: 1
2. The following table provides summary information for Alpha Corp. and its competitors Beta, Inc. and
Gamma Company. Use the information to compute the PB ratio for Beta and Gamma. In addition,
using Beta and Gamma as comparables, compute Alpha’s equity intrinsic value and equity intrinsic
value per share.

(All amounts in millions) Alpha Beta Gamma

Company assumed value $47,252 $35,368
Equity assumed value 42,865 35,024
Net operating assets $3,766 11,164 5,719
Book value of equity 2,922 6,777 5,375
Net nonoperating obligations 844 4,387 344
Common shares outstanding 92.4 325.8 185.4

©Cambridge Business Publishers, 2021

15-13 Financial Statement Analysis & Valuation, 6th Edition
 Answer:
In this case use a simple average of the two comparable companies PB ratios.

Beta Gamma
PB Ratios $42,865 / $6,777 = 6.33 $35,024 / $5,735 = 6.52

Average of two ratios = 6.43

Alpha
Equity intrinsic value 6.43 x 2,922 $18,788 million
Equity intrinsic value per share 18,788 / 92.4 $203.33

Topic: Market Multiples

LO: 1
3. In some cases an analyst will use an equity performance measure, such as earnings or book value; in
other cases an analyst may use a company performance measure, such as NOPAT or NOA to
determine value.

If the analyst ultimately wants to determine equity value per share what must he or she do differently
when using an equity performance measure as opposed to a company performance measure?

Answer:
If the analyst is using a company performance measure, then the value obtained is the value of the
entire firm. In this case, to obtain the equity value the analyst must subtract the net nonoperating
obligations from the value, and then divide by the number of shares outstanding, giving the equity
value per share. If the analyst is using an equity performance measure, then the value obtained is
the value of the firm’s equity and this amount can be divided by the number of shares outstanding to
get the equity value per share.

Topic: Valuation Using Income Statement Multiples

LO: 2
4. The following table provides summary information for X Corp. and its competitors Y, Inc. and Z Co.
Use the information to compute the price to NOPAT ratio for Y and Z. In addition, using Y and Z as
comparables, compute X’s company intrinsic value, equity intrinsic value and equity intrinsic value per
share.

X Y Z
Company assumed value $876,369 $995,748
Equity assumed value 512,324 913,198
NOPAT 683,741 150,587 422,515
Net income 508,043 108,807 341,022
Net nonoperating obligations 195,407 364,045 82,550
Common shares outstanding 8,778.5 446.3 635.2

©Cambridge Business Publishers, 2021

Test Bank, Module 15 15-14
 Answer:
In this case use a simple average of the two comparable companies’ price to NOPAT ratios.

Y Z
Price to NOPAT Ratio
(NOPAT market multiple) $876,369 / $150,587 = 5.82 $995,748 / $422,515 = 2.36

Average of two ratios = 4.09

X
Company intrinsic value (4.09 x $683,741) $2,796,501 million
Equity intrinsic value ($2,796,501 – $195,407) $2,601,094 million
Equity intrinsic value per share ($2,601,094 / 8,778.5) $296.30

Topic: Valuation Using Income Statement Multiples

LO: 2
5. The following table provides summary information for Max Corp. and its competitors Bernhard, Inc.
and Eva Co. Use the information to compute the net income multiple for Bernhard and Eva. In
addition, using Bernhard and Eva as comparables, compute Max’s equity intrinsic value and equity
intrinsic value per share.

Max Bernhard Eva

Company assumed value $667,964 $948,663
Equity assumed value 408,990 805,408
NOPAT $140,584 65,456 102,841
Net income 138,024 60,304 97,853
Net nonoperating obligations 215,648 258,974 143,255
Common shares outstanding 13,289 15,584 5,745

Answer:
In this case use a simple average of the two comparable companies’ net income multiples.

Bernhard Eva
Net Income multiple $408,990 / $60,304 = 6.78 $805,408 / $97,853 = 8.23

Average of two ratios 7.51

Max
Equity intrinsic value 7.51 x $138,024 $1,036,560 million
Equity intrinsic value per share $1,036,560 / $13,289 $78.00

©Cambridge Business Publishers, 2021

15-15 Financial Statement Analysis & Valuation, 6th Edition
Topic: Selecting Comparables for Market Multiples
LO: 3
6. Assuming that ROPI grows at a constant rate into perpetuity how do growth rates, profitability,
operating risk and leverage affect a company’s price to book ratio?

Answer:
The perpetuity with constant growth approach allows an analysis of PB ratios and the following
factors:

Growth rates—PB ratios increase with company expected growth

Profitability—PB ratios increase with company expected profitability
Operating risk—PB ratios decrease as a company’s operating risk increases
Leverage—PB ratios increase with company’s leverage

Topic: Selecting Comparables for Market Multiples

LO: 3
7. Discuss how growth, risk and profitability factors cause differences in price-earnings ratios across
firms.

Answer:
Expected growth in residual income leads to higher PE ratios. Risk will affect a company's cost of
equity capital, so that all things being equal more risky firms will experience a lower market value and
a lower PE ratio. Profitability will not affect a company’s PE ratio.

Topic: Reverse Engineering of Market Multiples

LO: 4
8. The following table provides summary data for Target on July 29, 2017, per Finance.Yahoo.com.
Analysts often use the observed PB ratio to infer market expectations regarding a company’s future
performance based on assumptions.

Assuming that the market’s expectation of Target’s future ROE is consistent with its past performance
and its discount rate is expected to be 10%, compute Target’s implied future growth rate.

TARGET
($ in billions)
Market value of equity $31.52
Book value of equity $11.10
ROE 24.51%

Answer:
PB Ratio ($31.52 / $11.10) 2.84
PB* Ratio (PB* = PB -1) 1.84

Assumed parameters
ROE 24.51%
Discount rate, re 10.00%

Implied parameter
Growth rate, (re + [PB* x re] – ROE) / PB* 2.11%*
*Answer may vary due to rounding.

©Cambridge Business Publishers, 2021

Test Bank, Module 15 15-16
Topic: Reverse Engineering of Market Multiples
LO: 4
9. The following table provides summary data for Target on July 29, 2017, per Finance.Yahoo.com.
Analysts often use the observed PB ratio to infer market expectations regarding a company’s future
performance based on assumptions.

Assuming that the market’s expectation of Target’s future ROE is consistent with its past performance
and its growth rate is expected to be 5.25%, compute Target’s implied future discount rate.

TARGET
($ in billions)
Market value of equity $31.52
Book value of equity $11.10
ROE 24.51%

Answer:
PB Ratio ($31.52 / $11.10) 2.84
PB* Ratio (PB* = PB -1) 1.84
Assumed parameters
ROE 24.51%
Growth rate, g 5.25%

Implied parameter
Discount rate, (ROE + [PB* x g]) / (1 + PB*) 12.03%*
*Answer may vary due to rounding.

Topic: Reverse Engineering of Market Multiples

LO: 4
10. The following table provides summary data for Target on July 29, 2017, per Finance.Yahoo.com.
Analysts often use the observed PB ratio to infer market expectations regarding a company’s future
performance based on assumptions.

Assuming that the market expects Target’s future growth to be 4.75% and its discount rate to 8.4%,
compute Target’s implied future ROE.

TARGET
($ in billions)
Market value of equity $31.52
Book value of equity $11.10
ROE 24.51%

Answer:
Solve for implied future ROE

PB Ratio ($31.52 / $11.10) 2.84

PB* Ratio (PB* = PB -1) 1.84
Assumed parameters
Discount rate, re 8.40%
Growth rate, g 4.75%

Implied parameter
ROE, (PB* x [re – g]) + re 15.12%
NOTE: Answer may vary due to rounding.

©Cambridge Business Publishers, 2021

15-17 Financial Statement Analysis & Valuation, 6th Edition
Problems

Topic: Market Multiples

LO: 1
1. Using market multiples to calculate a company’s value is a simple methodology, in that value is
determined by taking a summary performance measure and multiplying by a market multiple. List the
five steps an analyst would follow in estimating value using a market multiple.

Answer:
The five steps are:

1. Select the summary performance measure to be used

2. Select the comparable companies to use in determining the market multiple
3. Compute the market multiple for the comparable companies
4. Compute the target company’s value using the market multiple
5. Determine the value per share by dividing by shares outstanding

Topic: Valuation Using Income Statement Multiples

LO: 2
2. The following table provides summary information for Tom, Inc., and its competitors Andy Corp. and
Patrick Enterprises. Use the information to compute the Price to NOPAT ratio for Andy and Patrick.
In addition, using the Andy and Patrick as comparables, compute Tom’s company intrinsic value,
equity intrinsic value, and equity intrinsic value per share.

Next, use the information to compute the Price to Net Income ratio for Andy Corp. and Patrick
Enterprises. In addition, using Andy Corp. and Patrick Enterprises as comparables, compute Tom,
Inc.’s equity intrinsic value and equity intrinsic value per share.

Patrick Enter-
(amounts in millions) Tom, Inc. Andy Corp. prises
Company assumed value $76.25 $140.94
Equity assumed value 70.40 123.30
NOPAT 41.04 8.90 26.56
Net income 40.61 7.43 21.79
Net nonoperating obligations 41.20 5.85 17.64
Common shares outstanding 22.98 7.78 11.54

©Cambridge Business Publishers, 2021

Test Bank, Module 15 15-18
 Answer:
In this case use a simple average of the two comparable companies’ price to NOPAT ratios.

Andy Corp. Patrick Enterprises

Price to NOPAT Ratio (NOPAT
market multiple) $76.25 / $8.90 = 8.57 $140.94 / $26.56 = 5.31

Average of two ratios 6.94

Tom, Inc.
Company intrinsic value (6.94 x $41.04) $284.82
Equity intrinsic value ($284.82 – $41.20) $243.62
Equity intrinsic value per share ($243.62 / 22.98) $10.60

Andy Corp. Patrick Enterprises

Net income multiple $70.40 / $7.43 = 9.48 $123.30 / $21.79 = 5.66

Average of two ratios 7.57

Tom, Inc.
Equity intrinsic value 7.57 x $40.61 $307.42
Equity intrinsic value per share $307.42 / $22.98 $13.38

Topic: Identifying Comparables and Valuation Using PB and PE

LO: 1, 2, 3
3. Amanda, Inc. has a book value of equity is $44.2 million dollars and its forward earnings estimate is
$10.9 million. Below is information about Amanda and a peer group of companies.

5 year His-
Market Forward torical ROE (Trail- Debt-to-
Cap (mil- PB PE Growth ing Equity
lions) (current) (FY1) Rate 4 quarters) Ratio
Amanda, Inc. 24.00% 17.10% 23.00%
Barbara Corp. $145.6 4.13 18.5 26.00% 16.60% 28.00%
Cindy Co. $84.2 4.79 18.9 25.00% 16.40% 19.00%
Donna Corp. $68.5 4.05 19.8 29.00% 15.00% 32.00%
Elisa, Inc. $104.3 3.15 18.6 21.00% 14.90% 31.00%

Required:
a. Identify a set of two companies to use as comparables for estimating the equity intrinsic value of
Amanda, Inc. using the market multiple approach.
b. Estimate the equity intrinsic value of Amanda, Inc. using PB ratios from the comparable
companies, assuming that Barbara Corp. and Cindy Co. are the comparable companies.
c. Estimate the equity intrinsic value of Amanda using PE ratios from the comparable companies,
assuming that Barbara Corp. and Cindy Co. are the comparable companies.

©Cambridge Business Publishers, 2021

15-19 Financial Statement Analysis & Valuation, 6th Edition
 Answer:
a. There are a number of answers here, comparable companies should be chosen based on
comparable growth, risk and profitability characteristics.

b. Barbara Corp. and Cindy Co. have an average PB ratio of 4.46, multiplying Amanda, Inc. book
value of $44.2 by 4.46 results in an equity intrinsic value of $197.1 million.

c. Barbara Corp. and Cindy Co. have an average PE ratio of 18.7, multiplying Amanda, Inc.
earnings of $10.9 by 18.7 results in an equity intrinsic value of $203.8 million.

Topic: Reverse Engineering of Market Multiples

LO: 4
4. The following table provides summary data for Ethan Allen, on June 30, 2017 per
Finance.Yahoo.com. Analysts often use the observed PB ratio to infer market expectations regarding
a company’s future performance based on assumptions.

ETHAN ALLEN
($ in millions)
Market value of equity $808.320
Book Value of Equity $400.896
ROE 9.13%

Required:
For each of the cases determine implied parameter

Case 1: Assume that analysts expect Ethan Allen’s ROE to be consistent with past performance
and its discount rate to be 7.5%, calculate the implied growth rate.

Case 2: Assume that analysts are very uncertain about Ethan Allen’s future ROE but are fairly
certain the company will grow at a rate of 6.5% and have a discount rate of 7.5%. Use
this information to calculate the implied future ROE.

Answer:
Case 1: PB Ratio ($808.320 / $400.896) 2.02
PB* Ratio 1.02

Assumed parameters
ROE 9.13%
Discount rate, re 7.50%
Implied parameter
Growth rate, (re + [PB* × re] – ROE) / PB* 5.90%*
*Answer may vary due to rounding.

Case 2: PB Ratio ($808.320 / $400.896) 2.02

PB* Ratio 1.02
Assumed parameters
Growth rate 6.50%
Discount rate, re 7.50%
Implied parameter
ROE, (PB* × [re – g]) + re 8.52%*
*Answer may vary due to rounding.

©Cambridge Business Publishers, 2021

Test Bank, Module 15 15-20
Topic: Reverse Engineering of Market Multiples
LO: 4
5. Reverse engineering is the process of observing market price metrics such as the PB ratio and then
assessing the quality of the underlying expectations supporting the observed stock price. Starting
with the following formula, derive the PB ratio:

Equity Value = Owners Equity (EQ) + Present Value of Residual Income, discounted using re

What are the three variables that affect the PB ratio?

Answer:

Equity Value = OE + PV(RI)

Equity Value PV (RI)

=1+
EQ EQ

Expected ROE – re
PB = 1 +
re – g

The PB ratio is a function of the expected ROE, the discount rate and the growth rate.

©Cambridge Business Publishers, 2021

15-21 Financial Statement Analysis & Valuation, 6th Edition