Common Mistakes to Avoid
Watch out for these exam traps that candidates frequently miss on Equity Valuation Methods questions:
Using P/E ratio with negative earnings
Forgetting to subtract preferred dividends when calculating EPS
Confusing book value with market value
Sample Practice Questions
A stock is currently trading at $80 per share and has earnings per share (EPS) of $4. What is the stock's price-to-earnings (P/E) ratio?
D is correct. The P/E ratio is calculated as Price per Share ÷ Earnings per Share. In this case: $80 ÷ $4 = 20. A P/E ratio of 20 means investors are willing to pay $20 for every $1 of earnings. This ratio is one of the most widely used valuation metrics for comparing stocks.
A (10) is incorrect because it would require either a price of $40 or EPS of $8 to achieve. B (15) is incorrect because it would require either a price of $60 or EPS of approximately $5.33. C (18) is incorrect because it would require either a price of $72 or EPS of approximately $4.44. These calculations reverse or misapply the formula.
The P/E ratio is the most frequently tested valuation metric on the Series 65 exam. It appears in questions about stock valuation, comparing companies, and distinguishing growth stocks (high P/E) from value stocks (low P/E). Understanding this simple calculation helps you quickly assess whether a stock is relatively expensive or cheap compared to its earnings. A common exam scenario presents P/E ratios across different stocks or industries for comparison.
A company has net income of $10 million, preferred stock dividends of $2 million, and 4 million common shares outstanding. What is the company's earnings per share (EPS)?
A is correct. EPS is calculated as (Net Income - Preferred Dividends) ÷ Weighted Average Common Shares Outstanding. You must subtract preferred dividends because EPS measures earnings available to common shareholders. Calculation: ($10 million - $2 million) ÷ 4 million shares = $8 million ÷ 4 million = $2.00 per share.
B ($2.50) is incorrect because it fails to subtract the full $2 million in preferred dividends, perhaps only subtracting $1 million. C ($3.00) is incorrect because it appears to divide $12 million by 4 million shares, incorrectly adding rather than subtracting preferred dividends. D ($4.00) is incorrect because it fails to subtract preferred dividends at all, simply dividing $10 million by 2.5 million shares or making another calculation error.
This is one of the most common mistakes tested on the Series 65 exam. Many candidates forget to subtract preferred dividends when calculating EPS, which overstates the earnings available to common shareholders. This concept appears frequently in financial analysis questions and connects to P/E ratio calculations. Remember: preferred shareholders have a prior claim on earnings, so their dividends must be paid first before calculating what's left for common shareholders.
Which of the following best describes the dividend discount model (DDM) approach to stock valuation?
A is correct. The dividend discount model (DDM) values a stock based on the present value of all expected future dividend payments. The model assumes that a stock's intrinsic value equals the sum of its future dividends discounted back to present value using an appropriate discount rate. The Gordon Growth Model is a common version that assumes dividends grow at a constant rate.
B (comparing dividends to competitors) is incorrect because the DDM focuses on discounting future cash flows, not peer comparison. While relative valuation might compare dividend yields, that's not the DDM approach. C (dividing annual dividends by price) is incorrect because this calculates dividend yield, not the DDM valuation method. The DDM works in reverse, using dividends to determine what the price should be. D (past five years of dividends) is incorrect because the DDM is forward-looking, focusing on future expected dividends, not historical payments.
The dividend discount model is a fundamental valuation concept tested on the Series 65 because it demonstrates time value of money principles applied to equity valuation. Understanding that DDM focuses on future dividends discounted to present value connects this topic to NPV and DCF concepts from the analytical methods section. The DDM is most applicable to mature, dividend-paying companies with stable, predictable dividend growth. It's less useful for growth companies that don't pay dividends.
A company has total assets of $50 million, total liabilities of $30 million, and 2 million common shares outstanding. What is the book value per share?
A is correct. Book value per share is calculated as (Total Assets - Total Liabilities) ÷ Common Shares Outstanding, which equals Shareholders' Equity ÷ Shares Outstanding. Calculation: ($50 million - $30 million) ÷ 2 million shares = $20 million ÷ 2 million = $10 per share. Book value represents the accounting value of equity per share, based on historical costs on the balance sheet.
B ($15) is incorrect because it miscalculates the shareholders' equity as $30 million instead of $20 million. C ($20) is incorrect because it represents the total shareholders' equity in millions but fails to divide by the number of shares. D ($25) is incorrect because it divides total assets by shares ($50M ÷ 2M) without subtracting liabilities, which overstates book value.
Book value per share is essential for calculating the price-to-book (P/B) ratio, another key valuation metric. Understanding book value helps distinguish accounting value from market value. Value investors often seek stocks trading below book value (P/B ratio below 1.0), believing they're undervalued. Book value questions frequently appear alongside market value questions to test whether you understand the difference between balance sheet values and market prices.
A stock trades at $40 per share and has a book value per share of $25. What is the stock's price-to-book (P/B) ratio?
C is correct. The price-to-book (P/B) ratio is calculated as Market Price per Share ÷ Book Value per Share. In this case: $40 ÷ $25 = 1.6. A P/B ratio of 1.6 means the stock is trading at 1.6 times its book value, indicating investors are willing to pay a 60% premium over the company's accounting value.
A (0.625) is incorrect because it inverts the formula, dividing book value by market price ($25 ÷ $40). This reverses the ratio and would suggest the stock trades below book value when it actually trades above. B (1.0) is incorrect because it would require the market price and book value to be equal, which they're not in this scenario. D (2.5) is incorrect because it miscalculates the division, possibly confusing the numbers or using an incorrect formula.
The price-to-book ratio helps distinguish value stocks (low P/B) from growth stocks (high P/B). Value investors typically seek stocks with P/B ratios below 1.0, suggesting they're undervalued. Growth companies often trade at high P/B ratios because their intangible assets and growth prospects aren't fully reflected in book value. This metric appears frequently on the Series 65 alongside P/E ratios as a complementary valuation tool. Banks and financial companies are often valued using P/B because their assets are primarily financial and close to market value.
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Access Free BetaWhich of the following best describes fundamental analysis?
B is correct. Fundamental analysis involves evaluating a company's financial statements, competitive position, industry conditions, management quality, and economic factors to determine the intrinsic value of its stock. The goal is to identify whether a stock is overvalued or undervalued compared to its true worth. This approach uses metrics like P/E ratios, P/B ratios, dividend discount models, and financial ratio analysis.
A (price charts and volume) is incorrect because this describes technical analysis, not fundamental analysis. Technical analysis focuses on historical price patterns rather than company fundamentals. C (moving averages and support levels) is incorrect because these are technical analysis tools, not fundamental analysis methods. D (investor sentiment and breadth indicators) is incorrect because these are also technical or sentiment-based approaches, not fundamental analysis focused on intrinsic value.
Understanding the distinction between fundamental and technical analysis is essential for the Series 65 exam. Fundamental analysis aligns with the concept of intrinsic value and long-term investment decisions based on company quality. The exam tests whether you can identify fundamental metrics (P/E, P/B, ROE, debt ratios) versus technical indicators (moving averages, support/resistance). Investment advisers often use fundamental analysis to make recommendations based on a company's financial health rather than short-term price movements.
A company reports a net loss for the year, resulting in negative earnings per share. Which of the following best describes the limitation of the P/E ratio in this situation?
D is correct. When a company has negative earnings, the P/E ratio cannot be meaningfully calculated or interpreted. While you can mathematically divide price by negative earnings to get a negative number, this result has no practical meaning for valuation purposes. Analysts typically use alternative metrics for unprofitable companies, such as price-to-sales ratio or price-to-book ratio.
A (P/E will be zero) is incorrect because negative earnings don't produce a zero P/E; they produce a negative or undefined result. B (compare negative P/E to peers) is incorrect because a negative P/E ratio is meaningless for comparison purposes. You cannot compare a stock with a P/E of negative 20 to one with a P/E of positive 15 in any useful way. C (indicates undervalued) is incorrect because a negative P/E provides no valuation information at all, whether positive or negative about the stock's prospects.
This addresses one of the three common mistakes explicitly listed in the Series 65 subtopic guidance: "Using P/E ratio with negative earnings." This concept tests your understanding of when valuation metrics are appropriate and when they break down. The exam may present scenarios with unprofitable companies to see if you recognize that P/E ratios don't work in these situations. This concept also connects to understanding limitations of financial metrics and knowing when to use alternative valuation approaches.
Which type of stock typically has a higher price-to-earnings (P/E) ratio?
C is correct. Growth stocks typically have higher P/E ratios because investors are willing to pay a premium for expected future earnings growth. These companies reinvest most earnings rather than paying dividends, and investors anticipate significant appreciation. High P/E ratios reflect optimistic expectations about future profitability. Technology and biotech companies often have P/E ratios of 30, 40, or higher.
A (value stocks) is incorrect because value stocks typically have low P/E ratios, which is why they're considered undervalued. Value investors seek stocks trading at low multiples relative to earnings. B (defensive stocks) is incorrect because defensive stocks in mature industries typically have moderate to low P/E ratios due to limited growth prospects. D (income stocks) is incorrect because stocks that pay out most earnings as dividends typically have lower P/E ratios, similar to value stocks, because they have limited reinvestment opportunities.
Understanding the relationship between stock categories and P/E ratios helps you answer questions about growth versus value investing styles. Growth stocks command premium valuations (high P/E) because of future prospects, while value stocks trade at lower multiples. This distinction appears frequently when the exam tests portfolio management styles, suitability of investments for different clients, and risk-return characteristics. A client seeking growth might accept high P/E stocks, while a value investor would target low P/E opportunities.
The book value of a stock represents:
B is correct. Book value per share represents the accounting value of shareholders' equity divided by shares outstanding. It's calculated from balance sheet figures (assets minus liabilities) based on historical costs and accounting principles. Book value reflects what common shareholders would theoretically receive per share if all assets were sold at book value and all liabilities paid. However, book value often differs significantly from market value.
A (current market price) is incorrect because this describes market value, not book value. Market value fluctuates with supply and demand, while book value is an accounting figure from the balance sheet. C (present value of future dividends) is incorrect because this describes the intrinsic value as calculated by the dividend discount model, not book value. D (liquidation value) is incorrect because liquidation value represents what assets would actually fetch in a forced sale, which typically differs from accounting book value. Liquidation value is usually lower than book value due to distressed sale conditions.
Distinguishing book value from market value is critical for the Series 65 exam and addresses one of the three common mistakes listed: "Confusing book value with market value." This distinction underlies the price-to-book ratio and helps you understand value investing principles. Book value is backward-looking (historical accounting) while market value is forward-looking (expectations). Questions often test whether you can identify which measure is appropriate for different analysis purposes.
An analyst determines that a stock has an intrinsic value of $45 per share, but it is currently trading at $38 per share. Based on this analysis, the stock is most likely:
C is correct. When a stock's intrinsic value ($45) exceeds its current market price ($38), the stock is considered undervalued. Fundamental analysis suggests the stock is worth more than investors are currently paying for it, which represents a potential buying opportunity. The difference between intrinsic value and market price is called the "margin of safety" in value investing.
A (overvalued) is incorrect because this reverses the relationship. A stock is overvalued when market price exceeds intrinsic value, not the other way around. B (fairly valued) is incorrect because there's a $7 difference between intrinsic value and market price, indicating a meaningful valuation gap rather than equilibrium. D (need P/E ratio) is incorrect because intrinsic value analysis already incorporates all necessary information. The P/E ratio is one input among many, but once intrinsic value is determined, you can compare it directly to market price without additional metrics.
Understanding intrinsic value and its relationship to market price is fundamental to investment analysis and frequently tested on the Series 65. This concept connects fundamental analysis, valuation models (DDM, DCF), and investment decisions. When intrinsic value exceeds market price, value investors see a buying opportunity. When market price exceeds intrinsic value, the stock may be overvalued. This framework appears in questions about investment recommendations, portfolio construction, and when to buy or sell securities.
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