An analyst gathered info from a company’s most recent financials (in millions): Preferred stock: 40 Common stock: 120 Additional paid-in capital: 30 Retained earnings: 190 Treasury stock: (55) Total Shareholder’s equity: 325 # of Common shares outst.: 10 Million Tax rate: 40% The analyst determined that the company uses the LIFO inventory method, but MOST companies in the industry use FIFO method. The footnotes to the financials indicated that if the companyhad used FIFO, the inventory balance would have been $45 Million higher than the amount reported. If the company’s common stock is currently selling for $59/share, the MOST appropriate price to book value ratio to use in valuing the company is: A. 1.59 B. 1.68 C 1.79 D. 1.89 The answer is D, and “the answer people” found it by: 325-40 (to take out preferred stock)- makes sense. And then they took $45 Million in inventory and multiplied by 1-t to get the amount of retained earning that would have been added to equity if FIFO had been used. Now, my understanding is that when evaluating a company, you want FIFO assets and LIFO COGS, since you want to see how current costs are affecting the company. However, in adjusting for retained earnings, it seems like they are assuming that FIFO should be used in COGS, too, when evaluating a company. OR, are the “answer people” only adjusted the balance sheet, AND NOT THE INCOME STATEMENT in this case? Anyone want to take a stab at this?
BV = Shareholder¡¦s equity ¡V Preferred Stock = 325 ¡V 40 = 285 This contained a Retained Earnings component of 190 Adjusting Retained earnings for FIFO „³ RE(LIFO) + LIFO Reserve End * (1-T) = 190 + 45 * .6 = 217 So 27 needs to be added to BV above „³ 285 + 27 = 312 Per share BV = 312 / 10 = 31.2 P/BV = 59/31.2 = 1.89
But why would you even mess around with retained earnings? I thought the goal was to get FIFO inventory and LIFO COGS for the best analysis. I guess the only way I could see the rational for adjusting retained earnings is if you were NOT going to use LIFO COGS in your analysis since the industry uses FIFO. OR, if you only adjusted retained earnings, and then left ALL of the companies with LIFO COGS. Which one is it? Thanks.
US GAAP requires that when you have LIFO on the Balance sheet, you must have LIFO on the Income statement as well. When you move to FIFO on the Balance sheet - which is what is being done by changing the End. Inv. you need to make an adjustment to all the Income statement figures affected which would be a. COGS b. Tax --> because of COGS effect c. NI because of COGS effect This in turn will affect Retained earnings on the Balance sheet --> and from there the BV of the company. This is what they’re asking us to recognize in the problem above. CP
Yes, I understand that accountants have to use US GAAP rules. However, my question is aimed at analysis. As an analyst, I can adjust the financials so that I see LIFO COGS and FIFO inventory. This will give me a more accurate economic reality of the company, since both adjustments will make me see more current inventory costs and more current COGS. This is why in the curriculum, there are formulas for switching around inventory and COGS. Maybe when comparing companies, you don’t do this??? Maybe analysts only do this when looking at a single company??? Not sure. Peter Olinto, the Stalla instructor, talked about this on his 2006 CD’s. Really good stuff.
from schweser sample exam 2, afternoon session. a company uses lifo and had a lifo reserve in 2006 of 90,000 and 85,000 in 2005. the marginal tax rate is 28% and the cogs in 2006 is 100,000. #1. the 2006 retained earnings, if the firm would use fifo would change by… #2. the 2006 change in NI if lifo inventory would have been used is… i intentionally leave the a), b), c) and d) away. let’s go guys… 
RE FIFO = RE LIFO + LIFO RESERVE END * (1-T) so change would be 90000 * .72 = 64800 increase. NI FIFO = NI LIFO + Delta LIFO RESERVE * (1-T) So NI LIFO = NI FIFO - Delta LIFO RESERVE * (1-T) Change in NI LIFO = 5000 * (.72) = 3600 reduction. Is that right? CP
cpk, #1. correct #2. correct. i actually misspelled the second one… it should have said: change in NI if fifo inventory would have been used… sorry for that guys…
Bigfin - my take on reading the question was that since we’re looking at the P/BV ratio, and that most other firms in the industry use FIFO, then for comparison purposes it makes more sense to calculate this ratio using FIFO inventory as well, to give a more useful comparable value. Did anyone else interpret it that way?