Free CFA Level II Equity Valuation Practice Questions

The trailing (or current) P/E ratio uses the most recent 12 months of actual earnings in the denominator, paired with the current market price.

C is correct. Trailing P/E = Current Price / EPS over the last 12 months.

B is incorrect. This describes the leading (or forward) P/E ratio, which uses forecasted earnings for the next 12 months rather than historical earnings.

A is incorrect. P/E ratios use the current market price, not an average historical price. Using an average price would distort the ratio and is not standard practice.

A is correct. The justified trailing price-to-sales ratio derived from the Gordon Growth Model is:
$$\frac{P_0}{S_0} = \frac{\text{Net Profit Margin} \times \text{Payout Ratio} \times (1 + g)}{r - g}$$

Using the vignette data with net profit margin = 8%, payout ratio = 50%, sustainable growth rate = 6%, and required return = 10%:
$$\frac{P_0}{S_0} = \frac{0.08 \times 0.50 \times 1.06}{0.10 - 0.06} = \frac{0.0424}{0.04} \approx 1.08$$

The justified P/S ratio links profitability (margin), capital allocation (payout), growth, and risk (required return) into a single metric.

B is incorrect because 0.90 results from omitting the $(1+g)$ factor or using a lower profit margin in the formula, understating the justified multiple.

C is incorrect because 1.50 results from using a higher profit margin or lower required return, overstating the justified multiple. For example, using a 12% margin would produce a significantly higher P/S ratio.

B is correct. The two-stage FCFF model values the explicit high-growth period and the terminal value, then converts enterprise value to equity value per share.

High-growth phase (Years 1--3, $g = 10\%$):
$$\text{FCFF}_1 = 500 \times 1.10 = 550$$
$$\text{FCFF}_2 = 605$$
$$\text{FCFF}_3 = 665.5$$

Terminal value at end of Year 3 ($g_L = 3\%$):
$$\text{FCFF}_4 = 665.5 \times 1.03 = 685.47$$
$$TV_3 = \frac{685.47}{0.09 - 0.03} = \frac{685.47}{0.06} = 11{,}424$$

Present value at WACC = 9%:
$$\text{EV} = \frac{550}{1.09} + \frac{605}{1.09^2} + \frac{665.5 + 11{,}424}{1.09^3}$$
$$= 504.6 + 509.2 + \frac{12{,}090}{1.2950} = 504.6 + 509.2 + 9{,}336 \approx 10{,}350$$

Equity value per share:
$$\text{Equity} = \text{EV} - \text{Debt} + \text{Cash} = 10{,}350 - 3{,}000 + 200 = 7{,}550$$
$$\text{Per share} = \frac{7{,}550}{300} \approx 24.70$$

FCFF is discounted at WACC (not the cost of equity), and net debt must be subtracted to arrive at equity value.

A is incorrect because 31.85 results from dividing enterprise value by shares without subtracting net debt, or from using a lower WACC.

C is incorrect because 20.50 results from using the cost of equity (12%) instead of WACC to discount FCFF, producing an understated enterprise value.