Questions 18–24 relate to Mark Cannan

Mark Cannan is updating research reports on two well-­established consumer compa-

nies before first quarter 2021 earnings reports are released. His supervisor, Sharolyn
Ritter, has asked Cannan to use market-­based valuations when updating the reports.
Delite Beverage is a manufacturer and distributor of soft drinks and recently
acquired a major water bottling company in order to offer a broader product line. The
acquisition will have a significant impact on Delite’s future results.
You Fix It is a US retail distributor of products for home improvement, primarily
for those consumers who choose to do the work themselves. The home improvement
industry is cyclical; the industry was adversely affected by the recent downturn in the
economy, the level of foreclosures, and slow home sales. Although sales and earnings
at You Fix It weakened, same store sales are beginning to improve as consumers
undertake more home improvement projects. Poor performing stores were closed,
resulting in significant restructuring charges in 2020.
Before approving Cannan’s work, Ritter wants to discuss the calculations and choices
of ratios used in the valuation of Delite and You Fix It. The data used by Cannan in
his analysis are summarized in Exhibit 1.

Exhibit 1  Select Financial Data for Delite Beverage and You Fix It
Delite Beverage You Fix It

2020 earnings per share (EPS) $3.44 $1.77

2021 estimated EPS $3.50 $1.99
Book value per share end of year $62.05 $11.64
Current share price $65.50 $37.23
Sales (billions) $32.13 $67.44
Free cash flow per share $2.68 $0.21
Shares outstanding end of year 2,322,034,000 1,638,821,000

Cannan advises Ritter that he is considering three different approaches to value

the shares of You Fix It:
Approach 1 Price-­to-­book ratio (P/B)
Approach 2 Price-­to-­earnings ratio (P/E) using trailing earnings
Approach 3 Price-­to-­earnings ratio using normalized earnings
Cannan tells Ritter that he calculated the price-­to-­sales ratio (P/S) for You Fix It
but chose not to use it in the valuation of the shares. Cannan states to Ritter that it
is more appropriate to use the P/E than the P/S because
Reason 1 Earnings are more stable than sales.
Reason 2 Earnings are less easily manipulated than sales.
Reason 3 The P/E reflects financial leverage, whereas the P/S does not.
Cannan also informs Ritter that he did not use a price-­to-­cash-­flow multiple in
valuing the shares of Delite or You Fix It. The reason is that he could not identify a
cash flow measure that would both account for working capital and noncash revenues
and be after interest expense and thus not be mismatched with share price. Ritter
advises Cannan that such a cash flow measure does exist.
 Ritter provides Cannan with financial data on three close competitors as well as
the overall beverage sector, which includes other competitors, in Exhibit 2. She asks
Cannan to determine, based on the P/E-­to-­growth (PEG) ratio, whether Delite shares
are overvalued, fairly valued, or undervalued.

Exhibit 2  Beverage Sector Data

Forward P/E Earnings Growth

Delite — 12.41%
Fresh Iced Tea Company 16.59 9.52%
Nonutter Soda 15.64 11.94%
Tasty Root Beer 44.10 20%
Beverage sector average 16.40 10.80%

After providing Ritter his answer, Cannan is concerned about the inclusion of Tasty
Root Beer in the comparables analysis. Specifically, Cannan says to Ritter:
“I feel we should mitigate the effect of large outliers but not the impact
of small outliers (i.e., those close to zero) when calculating the beverage
sector P/E. What measure of central tendency would you suggest we use
to address this concern?”
Ritter requests that Cannan incorporate their discussion points before submitting
the reports for final approval.
18 Based on the information in Exhibit 1, the most appropriate price-­to-­earnings
ratio to use in the valuation of Delite is closest to:
A 18.71.
B 19.04.
C 24.44.
19 Based on the information in Exhibit 1, the price-­to-­sales ratio for You Fix It is
closest to:
A 0.28.
B 0.55.
C 0.90.
20 Which valuation approach would be most appropriate in valuing shares of You
Fix It?
A Approach 1
B Approach 2
C Approach 3
21 Cannan’s preference to use the P/E over the P/S is best supported by:
A Reason 1.
B Reason 2.
C Reason 3.
22 The cash flow measure that Ritter would most likely recommend to address
Cannan’s concern is:
A free cash flow to equity.
B earnings plus noncash charges.
 C earnings before interest, tax, depreciation, and amortization.
23 Based on the information in Exhibits 1 and 2, Cannan would most likely con-
clude that Delite’s shares are:
A overvalued.
B undervalued.
C fairly valued.
24 The measure of central tendency that Ritter will most likely recommend is the:
A median.
B harmonic mean.
C arithmetic mean.

The following information relates to Questions

25–30
Andrea Risso is a junior analyst with AquistareFianco, an independent equity research
firm. Risso’s supervisor asks her to update, as of 1 January 2020, a quarterly research
report for Centralino S.p.A., a telecommunications company headquartered in Italy.
On that date, Centralino’s common share price is €50 and its preferred shares trade
for €5.25 per share.
Risso gathers information on Centralino. Exhibit  1 presents earnings and divi-
dend data, and Exhibit 2 presents balance sheet data. Net sales were €3.182 billion in
2019. Risso estimates a required return of 15% for Centralino and forecasts growth
in dividends of 6% into perpetuity.

Exhibit 1 Earnings and Dividends for Centralino, 2016–2020

2016 2017 2018 2019 2020(E)

Earnings per share (EPS, €) 4.93 5.25 4.46 5.64 6.00

Dividends per share (DPS, €) 2.45 2.60 2.60 2.75 2.91
Return on equity (ROE) 13.01% 13.71% 11.58% 14.21% 14.96%

Note: The data for 2016–2019 are actual and for 2020 are estimated.

Exhibit 2 Summary Balance Sheet for Centralino, Year Ended 31 December 2019

Assets (€ millions) Liabilities and Shareholders’ Equity (€ millions)

Cash and cash equivalents 102 Current liabilities 259

Accounts receivable 305 Long-term debt 367
Inventory 333 Total liabilities 626
Total current assets 740 Preferred shares 80
Property and equipment, net 913 Common shares 826
Total assets 1,653 Retained earnings 121
 Exhibit 2  (Continued)

Assets (€ millions) Liabilities and Shareholders’ Equity (€ millions)

Total shareholders’ equity 1,027
Total liabilities and shareholders’ equity 1,653

Notes: The market value of long-­term debt is equal to its book value. Shares outstanding are 41.94 million common shares and 16.00 million
preferred shares.

Exhibit  3 presents forward price-­to-­earnings ratios (P/Es) for Centralino’s peer

group. Risso assumes no differences in fundamentals among the peer-­group companies.

Exhibit 3  Peer Group Forward P/Es

Company Forward P/E

Brinaregalo 5.9
Camporio 8.3
Esperto 3.0
Fornodissione 15.0
Radoresto 4.6

Risso also wants to calculate normalized EPS using the average return on equity
method. She determines that the 2016–19 time period in Exhibit 1 represents a full
business cycle for Centralino.
25 Based on Exhibit 1, the trailing P/E for Centralino as of 1 January 2020, ignor-
ing any business-­c ycle influence, is closest to:
A 8.3.
B 8.9.
C 9.9.
26 Based on Exhibit 1 and Risso’s estimates of return and dividend growth,
Centralino’s justified forward P/E based on the Gordon growth dividend dis-
count model is closest to:
A 5.4.
B 5.7.
C 8.3.
27 Based on Exhibit 2, the price-­to-­book multiple for Centralino is closest to:
A 2.0.
B 2.2.
C 2.5.
28 Based on Exhibit 2, the multiple of enterprise value to sales for Centralino as of
31 December 2019 is closest to:
A 0.67.
B 0.74.
C 0.77.
29 Based on Exhibit 1 and using the harmonic mean of the peer group forward P/
Es shown in Exhibit 3 as a valuation indicator, the common shares of Centralino
are:
A undervalued.
B fairly valued.
C overvalued.
30 Based on Exhibits 1 and 2, the normalized earnings per share for Centralino as
calculated by Risso should be closest to:
A €2.96.
B €3.21.
C €5.07.

The following information relates to Questions

31–37
Cátia Pinho is a supervisor in the equity research division of Suite Securities. Pinho
asks Flávia Silveira, a junior analyst, to complete an analysis of Adesivo S.A., Enviado
S.A., and Gesticular S.A.
Pinho directs Silveira to use a valuation metric that would allow for a meaningful
ranking of relative value of the three companies’ shares. Exhibit 1 provides selected
financial information for the three companies.

Exhibit 1 Selected Financial Information for Adesivo, Enviado, and

Gesticular (Brazilian Real, BRL)
Adesivo Enviado Gesticular

Stock’s current price 14.72 72.20 132.16

Diluted EPS (last four quarters) 0.81 2.92 –0.05
Diluted EPS (next four quarters) 0.91 3.10 2.85
Dividend rate (annualized most recent 0.44 1.24 0.00
dividend)

Silveira reviews underlying trailing EPS for Adesivo. Adesivo has basic trailing
EPS of BRL0.84. Silveira finds the following note in Adesivo’s financial statements:
“On a per share basis, Adesivo incurred in the last four quarters
i. from a lawsuit, a nonrecurring gain of BRL0.04; and
ii. from factory integration, a nonrecurring cost of BRL0.03 and a
recurring cost of BRL0.01 in increased depreciation.”
Silveira notes that Adesivo is forecasted to pay semiannual dividends of BRL0.24
next year. Silveira estimates five-year earnings growth rates for the three companies,
which are presented in Exhibit 2.
 Exhibit 2  Earnings Growth Rate Estimates over Five Years
Company Earnings Growth Rate Estimate (%)

Adesivo 16.67
Enviado 21.91
Gesticular 32.33

Pinho asks Silveira about the possible use of the price-­to-­sales ratio (P/S) in assess-
ing the relative value of the three companies. Silveira tells Pinho:
Statement 1 The P/S is not affected by revenue recognition practices.
Statement 2 The P/S is less subject to distortion from expense accounting
than is the P/E.
Pinho asks Silveira about using the Fed and Yardeni models to assess the value of
the equity market. Silveira states:
Statement 3 The Fed model concludes that the market is undervalued when
the market’s current earnings yield is greater than the 10-­year
Treasury bond yield.
Statement 4 The Yardeni model includes the consensus five-­year earnings
growth rate forecast for the market index.
Silveira also analyzes the three companies using the enterprising value (EV)-to-­
EBITDA multiple. Silveira notes that the EBITDA for Gesticular for the most recent
year is BRL560 million and gathers other selected information on Gesticular, which
is presented in Exhibit 4.

Exhibit 4  Selected Information on Gesticular at Year End (BRL Millions)

Market Value Market Value
Market Value of of Common of Preferred Short-­Term
Debt Equity Equity Cash Investments

1,733 6,766 275 581 495

Pinho asks Silveira about the use of momentum indicators in assessing the shares
of the three companies. Silveira states:
Statement 5 Relative-­strength indicators compare an equity’s performance
during a period with the performance of some group of equities
or its own past performance.
Statement 6 In the calculation of standardized unexpected earnings (SUE),
the magnitude of unexpected earnings is typically scaled by the
standard deviation of analysts’ earnings forecasts.

31 Based on Pinho’s directive and the data from the last four quarters presented in
Exhibit 1, the valuation metric that Silveira should use is the:
A price-­to-­earnings ratio (P/E).
B production-­to-­demand ratio (P/D).
C earnings-­to-­price ratio (E/P).
32 Based on Exhibit 1 and the note to Adesivo’s financial statements, the trailing
P/E for Adesivo using underlying EPS is closest to:
A 17.7.
B 18.2.
C 18.4.
33 Based on Exhibits 1 and 2, which company’s shares are the most attractively
priced based on the five-­year forward P/E-­to-­growth (PEG) ratio?
A Adesivo
B Enviado
C Gesticular
34 Which of Silveira’s statements concerning the use of the P/S is correct?
A Statement 1 only
B Statement 2 only
C Both Statement 1 and Statement 2
35 Which of Silveira’s statements concerning the Fed and Yardeni models is
correct?
A Statement 3 only
B Statement 4 only
C Both Statement 3 and Statement 4
36 Based on Exhibit 4, Gesticular’s EV/EBITDA multiple is closest to:
A 11.4.
B 13.7.
C 14.6.
37 Which of Silveira’s statements concerning momentum indicators is correct?
A Statement 5 only
B Statement 6 only
C Both Statement 5 and Statement 6