Try 10 focused CISI IM questions on Valuation, with answers and explanations, then continue with Securities Prep.
| Field | Detail |
|---|---|
| Exam route | CISI IM |
| Issuer | CISI |
| Topic area | Valuation |
| Blueprint weight | 14% |
| Page purpose | Focused sample questions before returning to mixed practice |
Use this page to isolate Valuation for CISI IM. Work through the 10 questions first, then review the explanations and return to mixed practice in Securities Prep.
| Pass | What to do | What to record |
|---|---|---|
| First attempt | Answer without checking the explanation first. | The fact, rule, calculation, or judgment point that controlled your answer. |
| Review | Read the explanation even when you were correct. | Why the best answer is stronger than the closest distractor. |
| Repair | Repeat only missed or uncertain items after a short break. | The pattern behind misses, not the answer letter. |
| Transfer | Return to mixed practice once the topic feels stable. | Whether the same skill holds up when the topic is no longer obvious. |
Blueprint context: 14% of the practice outline. A focused topic score can overstate readiness if you recognize the pattern too quickly, so use it as repair work before timed mixed sets.
These questions are original Securities Prep practice items aligned to this topic area. They are designed for self-assessment and are not official exam questions.
Topic: Valuation
A manager running a UK equity growth portfolio benchmarked to the FTSE All-Share is comparing two retailers. Both are forecast to grow revenue by 8% next year and both trade on a price/sales ratio of 1.2x. Company A has a 14% operating margin and net debt/equity of 20%. Company B has a 6% operating margin and net debt/equity of 140%, with most debt at floating rates. Which is the best valuation conclusion?
Best answer: A
What this tests: Valuation
Explanation: The best answer is the view favouring Company A. Similar revenue growth does not imply similar valuation when one business converts sales into much more operating profit and carries much less financial risk. Equal price/sales multiples can therefore mask a meaningful relative mispricing.
This is a capital structure and operating economics question. A price/sales ratio looks only at top-line value, so it can miss two critical drivers of equity valuation: how efficiently sales become operating profit, and how much risk debt adds to the equity. Company A has a much stronger operating margin, so each pound of revenue produces more EBIT and potential cash flow. It also has far lower leverage, which reduces interest burden, refinancing pressure, and sensitivity to rising rates.
Company B may have the same revenue growth, but weaker margins and heavy floating-rate debt make its equity riskier and less resilient. If both companies trade on the same price/sales ratio, the stronger business and cleaner balance sheet would usually deserve the higher multiple.
The key takeaway is that similar growth can still lead to different valuation conclusions once profitability and leverage are considered together.
Higher margins and far lower leverage mean Company A should normally command a stronger equity valuation than Company B, so the same price/sales ratio suggests relative undervaluation.
Topic: Valuation
An analyst is reviewing Kestrel plc and uses market-value weights when calculating WACC.
Extract:
| Item | Figure |
|---|---|
| Ordinary shares outstanding | 30 million |
| Share price | £6.00 |
| Cost of equity | 12% |
| Listed bonds nominal value | £200 million |
| Bond market value | £120 million |
| Pre-tax cost of debt | 7% |
| Corporation tax rate | 25% |
Which statement is best supported?
Best answer: D
What this tests: Valuation
Explanation: WACC should use market-value weights and the after-tax cost of debt. Equity is £180m and debt is £120m, so the business is 60% equity financed; applying 12% for equity and 5.25% for debt gives a WACC of about 9.3%.
The core concept is that WACC uses the market values of financing sources, not the bond nominal value, and debt is adjusted for the tax relief on interest. From the extract, equity market value is 30 million × £6 = £180 million, while debt contributes its market value of £120 million. Total capital is therefore £300 million, giving weights of 60% equity and 40% debt.
The closest distractor keeps the correct capital weights but forgets to tax-adjust the cost of debt.
Using market values gives equity of £180m and debt of £120m, so WACC is (0.60 × 12%) + (0.40 × 7% × 0.75) = 9.3%.
Topic: Valuation
A capital project is expected to report a positive accounting profit, but its return on capital is below the firm’s weighted average cost of capital (WACC). Which statement is correct?
Best answer: B
What this tests: Valuation
Explanation: Positive accounting profit does not by itself mean a project creates shareholder value. If the return on capital is below WACC, the project fails to earn its required return, so economic value added is negative.
The key concept is the difference between accounting profit and economic profit. Accounting profit records revenues less accounting expenses, but economic value creation also charges for the opportunity cost of all capital employed, including equity. That is why EVA is a useful measure in capital budgeting and performance analysis.
If a project’s return on capital is below WACC, it is not covering its required cost of capital. In economic terms, the project is destroying value even if reported profit is positive.
The closest confusion is to treat reported profit as proof of value creation, but value creation depends on returns exceeding the cost of capital.
EVA deducts the full cost of capital, so a return below WACC means value is being destroyed despite positive accounting profit.
Topic: Valuation
A portfolio manager for a UK equity fund compares two listed business-services companies. Alpha has invested in a digital platform with high fixed development costs, very low incremental servicing cost, 85% recurring subscription revenue and spare capacity. Beta has expanded rapidly, but management layers, customer-support costs and rework are rising faster than revenue. End-markets and balance-sheet leverage are otherwise similar. If both trade on the same forward EV/EBIT multiple, which is the best assessment?
Best answer: D
What this tests: Valuation
Explanation: Alpha shows classic economies of scale: once the platform is built, additional subscription revenue can be serviced at low marginal cost. Because most revenue is recurring, that operating leverage is more likely to convert into resilient margins and stronger valuation support than Beta’s diseconomies of scale.
The core concept is that economies of scale spread fixed costs over a larger revenue base, lowering unit cost and improving operating leverage when demand grows. Alpha’s platform has high fixed development cost but low incremental servicing cost, so extra subscription revenue should flow through to EBIT more efficiently. The 85% recurring revenue base also makes those margins more resilient because revenue visibility is stronger. By contrast, Beta’s rising management, support and rework costs indicate diseconomies of scale: complexity is increasing costs faster than sales, which weakens margin resilience and reduces confidence in future operating leverage. If both shares trade on the same forward EV/EBIT multiple, Alpha is the one more likely to deserve the premium, not Beta.
Alpha combines economies of scale with recurring revenue, so incremental sales should lift EBIT margins while Beta’s rising overhead suggests diseconomies.
Topic: Valuation
An investment manager is reviewing Apex Engineering plc. For this question, financial gearing = net debt / ordinary shareholders’ funds, and interest cover = operating profit / net finance cost.
| £m | 2023 | 2024 |
|---|---|---|
| Operating profit | 96 | 90 |
| Net finance cost | 12 | 18 |
| Net debt | 240 | 300 |
| Ordinary shareholders’ funds | 400 | 360 |
Which interpretation is best supported by the exhibit?
Best answer: B
What this tests: Valuation
Explanation: Using the stated definitions, financial gearing rises from 60% to 83.3%, while interest cover falls from 8.0x to 5.0x. That means the company is more leveraged and has less headroom to service its interest payments, so financial risk has increased.
The key is to assess both leverage and debt-servicing capacity using the definitions given in the stem. Financial gearing rises because net debt increases from £240m to £300m while ordinary shareholders’ funds fall from £400m to £360m. Interest cover weakens because operating profit falls and net finance cost rises.
Taken together, those ratios show higher financial risk, not improvement. The closest distractor is the idea that positive profit means better cover, but interest cover depends on profit relative to interest cost, not on profit simply remaining positive.
Net debt increased while equity fell, and operating profit covered interest fewer times than before.
Topic: Valuation
An ESG disclosure is most likely to be material to an investor when it could reasonably:
Best answer: C
What this tests: Valuation
Explanation: An ESG point is financially material when a reasonable investor could use it to change valuation assumptions. If it can affect cash flows, asset values, or the discount rate, it may alter price or portfolio decisions; narrative value or reporting format alone is not enough.
The core concept is financial materiality. For an investor, ESG information is material when it has a credible pathway to valuation, such as changing revenues, margins, capital expenditure, liabilities, asset lives, or the discount rate used in valuation models. In other words, it must be capable of affecting expected return or risk.
Descriptive ESG content can still be useful, but it is not automatically material just because it sounds positive, is widely discussed, or follows a recognised reporting framework. Materiality depends on decision-usefulness for investors, not on presentation quality or general stakeholder interest.
The key test is whether the disclosure could change the numbers or risks that drive value, rather than simply adding context.
Investor materiality is about whether the information can affect valuation inputs and therefore the investment decision.
Topic: Valuation
A UK equity analyst is reviewing a listed engineering company’s proposal to build one of two mutually exclusive plants. The projects have conventional cash flows but different initial sizes, and the company’s WACC has already been estimated at 8%. The analyst wants the framework that best shows which project adds the most shareholder value in GBP.
Which is the single best choice?
Best answer: A
What this tests: Valuation
Explanation: NPV is most appropriate when the aim is to choose between mutually exclusive projects and identify which one creates the greatest monetary value. Because WACC is already known, it can be used as the discount rate, while NPV gives the clearest GBP measure of shareholder value added.
The core concept is matching the tool to the decision. WACC is primarily the discount rate or hurdle rate, not the final decision framework. IRR is often useful, but with mutually exclusive projects of different scale it can rank projects incorrectly because it gives a percentage return rather than the absolute value created. EVA is mainly a period-by-period performance measure based on profit after a capital charge, rather than the standard capital-budgeting method for selecting between projects.
Here, the analyst wants to know which project adds the most shareholder value in money terms, so NPV is the most appropriate framework. The key takeaway is that when projects are mutually exclusive and differ in size, NPV is usually preferred over IRR.
NPV is the best choice because, given an estimated WACC, it measures the absolute GBP value created and is most reliable for comparing mutually exclusive projects of different scale.
Topic: Valuation
An equity analyst is reviewing a potential investment in a listed manufacturer. Use gross profit = revenue - cost of sales, and calculate both margins as a percentage of revenue.
Revenue: £250 million Cost of sales: £150 million Net profit after tax: £15 million
Which assessment best applies valuation discipline?
Best answer: B
What this tests: Valuation
Explanation: Gross profit is £100 million, so gross profit margin is 40%, while net profit margin is 6%. A large gap between these margins usually means costs below cost of sales, such as overheads, interest or tax, are absorbing much of the profit generated from trading.
The key concept is to separate profitability at the gross level from profitability after all expenses. From the figures given, gross profit is £250 million - £150 million = £100 million, so gross margin is £100 million / £250 million = 40%. Net profit margin is £15 million / £250 million = 6%.
So, the most appropriate valuation conclusion is that underlying trading margin looks reasonable, but overall profitability is being heavily reduced by other costs.
Gross profit is £100 million, so the gross margin is 40%; net margin is 6%, showing substantial costs below gross profit.
Topic: Valuation
In fundamental analysis, return on capital employed (ROCE) is commonly decomposed into which two components?
Best answer: D
What this tests: Valuation
Explanation: ROCE combines a profitability measure with an efficiency measure. In standard analysis, it is broken into operating margin and asset turnover, showing how much operating profit is earned on sales and how effectively capital employed generates revenue.
The core concept is that ROCE measures return from operations relative to the capital used in the business, and it can be split into two drivers: margin and turnover.
\[ \begin{aligned} ROCE &= \frac{\text{Operating profit}}{\text{Capital employed}} \\ &= \frac{\text{Operating profit}}{\text{Revenue}} \times \frac{\text{Revenue}}{\text{Capital employed}} \end{aligned} \]The first part is operating margin, and the second part is asset turnover. This helps an analyst see whether a strong ROCE comes from high operating profitability, efficient use of the asset base, or both. The closest distractor is the pair using gross margin, but ROCE uses operating profit rather than gross profit.
ROCE can be written as operating profit divided by revenue, multiplied by revenue divided by capital employed.
Topic: Valuation
Which measure is derived directly from income-statement figures and used as a profitability indicator?
Best answer: B
What this tests: Valuation
Explanation: Operating profit margin is the clearest income-statement profitability measure because it uses operating profit and revenue. The other measures rely on balance-sheet amounts or cash-flow information, so they do not arise directly from the income statement alone.
The key distinction is whether the measure is built from profit-and-loss figures or from balance-sheet or cash-flow data. Operating profit margin is an income-statement profitability indicator because it relates operating profit to revenue, both reported in the income statement. By contrast, return on capital employed mixes profit with capital employed from the balance sheet, current ratio is a balance-sheet liquidity measure, and free cash flow is a cash-flow measure rather than an accounting-profit measure.
A common trap is to choose a profitability ratio such as ROCE, but it is not derived from income-statement figures alone.
Operating profit margin compares operating profit with revenue, both taken from the income statement.
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