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FE-1 Equity practice questions

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Question 1Equity Markets and Instruments

Which type of equity security typically carries a fixed dividend rate and priority over common shares for dividend payments and liquidation proceeds?

  1. Treasury stock
  2. Warrant
  3. Common stock
  4. Preferred stock Correct answer.

Explanation

Preferred stock has a stated dividend rate and ranks ahead of common stock in the payment of dividends and in the distribution of assets on liquidation. Common stock dividends and liquidation claims are subordinate and variable.

Question 2Equity Markets and Instruments

A company issues 10,000 shares with a $1 par value at an offer price of $25 per share. How much is recorded in additional paid-in capital?

  1. $250,000
  2. $10,000
  3. $260,000
  4. $240,000 Correct answer.

Explanation

Additional paid-in capital equals the excess of the offer price over par value, multiplied by the number of shares: ($25 - $1) x 10,000 = $240,000. The $10,000 par amount is recorded in common stock at par, and the total proceeds are $250,000.

Question 3Equity Markets and Instruments

An investor buys 500 shares of a $40 stock on 60% margin. What is the investor's initial equity in the position?

  1. $12,000 Correct answer.
  2. $24,000
  3. $8,000
  4. $20,000

Explanation

Total purchase cost is 500 x $40 = $20,000, and initial equity is the margin percentage times that cost: 0.60 x $20,000 = $12,000. The remaining $8,000 is financed with borrowed funds.

Question 4Equity Markets and Instruments

A stock trades at $50 and the maintenance margin is 25%. Ignoring commissions, at what price does a long margin account first receive a margin call?

  1. $62.50
  2. $33.33 Correct answer.
  3. $40.00
  4. $37.50

Explanation

For a long account the call price solves (price - debit) / price = maintenance margin. With a 50% initial margin the debit is $25, so 0.75P = 25 and P = $33.33. Below that price equity falls under 25% of market value.

Question 5Equity Markets and Instruments

Which order type becomes a market order once the stock trades at or through a specified trigger price?

  1. Limit order
  2. Stop order Correct answer.
  3. Market-not-held order
  4. Peg order

Explanation

A stop order rests off the book until the stop price is reached, then converts to a market order for immediate execution. A limit order instead posts a maximum buy or minimum sell price and does not convert automatically.

Question 6Equity Markets and Instruments

What does the ex-dividend date represent for a cash dividend?

  1. The first date on which a buyer of the shares is not entitled to the declared dividend Correct answer.
  2. The date the dividend is actually paid to holders
  3. The date the board formally declares the dividend
  4. The last date on which the shares trade cum-dividend

Explanation

On the ex-dividend date the shares begin trading without the right to the declared dividend, so a purchaser on or after that date does not receive it. The record date and payment date serve different functions.

Question 7Equity Markets and Instruments

A stock's last sale was $80 and it now trades ex-dividend for a $2.00 cash dividend. Ignoring taxes and market moves, what is the expected opening price adjustment?

  1. A decline of about $0.50
  2. An increase of about $2.00
  3. No change
  4. A decline of about $2.00 Correct answer.

Explanation

On the ex-date the exchange adjusts the prior close downward by the dividend amount, so the reference price falls by roughly $2.00. The dividend leaves the company and is replaced by cash in the shareholder's hands, so total value is unchanged.

Question 8Equity Markets and Instruments

Which measure divides the annual dividend per share by the current market price per share?

  1. Dividend payout ratio
  2. Book value per share
  3. Dividend yield Correct answer.
  4. Earnings retention ratio

Explanation

Dividend yield expresses the cash dividend as a percentage of the share price and is used to compare income returns across stocks. The payout ratio instead relates dividends to earnings rather than to price.

Question 9Equity Markets and Instruments

A company earns $4.00 per share and pays a $1.20 dividend. What is its dividend payout ratio?

  1. 33%
  2. 70%
  3. 30% Correct answer.
  4. 120%

Explanation

The payout ratio is dividends per share divided by earnings per share: $1.20 / $4.00 = 30%. The remaining 70% is retained in the business and is called the retention ratio.

Question 10Equity Markets and Instruments

Under a stock split, what happens to the number of shares outstanding and to the par value per share?

  1. Shares stay unchanged and par value per share decreases
  2. Shares increase and par value per share decreases proportionally Correct answer.
  3. Shares increase and par value per share stays unchanged
  4. Shares decrease and par value per share increases proportionally

Explanation

A split divides each share into multiple shares, so the share count rises while total par value is preserved by a proportional reduction in par per share. Book equity and total market value are unaffected by the split itself.

Question 11Equity Markets and Instruments

An investor holds 100 shares bought at $30. The company declares a 3-for-2 split. What is the investor's post-split share count?

  1. 200
  2. 100
  3. 150 Correct answer.
  4. 67

Explanation

A 3-for-2 split multiplies the share count by 1.5, so 100 x 1.5 = 150 shares. The cost basis per share falls proportionally so total position value is unchanged.

Question 12Equity Markets and Instruments

Which statement correctly describes the relationship between preemptive rights and a rights offering?

  1. Preemptive rights obligate holders to buy every new issue, and a rights offering enforces that obligation
  2. Preemptive rights apply only to bondholders, and a rights offering is a debt instrument
  3. Preemptive rights are granted to preferred holders only, and a rights offering bypasses common holders
  4. Preemptive rights let existing holders buy new shares before the public, and a rights offering implements that privilege Correct answer.

Explanation

Preemptive rights protect existing shareholders from dilution by allowing them to subscribe to new shares in proportion to their holdings before outside investors. A rights offering is the mechanism through which those subscription privileges are distributed.

Question 13Equity Markets and Instruments

An investor purchases a warrant. What does the warrant give the holder?

  1. The right to vote at the annual meeting
  2. The right to receive a fixed coupon from the issuer
  3. The right to buy newly issued shares from the company at a set price before expiry Correct answer.
  4. The right to sell existing shares to the company at a set price

Explanation

A warrant is a long-dated call-like security issued by the company that entitles the holder to purchase new shares at a specified exercise price. Because new shares are issued, exercise dilutes existing holders.

Question 14Equity Markets and Instruments

How does an American depositary receipt (ADR) allow a US investor to hold foreign equity?

  1. The investor holds a bond convertible into the foreign company's shares
  2. The investor buys the foreign shares directly on the foreign exchange in local currency
  3. A US bank holds the foreign shares and issues a dollar-denominated receipt that trades in the US market Correct answer.
  4. The foreign company lists its common shares on a US exchange under its own name

Explanation

An ADR is created by a depositary bank that holds the underlying foreign shares and issues receipts representing them, priced in dollars and settled in US markets. This gives US investors exposure without trading on the foreign exchange.

Question 15Equity Markets and Instruments

An index is constructed as a price-weighted average. Which stock has the greatest influence on the index level?

  1. The stock with the highest share price Correct answer.
  2. The stock with the largest market capitalization
  3. The stock with the highest dividend yield
  4. The stock with the largest number of shares outstanding

Explanation

In a price-weighted index each stock contributes in proportion to its price per share, so a high-priced stock dominates regardless of company size. Market-cap weighting instead gives influence according to total market value.

Question 16Equity Markets and Instruments

Which statement best describes a market-capitalization-weighted index?

  1. Each constituent receives an equal weight that is rebalanced periodically
  2. Each constituent's weight equals its market value divided by the total market value of all constituents Correct answer.
  3. Each constituent's weight is proportional to its trading volume
  4. Each constituent's weight is proportional to its share price

Explanation

A cap-weighted index assigns weights based on each company's market capitalization relative to the aggregate, so larger companies dominate index movements. This is the most common construction for broad equity benchmarks.

Question 17Equity Markets and Instruments

Which of the following is an example of a systematic (non-diversifiable) risk affecting equity portfolios?

  1. A labor strike at a single manufacturer
  2. A product recall at one portfolio company
  3. A change in central bank interest rate policy Correct answer.
  4. The departure of one firm's chief executive

Explanation

Systematic risk affects the broad market and cannot be removed by diversification, and interest rate policy is a market-wide factor. Firm-specific events are unsystematic and can be diluted across a diversified portfolio.

Question 18Equity Markets and Instruments

Beta measures which relationship for an individual stock?

  1. Its sensitivity of returns to movements in the broad market Correct answer.
  2. Its total return volatility measured by standard deviation
  3. Its price relative to book value
  4. Its dividend growth rate relative to peers

Explanation

Beta captures the covariance of a stock's returns with the market divided by the market variance, so it reflects systematic risk. A beta above 1 indicates greater sensitivity to market moves than the index itself.

Question 19Equity Markets and Instruments

A stock has a beta of 1.5, the risk-free rate is 3%, and the expected market return is 9%. Using the CAPM, what is the expected return?

  1. 12.0% Correct answer.
  2. 9.0%
  3. 13.5%
  4. 10.5%

Explanation

CAPM expected return equals the risk-free rate plus beta times the market risk premium: 3% + 1.5 x (9% - 3%) = 3% + 9% = 12.0%. The market risk premium here is 6%.

Question 20Equity Markets and Instruments

Under the Gordon growth model, a stock pays a dividend of $2.00 next year, the required return is 10%, and growth is 4%. What is the intrinsic value?

  1. $33.33 Correct answer.
  2. $50.00
  3. $14.29
  4. $20.00

Explanation

The Gordon growth model values the stock as the next dividend divided by the required return minus growth: $2.00 / (0.10 - 0.04) = $33.33. Using the expected next dividend rather than the trailing dividend is essential.

Question 21Equity Markets and Instruments

A company has a price-to-earnings ratio of 18 and earnings per share of $3.00. What is its share price?

  1. $21.00
  2. $18.00
  3. $6.00
  4. $54.00 Correct answer.

Explanation

The P/E ratio equals price divided by earnings per share, so price equals the ratio times EPS: 18 x $3.00 = $54.00. The earnings yield, the reciprocal of the P/E, would be about 5.6%.

Question 22Equity Markets and Instruments

A stock has an expected return of 11%, the risk-free rate is 4%, and its beta is 1.4. What is its Treynor ratio?

  1. 0.14
  2. 0.05 Correct answer.
  3. 0.07
  4. 0.0786

Explanation

The Treynor ratio is excess return over the risk-free rate divided by beta: (11% - 4%) / 1.4 = 7% / 1.4 = 0.05. It measures return per unit of systematic risk.

Question 23Equity Markets and Instruments

An investor sells 200 shares short at $25 and later covers at $20, ignoring commissions. What is the gain?

  1. $1,000 Correct answer.
  2. $4,000
  3. $500
  4. $5,000

Explanation

Short sellers profit when the price falls, and the gain equals the price decline times the share count: ($25 - $20) x 200 = $1,000. The proceeds from the sale are held as collateral while the position is open.

Question 24Equity Markets and Instruments

Which of the following best describes an exchange-traded fund (ETF) holding a basket of equities?

  1. Shares trade intraday on an exchange and generally track an index or basket Correct answer.
  2. Shares pay a fixed coupon set at issuance
  3. Shares are priced once daily at the fund's net asset value
  4. Shares carry a guaranteed principal repayment at maturity

Explanation

An ETF is an open-end fund whose shares list on an exchange and trade throughout the day at market-determined prices near net asset value. Creation and redemption by authorized participants keep the market price close to the underlying basket value.

Question 25Equity Markets and Instruments

Which statement about the role of a specialist or designated market maker on an equity exchange is accurate?

  1. The market maker quotes bid and ask prices and may hold inventory to facilitate trades Correct answer.
  2. The market maker sets the closing price by regulatory decree
  3. The market maker is prohibited from trading for its own account
  4. The market maker guarantees that no investor will ever incur a loss

Explanation

Designated market makers provide liquidity by continuously quoting bid and ask prices and by taking the other side of orders, which requires holding inventory and bearing risk. They do not eliminate investor losses or set prices by fiat.

Question 26Equity Markets and Instruments

An investor places an order to buy 500 shares of a stock at $42.00 per share, and the order specifies that it remains active until it is either executed or explicitly cancelled. Which order type is this?

  1. A fill-or-kill order
  2. A stop-limit order
  3. A good-till-cancelled (GTC) limit order Correct answer.
  4. A market order

Explanation

A GTC order remains on the book until executed or cancelled, unlike a day order. Because the order specifies a price of $42.00, it is a limit order rather than a market order. A stop-limit order would require a stop price to trigger it, and a fill-or-kill order must execute immediately in full.

Question 27Equity Markets and Instruments

A company's board declares a cash dividend of $0.80 per share payable to shareholders of record on June 15. Under standard settlement conventions, which date is the earliest on which a buyer of the shares would not be entitled to receive the dividend?

  1. June 15, the record date
  2. June 14, the day before the record date Correct answer.
  3. June 16, the day after the record date
  4. The declaration date

Explanation

The ex-dividend date is the first date on which a buyer no longer receives the declared dividend. With a one-business-day settlement cycle, the ex-dividend date falls one business day before the record date, so a purchase on June 14 would settle after the record date and miss the dividend. The declaration date is when the dividend is approved, not when entitlement is determined.

Question 28Equity Markets and Instruments

A corporation issues a new class of preferred stock that pays a fixed dividend and gives holders priority over common shareholders for dividend payments, but the shares carry no voting rights and no maturity date. Which instrument has the corporation most likely issued?

  1. A common share
  2. A cumulative preferred share
  3. A non-participating preferred share Correct answer.
  4. A convertible bond

Explanation

Non-participating preferred stock pays a fixed dividend with priority over common dividends but does not share in residual earnings beyond that fixed amount. It typically carries no voting rights and has no maturity date, matching the description. Cumulative preferred would also require disclosure of dividend arrears, which the stem does not mention.

Question 29Equity Markets and Instruments

An investor buys 1,000 shares of a stock at $20.00 per share on margin, using the maximum initial margin permitted by Regulation T, which is 50%. The maintenance margin requirement is 25%. Ignoring commissions and interest, at what approximate stock price would the investor first receive a margin call?

  1. $10.00
  2. $16.00
  3. $15.00
  4. $13.33 Correct answer.

Explanation

The investor posts $10,000 of equity and borrows $10,000, so the initial equity is 50% of the $20,000 position. The maintenance margin call price equals the loan amount divided by the number of shares times one minus the maintenance margin: $10,000 / (1,000 × (1 − 0.25)) = $13.33. At that price, equity equals 25% of the position value.

Question 30Equity Markets and Instruments

Which statement accurately describes the role of a transfer agent for a publicly traded corporation?

  1. The transfer agent maintains the record of registered shareholders and cancels and issues certificates when ownership changes. Correct answer.
  2. The transfer agent sets the opening price for the stock each trading day.
  3. The transfer agent matches buy and sell orders on the exchange floor.
  4. The transfer agent guarantees settlement of trades between brokers.

Explanation

A transfer agent keeps the official register of a company's registered shareholders and processes transfers of ownership, including cancelling old certificates and issuing new ones. This record-keeping function is distinct from trading and settlement. Order matching, opening price setting, and settlement guarantees are performed by exchanges, market makers, and clearinghouses.

Question 31Equity Valuation Fundamentals

An analyst estimates a company's next dividend at $2.00 per share. The required return on equity is 10% and the expected constant dividend growth rate is 4%. Using the Gordon growth model, what is the estimated intrinsic value per share?

  1. $14.29
  2. $33.33 Correct answer.
  3. $20.00
  4. $50.00

Explanation

The Gordon growth model values a share as D1 divided by (r minus g). Here that is $2.00 / (0.10 - 0.04) = $2.00 / 0.06, which equals $33.33. The growth rate must be below the required return for the model to produce a finite, positive value.

Question 32Equity Valuation Fundamentals

Which statement best describes the relationship between a stock's justified P/E and its fundamentals under the Gordon growth framework?

  1. The justified P/E falls as the expected growth rate increases
  2. The justified P/E rises when the retention ratio rises, holding all else constant
  3. The justified P/E equals the dividend payout ratio divided by the difference between required return and growth Correct answer.
  4. The justified P/E is independent of the required return on equity

Explanation

The trailing justified P/E can be written as payout ratio divided by (r minus g), linking the multiple directly to fundamentals. Growth raises the multiple while a higher required return lowers it, so the multiple is not independent of r. A higher retention ratio lowers the payout ratio and, all else equal, lowers the justified P/E.

Question 33Equity Valuation Fundamentals

A firm has a return on equity of 15% and retains 40% of its earnings. Under the sustainable growth framework, what is its implied dividend growth rate?

  1. 15.0%
  2. 4.0%
  3. 9.0%
  4. 6.0% Correct answer.

Explanation

Sustainable growth equals the retention ratio multiplied by return on equity. With 40% retention and 15% ROE, growth is 0.40 x 0.15 = 6.0%. This is the growth the firm can sustain without changing leverage or issuing new equity.

Question 34Equity Valuation Fundamentals

Which cash flow measure is most appropriate to discount when valuing the entire firm rather than just its equity?

  1. Dividends per share, discounted at the required return on equity
  2. Net income, discounted at the risk-free rate
  3. Free cash flow to the firm, discounted at the weighted average cost of capital Correct answer.
  4. Free cash flow to equity, discounted at the cost of equity

Explanation

Enterprise valuation discounts free cash flow to the firm at the weighted average cost of capital, because that cash flow belongs to all capital providers. Free cash flow to equity and dividends belong to shareholders and are discounted at the cost of equity. Matching the cash flow to the correct discount rate is the core consistency rule.

Question 35Equity Valuation Fundamentals

An analyst values a company using comparables and finds its EV/EBITDA multiple is well below the peer median, while its P/E is in line with peers. Which factor most likely explains the divergence?

  1. The company pays a higher dividend than peers
  2. The company carries significantly more debt than peers Correct answer.
  3. The company has a higher tax rate than peers
  4. The company has unusually high depreciation relative to peers

Explanation

EV/EBITDA is capital-structure neutral, while P/E is affected by leverage through interest expense and the equity base. A heavily indebted firm can show a low EV/EBITDA if enterprise value is depressed relative to operating earnings, yet a normal P/E once interest is deducted. Comparing the two multiples helps isolate leverage effects from operating effects.

Question 36Equity Valuation Fundamentals

In a two-stage dividend discount model, which assumption is typically required for the terminal value calculation?

  1. Earnings growth equals the required return in perpetuity
  2. The firm stops paying dividends after the forecast horizon
  3. Dividends grow at a constant rate below the required return in perpetuity after the transition Correct answer.
  4. The required return falls to the risk-free rate in the terminal period

Explanation

The terminal value in a two-stage model applies the Gordon growth formula, which requires a constant perpetual growth rate that is below the required return. If growth met or exceeded the required return, the terminal value would be infinite or negative. The transition period bridges high initial growth to that stable rate.

Question 37Equity Valuation Fundamentals

A company's book value of equity is $500 million and it has 50 million shares outstanding. If its justified price-to-book ratio based on fundamentals is 1.8, what is the estimated value per share?

  1. $9.00
  2. $10.00
  3. $18.00 Correct answer.
  4. $90.00

Explanation

Book value per share is $500 million / 50 million = $10.00. Multiplying by the justified price-to-book ratio of 1.8 gives $18.00 per share. The justified P/B ties the multiple to ROE, growth, and required return.

Question 38Equity Valuation Fundamentals

Which input change would increase the present value of a stock under a discounted cash flow model, holding all other inputs constant?

  1. A shorter forecast horizon with no terminal value
  2. A lower required return on equity Correct answer.
  3. A lower expected growth rate
  4. A higher required return on equity

Explanation

Present value moves inversely to the discount rate, so a lower required return raises the discounted value of future cash flows. Higher growth also raises value, while a shorter horizon without terminal value removes distant cash flows. The discount rate reflects risk, so lowering it must be justified by fundamentals.

Question 39Equity Valuation Fundamentals

A firm reports free cash flow to equity of $120 million, and its cost of equity is 11%. If FCFE is expected to grow at 3% in perpetuity, what is the estimated equity value?

  1. $1,091 million
  2. $1,500 million Correct answer.
  3. $1,636 million
  4. $1,200 million

Explanation

Applying the constant growth formula to FCFE gives $120 million / (0.11 - 0.03) = $120 million / 0.08 = $1,500 million. This is the equity value because FCFE is a shareholder cash flow discounted at the cost of equity. Growth must stay below the cost of equity for the result to be meaningful.

Question 40Equity Valuation Fundamentals

Which characteristic distinguishes a firm's enterprise value from its market capitalization?

  1. Enterprise value includes debt and other claims while excluding cash from equity value Correct answer.
  2. Enterprise value adds cash and subtracts debt from market capitalization
  3. Enterprise value equals market capitalization plus total revenue
  4. Enterprise value measures only the book value of operating assets

Explanation

Enterprise value represents the value of the operating business to all capital providers, so it adds debt and preferred stock and subtracts cash from equity value. Market capitalization reflects only shareholders' claim. This makes EV the appropriate numerator for capital-structure-neutral multiples such as EV/EBITDA.

Question 41Equity Valuation Fundamentals

An analyst computes a company's ROE as 18%, its required return on equity as 12%, and its sustainable growth rate as 7%. Using the justified P/B relationship, which conclusion is most consistent?

  1. The justified P/B equals 1.0 regardless of ROE
  2. The justified P/B is below 1.0 because growth is positive
  3. The justified P/B cannot be determined without the payout ratio only
  4. The justified P/B is above 1.0 because ROE exceeds the required return Correct answer.

Explanation

When ROE exceeds the required return on equity, the firm creates value on retained earnings, so the justified P/B exceeds book value. The relationship is approximately (ROE minus g) divided by (r minus g). Since 18% ROE is above the 12% required return, the justified multiple is above 1.0.

Question 42Equity Valuation Fundamentals

A company just paid a dividend of $1.50 per share. Dividends are expected to grow at 5% per year, and the required return is 9%. What is the expected dividend for next year used in the valuation?

  1. $2.00
  2. $1.425
  3. $1.50
  4. $1.575 Correct answer.

Explanation

The valuation formula uses D1, the dividend expected one year from now, which equals the current dividend times (1 plus g). Here that is $1.50 x 1.05 = $1.575. Using the just-paid dividend instead of D1 is a common error that understates value.

Question 43Equity Valuation Fundamentals

Which situation most likely makes a price-to-earnings multiple less comparable across two firms?

  1. Both firms operate in the same industry with similar margins
  2. One firm has a large one-time gain inflating its reported earnings Correct answer.
  3. Both firms report under the same accounting standards
  4. Both firms have similar capital structures

Explanation

A one-time gain distorts the denominator, so the P/E reflects a temporary earnings spike rather than sustainable earnings power. Analysts typically normalize earnings to remove non-recurring items before comparing multiples. Consistent accounting, similar leverage, and similar industry economics all improve comparability.

Question 44Equity Valuation Fundamentals

In the context of equity valuation, what does the terminal value in a DCF model represent?

  1. The cumulative dividends paid during the forecast period
  2. The book value of equity at the valuation date
  3. The present value of all cash flows beyond the explicit forecast period Correct answer.
  4. The liquidation value of assets at the end of the forecast

Explanation

Terminal value captures the value of cash flows expected after the explicit forecast horizon, usually as a growing perpetuity. It often constitutes the majority of total estimated value, so its assumptions deserve scrutiny. It is not a liquidation or historical book measure.

Question 45Equity Valuation Fundamentals

A stock trades at $40, its expected dividend next year is $2, and its expected growth rate is 6%. Using the implied required return from the Gordon model, what is the required return?

  1. 5.0%
  2. 11.0% Correct answer.
  3. 6.0%
  4. 8.0%

Explanation

Rearranging the Gordon model gives r = D1/P0 + g. Here that is $2/$40 + 0.06 = 0.05 + 0.06 = 11.0%. This is the market-implied required return given the current price and growth expectations.

Question 46Equity Valuation Fundamentals

Which statement about the dividend discount model's applicability is most accurate?

  1. It is the preferred model for firms that pay no dividends
  2. It requires the growth rate to exceed the required return
  3. It is best suited to firms with stable, predictable dividend policies Correct answer.
  4. It ignores the time value of money

Explanation

The DDM works best for mature firms with established dividend policies that reflect earnings capacity. For non-dividend payers, analysts turn to free cash flow or residual income models. The model explicitly discounts future dividends, so it does incorporate the time value of money.

Question 47Equity Valuation Fundamentals

A firm has a payout ratio of 30%, a required return on equity of 10%, and an expected growth rate of 4%. What is its trailing justified P/E?

  1. 4.3
  2. 5.0 Correct answer.
  3. 3.0
  4. 7.5

Explanation

The trailing justified P/E equals the payout ratio divided by (r minus g). Here that is 0.30 / (0.10 - 0.04) = 0.30 / 0.06 = 5.0. Using the leading payout ratio would instead give a leading justified P/E.

Question 48Equity Valuation Fundamentals

Which factor would most likely justify a higher price-to-sales multiple for one retailer compared with another in the same industry?

  1. A higher book value of equity
  2. A higher expected net profit margin on each dollar of sales Correct answer.
  3. A higher share count
  4. A lower dividend payout ratio

Explanation

Price-to-sales is sensitive to profitability, so a firm expected to convert each sales dollar into more profit deserves a higher multiple. The P/S ratio is often paired with the net margin to assess whether the multiple is justified. Share count, payout policy, and book value do not directly drive sales-based value.

Question 49Equity Valuation Fundamentals

What is the primary purpose of normalizing earnings when applying a P/E multiple?

  1. To restate earnings under a different currency
  2. To remove non-recurring items so the multiple reflects sustainable earnings Correct answer.
  3. To adjust the multiple for the firm's dividend policy
  4. To convert accrual earnings to cash flow

Explanation

Normalization strips out one-time gains, losses, and other distortions so the earnings base represents ongoing earning power. A multiple applied to distorted earnings produces a misleading value estimate. Normalization is distinct from cash flow conversion and currency translation.

Question 50Equity Valuation Fundamentals

An analyst estimates a stock's value at $55 using a DCF model and observes the market price at $50. Which interpretation is most appropriate?

  1. The stock is undervalued by about 10% relative to the estimate Correct answer.
  2. The DCF model cannot be compared with market price
  3. The estimate and price are identical, implying fair value
  4. The stock is overvalued by about 10% relative to the estimate

Explanation

When the estimated intrinsic value exceeds the market price, the security appears undervalued by the difference. The gap here is $5 on a $50 price, or about 10%. Analysts then weigh estimation error and margin of safety before acting.