Question #17 - Reading 19 Equity Valuation - Applications and Processes

Reading: Reading 19 Equity Valuation - Applications and Processes

PDF File: Reading 19 Equity Valuation - Applications and Processes.pdf

Page: 7

Status: Correct

Correct Answer: A

Shared Context

of 39 Notes to financial statements contain: A) important information about the firm's accounting practices and basis of presentation. B) discussion of the firm's accounting practices and basis of presentation. C) a description of the firm’s financial condition and future prospects. Joe Dentice has an opportunity to buy 5% of Gold Star Oil, Inc., a closely held oil company. He wants to value the company so as to make a decision on a fair price to pay for the investment.

Question

Consider the steps in the top down valuation approach as it is applicable for Gold Star. Dentice should forecast the growth of:

Answer Choices:

A. the overall economy, growth of the industry, and the growth rate of Gold Star

B. Gold Star, the growth of the oil industry, and then the growth of the overall economy

C. each firm in the oil industry, the growth rate of the oil industry, and the growth rate of the economy

Explanation

The top down model for valuation would begin with analysis of the overall economy and the expectation of the growth rate in the economy. Further, the impact of the expected growth rate of the economy on the oil industry needs to be ascertained. The second component is the analysis of the oil industry in which Gold Star operates. That involves the determination of the competitive forces in the industry and the future threats and opportunities faced by the industry. It also determines the variables that determine the future profitability of the entire oil industry. The analyst then forms future expectations of these variables given the expectations about the overall economy. The expectations of variables determining the growth and profitability of the oil industry are then used to determine the expectations of the overall growth of Gold Star. In the company analysis, the analyst reviews the quality of earnings, financial ratios, management and intangibles to ascertain the growth prospects for the company. The analyst then selects an appropriate model to value the company. Assumptions used in the valuation must be clearly spelled out and updated to reflect new information.

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