Deck 7: Valuation of the Individual Firm

Question 1

Least squares trend analysis is the only method of obtaining a completely objective estimate of future earnings per share.

Answer 1

False

Question 2

In the formula P₀ = D₁/(K_e - g), one limiting factor is that K_e must always be smaller than g.

Answer 2

False
Explanation: K_e is the required rate of return, and is set by the investor's expectations. It may well be greater than g.

Question 3

In the formula P₀ = D₁/(K_e - g), if D₁= $2.00, K_e= .10, and g = .06, P₀ is equal to $55.

Answer 3

False

Question 4

The appropriate price-earnings ratio (P/E ratio) to be used for stock valuation can be calculated at any time by dividing the current stock price by the last twelve months of earnings per share.

Question 5

In general, young, rapidly expanding firms are more likely to carry higher P/E ratios than mature firms.

Question 6

In the formula P₀ = D₁/(K_e - g), if K_e rises while dividends and growth stay the same, the stock price will decline.

Question 7

Empirical evidence indicates that rising dividends are no guarantee that the associated common stock price will also rise in the short run.

Question 8

Under most dividend valuation models, a stock with an expected level dividend (zero dividend growth) would have no value.

Question 9

A growth stock is sometimes defined as the common stock of a company which is growing faster than the economy in general.

Question 10

The strong inverse relationship between P/E ratios and changes in the Consumer Price Index can be directly traced to investors' required rate of return.

Question 11

The final value calculated in dividend valuation models is typically very accurate.

Question 12

Dividend valuation models are best suited for firms in the expansion or maturity phase of their life cycle.

Question 13

Under a non-constant growth model, K_e (required rate of return) is varied from time period to time period.

Question 14

In the formula P₀ = D₁/(K_e - g), if g decreases, the price of the stock will go down.

Question 15

The general dividend model assumes the value of a firm is equal to the present value of future dividends.

Question 16

All dividend valuation models are based on the present value of a future income stream.

Question 17

Under a non-constant growth model, the growth rate (g) is varied from time period to time period.

Question 18

The current price of a stock should equal the future value of the expected dividend stream.

Question 19

Under the constant dividend growth model, it is possible for a negative stock value to result.

Question 20

The first step in using the income-statement method of estimating earnings per share (EPS) is to develop an accurate sales forecast.

Question 21

When an analyst uses the income statement method of forecasting earnings, she has a limited amount of flexibility in adjusting the inputs.

Question 22

The combined earnings and dividend model considers the present value of dividends, plus the present value of a future P/E ratio times future projected earnings.

Question 23

History shows that, as inflation increases, price-earnings ratios increase along with inflation.

Question 24

Inflation has an indirect effect on price-earnings ratios through its impact on K_e.

Question 25

There is little relationship between R&D expenditures as a percent of sales, and growth of earnings per share.

Question 26

Firms with highly liquid cash positions may be attractive merger candidates, mainly because their cash can be used to pay dividends.

Question 27

In general, if the market perceives that the direction of interest rates and inflation is down, this perception will have a positive effect on price-earnings ratios.

Question 28

Mathematically, the price-earnings ratio (P/E) is simply the price per share divided by earnings per share.

Question 29

The problem with the pure short-term earnings model is that the stock value is highly sensitive to short-term swings in earnings per share (EPS).

Question 30

With the income-statement method of forecasting earnings per share (EPS), you start with a forecast of profits.

Question 31

Hidden assets refer to assets that are not readily apparent to investors in a traditional sense, but add substantial value to the firm.

Question 32

Every valuation method has its limitations.

Question 33

Valuation models using average price ratios and 10-year averages can be more useful with cyclical companies, because valuation of cyclical companies benefits from an analysis of longer time periods including at least one business cycle.

Question 34

As inflation increases, the required rate of return on common stocks falls, as well as the prices.

Question 35

All things being equal, the less debt that a firm has, the more likely it is to be highly valued in the marketplace.

Question 36

For cyclical companies, the most accurate price-earnings ratio would be derived by dividing the current stock price by the latest 12 months earnings.

Question 37

It is thought that historical growth rates have more impact on an individual company's P/E ratio than expected future growth rate.

Question 38

All things being equal, the more rapid growth a firm enjoys, the higher the P/E ratio.

Question 39

Least squares trend analysis is used to take a simple average of past data.

Question 40

The key to firms having assets as sources of value is their current return on these assets.

Question 41

A high P/E ratio for any individual stock may be misleading

A)in an inflationary economy.
B)if the firm is in a cyclical industry, like automobiles.
C)if the firm has a strong future growth rate.
D)More than one of the above

Question 42

An individual investor could rely on earnings forecasts from any of the following, except:

A)Standard and Poor's earnings forecaster.
B)a firm's annual report.
C)Value Line Investment Survey.
D)Zacks, I/B/E/S, or other professional consensus reporting firms.

Question 43

One basic problem with the application of the Capital Asset Pricing Model when computing K_e is that

A)(K_m- R_F) is not observable in the market.
B)the analyst needs to forecast dividends for next year.
C)beta is a historical number.
D)the risk-free rate changes every day.

Question 44

If the Treasury bill rate (R_F) increases, then K_e will

A)decrease.
B)increase.
C)stay the same.
D)go up by beta times the Treasury bill rate.

Question 45

The P/E ratio approach to stock valuation is based on:

A)a yearly range of historical P/E ratios resulting in an average expected P/E ratio, an earnings forecast derived from expected growth rates in earnings, and the stock's current P/E ratio.
B)the average yearly P/E ratio, relative to the market; a yearly range of P/E ratios; and earnings based on an assumed constant growth rate.
C)an increasing yearly range of P/E ratios and an earnings forecast based on the EPS of previous years.
D)The current P/E ratio, compared to the P/E ratio of some market index.

Question 46

Which of the following would most likely affect the P/E ratio of the market in general?

A)A significant change in government fiscal policy
B)Declining earnings of the S&P 500 companies
C)Investors' expectations about inflation changes and becomes either more positive or more negative
D)All of the above could have a significant impact.

Question 47

The general dividend valuation model assumes the investor knows the _______ and the discount rate.

A)exact dividend to be paid in each and every year
B)current year's dividend, the anticipated annual dividend growth rate
C)investor's required rate of return
D)book value per share of the company

Question 48

The P/E ratio of a particular firm would probably be affected by which of the following?

A)Investors' perception of the quality of the firm's management
B)The firm's accounting practices
C)Supply and demand for the security
D)All of the above

Question 49

Stock valuation based on the relationship between a stock's P/E ratio and the market may result in superior returns if:

A)the firm is riskier than the market.
B)the firm has a high P/E ratio, relative to the market.
C)the stock is trading at the low end of its P/E ratio, relative to the market.
D)More than one of the above

Question 50

In general, the P/E ratio of a stock _______________ as inflation _____________.

A)increases; decreases
B)increases; increases
C)decreases; decreases
D)none of the above

Question 51

The purpose of stock valuation is

A)to set the fair market price for a given common stock.
B)to determine whether the common stock's value is fairly represented by its market price.
C)of limited value, since the efficient market hypothesis proves that all common stock is always fairly priced.
D)to find common stocks whose market price equals the intrinsic value.

Question 52

The required rate of return is intended to provide

A)compensation for expected inflation.
B)a premium for risk assumed.
C)a minimum real rate of return.
D)All of the above

Question 53

If the equity risk premium (ERP) expands, K_e will:

A)increase by beta times the equity risk premium.
B)not be affected.
C)go down.
D)decrease by beta times the equity risk premium.
E)increase by beta minus the equity risk premium.

Question 54

Short-term speculators would probably NOT use _________ to develop a stock value.

A)dividend growth rates
B)discount rates
C)a stream of earnings or dividends
D)the income-statement method
E)any of the above

Question 55

In order for any dividend valuation model to reflect a valid stock price for a company,

A)the company must pay dividends.
B)the dividend growth rate must remain constant.
C)the required rate of return (discount rate) must remain constant.
D)More than one of the above is true

Question 56

One way of calculating K_e is to use the Capital Asset Pricing model, as follows:

A)K_e = R_F + (K_M - R_F)
B)K_e = RR + IP + ERP
C)K_e = R_F + b(K_M - R_F)
D)K_e = D₁/P₀ + g
E)K_e = R_F + b(K_M)

Question 57

The primary difference between dividend valuation models and earnings valuation models is:

A)selecting the appropriate discount rate.
B)dividends are not considered in earnings models.
C)whether the investor's income stream or the firm's income stream is measured.
D)More than one of the above

Question 58

What is the value of a stock which has a current dividend (D₀) of $1.50, and is growing at the rate of 7%? The investor's required rate of return is 12%.

A)$26.75
B)$30.00
C)$32.10
D)$21.42
E)$13.38

Question 59

The constant growth dividend valuation model assumes

A)a constant annual dividend.
B)a constant dividend growth rate for no more than the first 10 years.
C)that the discount rate must be greater than the dividend growth rate.
D)that the dividend growth rate must be greater that the discount rate.
E)A and B are true assumptions

Question 60

In the non-constant growth model where the first phase of growth is 5 years, followed by a second phase of constant growth:

A)P₅= D₆/(K_e-g).
B)P₀ = the present value of dividends from years 1 - 5 plus the present value of P₅.
C)the company's growth rate is probably higher than K_e during the first 5 years.
D)All of the above are correct

Question 61

In developing a least squares trend line, the analyst should:

A)include several business cycles.
B)fit the trendline between a peak and a trough, or vice versa.
C)use as many data points as are practical.
D)All of the above

Question 62

Beta measures:

A)the relationship of the P/E ratio to the earnings growth rate.
B)individual company stock price risk, relative to the market.
C)the risk within a portfolio than cannot be diversified away.
D)the stock price growth of one company compared to that of a second company.

Question 63

Which of the following statements about stock valuation based on asset value is NOT true?

A)Natural resources often give a company value, even if an income stream is not produced
B)The value of the assets may not even appear on the balance sheet
C)Current assets are usually excluded from the valuation process, since they will be used up in the next business cycle
D)Hidden assets can add substantial value to the firm

Question 64

Studies generally show that the price-earnings ratio is a function of:

A)expected changes in interest rates.
B)future estimated growth of earnings for the individual company.
C)expected changes in the required rate of return, K_e.
D)All of the above impact price-earnings ratios

Question 65

The best time period for use in the combined earnings and dividend valuation model is:

A)2 years.
B)5 years.
C)10 years.
D)Any time period is acceptable

Question 66

P/E ratios are influenced by a company's

A)growth rate.
B)risk.
C)capital structure.
D)management.
E)All of the above and more

Question 67

The nonconstant dividend discount model is best applied to companies in the:

A)maturity stage of their life cycle.
B)development stage of their life cycle.
C)expansion stage of their life cycle.
D)A and B

Question 68

The basis of stock valuation includes an analysis of

A)economic variables.
B)industry variables.
C)financial statements.
D)All of the following

Question 69

The valuation models using price to sales, price to earnings, price to book value, price to cash flow, and price to dividends, assume that:

A)there is a historical relationship between these ratios and the current price ratio.
B)when the current price ratio is below the historical ratio, the stock may be undervalued.
C)there is some general accounting relationship between these five ratios, based on historical performance.
D)All of the above are true

Question 70

The value of the price-earnings ratio is affected by:

A)the earnings period used for its calculation.
B)expected growth in earnings per share.
C)overall conditions in the stock market.
D)inflationary expectations.
E)All of the above

Question 71

The use of many valuation models provides the analyst with

A)one model that gives the right answer.
B)multiple models of how the market might value the firm's stock price.
C)a confusing array of answers.
D)the ability to choose the best model that matches his or her previous judgment.

Question 72

A good example of an industry that has a lot of growth companies in it is the:

A)automobile industry.
B)biotechnology industry.
C)food and beverage industry.
D)consumer products industry.

Question 73

Which of the following is NOT a characteristic of a growth company?

A)The company has a relatively high average expenditure on research and development
B)The company usually pays a dividend equal to 40-50% of earnings
C)The company has consistently stable and high profit margins
D)The company has a growth rate that is significantly higher than the growth of GDP

Question 74

The pure, short-term earnings model:

A)ignores present value analysis and its long-term forecasts of dividends and earnings per share.
B)uses the past three months to estimate earnings per share.
C)disregards the long-term growth forecasts for earnings per share.
D)uses the payout ratio and return on equity to derive the P/E ratio.

Question 75

The reason price-earnings ratios and inflation are related is because:

A)as inflation increases, the required return in the market rises, pushing down the prices of securities.
B)as inflation increases, the required return in the market rises, pushing up the prices of securities.
C)as price-earnings ratios fall, the market changes its expectations about the future rate of inflation.
D)as price-earnings ratio rise, the market anticipates that inflation will decrease, sending stock prices higher.

Question 76

Forecasts for companies that follow economic cycles are best based on analysis of

A)2 economic peaks and troughs.
B)1 economic peak and trough.
C)the last 3 to 5 years of data.
D)None of the above

Question 77

Dividend models are best suited for those companies that are in the:

A)introduction phase of the life cycle.
B)expansion phase of the life cycle.
C)maturity phase of the life cycle.
D)Both B and C

Question 78

The value of common stock can be viewed as:

A)a dividend stream, plus a market price at the end of the dividend stream.
B)a present value of a dividend stream, plus a market price at the end of the dividend stream.
C)the terminal value of the dividend stream.
D)the sum of the dividend stream, taken to infinity.

Question 79

Using pro forma income statements to estimate earnings per share instead of using regression analysis has several advantages, except which one of the following?

A)The analyst is able to study profitability and the effects of taxes on profit margins
B)Interest expense and debt and equity financing can be factored into the analysis
C)Hidden problems in stable growth firms would be brought out
D)Effects of the business cycle on profit margins can be included in the forecast

Question 80

Least squares trend analysis involves fitting a straight line through a series of data, which, by definition:

A)minimizes the distance of each data point from the line, and minimizes the squared area above and below the trendline.
B)minimizes the distance between each data point.
C)must include at least one peak and at least one trough.
D)must include a minimum of 20 points to get a usable trendline.