CFA Institute CFA Institute Certifications CFA-LEVEL-1 Questions & Answers

• Question 591:

  A market strategist with Churn Brothers Brokerage is trying to determine the earnings multiplier of an equity index comprised of grocery stores, and has gathered the following information:

  g: 6.00% per year

  k: 8.50% per year EPS: $3.35 D0: $1.20

  Using this information, what is earnings multiplier for this equity index? Further, assuming that the grocery business is a mature industry, and that the economy is experiencing stable growth, is this earnings multiple realistic?

  A. None of these answers is correct.

  B. 4.21, this multiple is too low

  C. 5.97, this multiple is too low

  D. 130, this multiple is much too high

  E. 15.67, this multiple is likely realistic

  F. 14.33, this multiple is likely realistic

  Correct Answer: F

  To determine the earnings multiplier, or "P/E ratio," of a stock market series, use the following equation: P/ E = [(D1 / E1) / (k-g)

  Where: D1 = the annual per-share dividend at t1, E1 = the EPS figure at t1, k = the required rate of return on common stock, and g = the expected growth rate of dividends.

  In this example, all of the necessary information has been provided, and putting it into the equation above will yield the following:

  P/E of a stock market series = [($1.20*1.06 / ($3.35*1.06)) / (0.085 - 0.06)] = 14.33

  This earnings multiple is appropriate for lower growth industries, such as the grocery business, which has historically grown in the mid-to-high single digits for much of the last decade. Consider the fact that the P/E ratio is a proxy for future growth. Firms in the automobile, basic materials, or other mature industries, which are expected to grow slowly, are characterized by lower earnings multiples and higher dividend payout ratios. Firms in the software, networking, biotechnology, and other high-growth industries, are typically characterized by high earnings multiples and low dividend payout ratios. What is happening here is that investors are giving up current income (i.e. dividends) in the hopes of rapid earnings growth (i.e. greatly increased EPS in the future).

  A complete understanding of this relationship is absolutely crucial, and as a Level 1 candidate, I encourage you to examine this relationship further if you are not completely comfortable with the P/E ratio, its components and the relationships between them, and the implications of the earnings multiplier across different industries. Indeed, the P/E ratio is a valuable tool, one which can provide significant information about the growth prospects priced into a common stock.

• Question 592:

  Technical analysts may view a decline in credit balances as

  A. a bullish sign.

  B. a bearish sign.

  C. the result of low mutual fund cash positions.

  D. a sign indicating a short-term, transient bull market.

  Correct Answer: B

  A credit balance results when an investor sells stocks and deposits the proceeds with his broker. Technical analysts view a decline in credit balances as a decrease in a pool of potential buying power. For this reason, such a decline is viewed as a bearish sign.

• Question 593:

  A technical analyst with Bullfighter.com, a noted investment research firm, has been examining the U.S. securities markets, and believes that the market is technically "overbought." Which of the following technical indicators would this analyst likely use to support his opinion? Choose the best answer.

  A. The Block Uptick-Downtick Ratio has declined below 0.70.

  B. All of these choices indicate an "overbought" condition.

  C. The Diffusion Index has increased significantly.

  D. The Block Uptick-Downtick Ratio has advanced beyond 1.1.

  E. The CBOE Put/Call Ratio has declined to 0.50.

  Correct Answer: D

  The Block Uptick-Downtick Ratio is used by technical analysts to gauge institutional investment activity by measuring the percentage of block trades which result in an uptick versus the block trades which are executed on a downtick. The idea behind this ratio is the belief that a block buyer would initiate an "uptick", or a bid up in the securities' price, and a block seller would initiate a "downtick," or a bid down in the securities' price. Technical analysts view a decline in the Block Uptick-Downtick Ratio below 0.70 as an indication of an oversold condition, and an increase in the Block Uptick-Downtick Ratio above 1.10 as indicative of an overbought condition.

  The "Diffusion Index" is a measure of market breadth, and is defined as [(# of advancing issues + 1/2 # of issues unchanged) / # of issues traded]. An increase in the diffusion index is indicative of an increase in advancing issues relative to declining issues. The CBOE Put/Call Ratio is a contrarian technical indicator used to gauge the sentiment of investment professionals, and a ratio greater than 50% is viewed by contrarian technical analysts as overtly bullish. Finally, contrarian technical analysts would view a large increase in the amount of futures traders who express bullish sentiment on stock index futures as a bearish signal.

  The % of issues trading below their 200-day moving average is frequently cited by technical analysts as a measure of oversold and overbought market conditions. Specifically, technical analysts see the market as "overbought" when 80% of issues are trading above their 200-day moving average, and consider a market "oversold" when 80% of issues are trading under their 200-day moving average.

• Question 594:

  Joe Wellworth, an oil analyst with Smith, Kleen and Beetchnutty institutional brokerage, is trying to determine an appropriate earnings multiplier for the natural gas industry. In his research, Mr. Wellworth has examined the relationship between the earnings multiplier of the natural gas industry and the Price-to-Earnings ratio of the Standard and Poors 500. Using a time series analysis, Joe examines the trend in the relationship between the natural gas industry and the overall market and uses this information to estimate the appropriate earnings multiplier for the natural gas industry. Which of the following best characterizes this method of estimating the earnings multiplier of an industry? Choose the best answer.

  A. Correlation analysis

  B. Microanalysis

  C. The bottom-up approach

  D. Macroanalysis

  E. Time series analysis

  Correct Answer: D

  The answer called for in this example is macroanalysis. This method involves an examination of the relationship between the earnings multiplier of a stock market series and the earnings multiplier of the overall market. For example, an individual projecting an earnings multiplier for a software index using macroanalysis would begin by examining the relationship between the P/E ratio of the software index and the P/E ratio of a broad market index such as the Standard and Poors 500. Both historical trends and point estimates would be examined, and from this information, a projection of the earnings multiplier for the stock market series is deduced. This is precisely the process illustrated in this example.

  This is contrasted by microanalysis, which involves an examination of the components of the earnings multiplier, including the anticipated growth rate of dividends, the required rate of return, and the dividend payout ratio. Once these variables have been examined, both from the perspective of trend analysis and point estimation, a value for the earnings multiplier is deduced.

  The bottom-up approach is used in the investment selection process, and involves identifying superior investments by first examining companies, rather than beginning with an examination of macroeconomic cycles and influence. Time series analysis, while materially correct, does not represent the best possible answer.

• Question 595:

  Which statement is not true?

  A. Within industries, firms tend to have similar capital structures.

  B. Most ratios vary across time within a given industry.

  C. The higher proportion of debt, the higher the return on equity ratio will be.

  D. The lower the dividend yield, the greater the anticipated price appreciation.

  E. High P/E ratios tend to go with high payout ratios.

  F. The higher the payout ratio in a given industry, the more important dividends are to shareholders.

  Correct Answer: E

  High P/E ratios tend to go with low payout ratios as both of these measures are associated with higher growth rates. Remember that low payout ratios are common for high-growth companies as they give up a paying large dividends to finance their firm.

• Question 596:

  An fundamental analyst with Street Brothers asset management is considering shares of Polynomial Software Solutions, Inc., for possible investment. In her analysis, this investor has determined the following information:

  The Company currently pays a $2.20 per share dividend, and this dividend is anticipated to grow at 13% annually. Additionally, the investor has assumed that she will be able to sell the stock for $125 per share at the end of four years. Similar investments have warranted a 15.25% per year required rate of return. What is the value of Polynomial Software Solutions?

  A. $79.23

  B. $110.64

  C. $71.89

  D. $122.16

  E. The Multiple Holding Period DDM will produce a nonsensical answer for this stock.

  Correct Answer: A

  The Multiple Holding Period form of the Dividend Discount Model takes the following form: {V = {[d1 / (1 + k)] + [d2 / (1 + k)^2] + ... .[dn / (1 + k)^n] + [Pn / (1 + k)^n]}

  Where: V = the price of the common stock at t0, d1 = the annual dividend at t1 (this is found by multiplying the annual dividend at t0 by (1 + the anticipated growth rate), d2 = the annual dividend at t2 (this is found by multiplying the dividend at t1 by (1 + the anticipated growth rate), k = the required rate of return, n = period "n", and Pn = the sale price of the common stock at time "n".

  In this example, time "n" is the fourth year, as this is the end horizon for this investors holding period. Had the investor in this example forecasted selling the shares at the end of the 10th year, then "n" would be the tenth year.

  Now that the formality of expressing the equation for this form of the DDM has been carried through, we can move toward a calculation of the value of this common stock. In this example, all of the necessary information has been provided, and the calculation of the value of this retail stock is as follows:

  {V = [($2.20 * 1.13) / (1 + 0.1525)^1] + [($2.486 * 1.13) / (1 + 0.1525)^2] + [($2.80918 * 1.13) / (1 + 0.1525) ^3] + [($3.174373 * 1.13) / (1 + 0.1525)^4] + [$125 / (1 + 0.1525)^4]}

  Which breaks down into the following:

  {V = [$2.15705 + $2.114938 + $2.073649 + $2.033165 + $70.851048] = $79.23

• Question 597:

  Given that the beginning value of a stock is $120, the ending value is $110, earnings are $40, and the retention rate of earnings is 0.6, what is the rate of return on the stock over this period?

  A. 6%

  B. 5.7%

  C. 5%

  D. -8.3%

  E. Not enough information.

  Correct Answer: C

  The dividend payout ratio is equal to one minus the retention rate (1 - 0.6 = 0.4). Dividends are equal to the dividend payout ratio multiplied by earnings (0.4 x 40 = $16). The rate of return is equal to the ending price plus the dividend payments, divided by the beginning price, minus one. In this question, the rate of return is [(110 + 16)/ 120] - 1 = 0.05 = 5%.

• Question 598:

  If a stock has an expected dividend payout ratio of 50%, a required rate of return of 13% and an expected dividend growth rate of 10%, what is the P/E ratio?

  A. 10

  B. 12.5

  C. None of these answers

  D. 8.5

  Correct Answer: C

  The price/earnings ratio can be computed by dividing the expected dividend payout ratio (dividends divided by earnings) by the required rate of return (k) minus the expected growth rate of dividends (g).

  In this case, P/E = .50/(.13-.10) = 16.7

• Question 599:

  Historically, the earnings per share (EPS) figure for a stock market series has been less volatile than the earnings multiplier for the same series. Which of the following best characterizes the primary reason for the greater volatility experienced by the earnings multiplier? Choose the best answer.

  A. The price/earnings figure experiences a tax leveraging effect that is not passed on to the EPS figure.

  B. The EPS figure is less volatile due to accounting manipulations and the malleability of international and domestic accounting standards including GAAP.

  C. The earnings multiplier is more sensitive to changes in dividend policies than is the EPS figure.

  D. None of these answers is correct.

  E. The price/earnings ratio is more sensitive to changes in the spread between the required rate of return and the anticipated future growth rate.

  F. The earnings multiplier is more sensitive to fluctuations in the equity markets than is the EPS figure; i.e. the earnings multiplier is "forward looking."

  Correct Answer: E

  The greater relative volatility of the earnings multiplier versus the EPS figure is primarily attributable to an increased sensitivity to changes in the spread between the required rate of return "k" and the anticipated growth rate "g." Remember that the equation used to determine the appropriate earnings multiplier for a stock market series is the following:

  P/E = [D/E / (k - g)]

  Where: P/E = the earnings multiplier, or Price-to-Earnings ratio, D/E = the dividend payout ratio at t1, k = the required rate of return, and g = the anticipated growth rate of dividends.

  As you can see, changes in the spread between the required rate of return and the anticipated growth rate can have a dramatic effect on the earnings multiplier for a stock market series. While the earnings multiplier is sensitive to changes in the dividend payout ratio, volatility in this figure is not cause for the increased volatility of the earnings multiplier versus the EPS figure.

• Question 600:

  Which of the following is an advantage of technical analysis?

  A. It explains why investors are buying and selling.

  B. It involves adjusting for accounting problems.

  C. It only incorporates economic reasoning.

  D. It is quick and easy.

  Correct Answer: D

  Technical Analysis is viewed as less vigorous than fundamental analysis.