Deck 8: Stock Valuation

Question 1

A temporary decline in earnings per share usually results in a temporary reduction of dividends.

Answer 1

False

Question 2

List the key variables that affect the P/E ratio and explain the relationship between each variable and the P/E ratio.

Answer 2

(a) growth rate in earnings; the higher the growth rate, the higher the P/E ratio
(b) general state of the economy; the better the economic outlook, the higher the P/E
(c) amount of debt in a company's capital structure; the lower the debt ratio, the higher the P/E
(d) current and projected rate of inflation; the lower the inflation, the higher the P/E
(e) level of dividends; the lower the dividend payout, the higher the P/E

Question 3

The estimated price of a stock in the future is important because it includes the projected capital gain on the stock.

Answer 3

True

Question 4

Which of the following will affect the firm's future cash flows?
I) state of the economy
II) state of the industry
III) the firm's recent and current earnings
IV) new products in the firm's pipeline

A) I, II and III only
B) I, II and IV only
C) I, III and IV only
D) I, II, III and IV

Question 5

The key to the future financial success of a company lies in the sales growth and the net profit margin.

Question 6

The current value of a stock is an estimate of

A) the present value of future dividends and the future price of the stock.
B) future earnings and future P/E ratios.
C) all future dividends discounted at the required rate of return minus the growth rate.
D) the stock's future beta and the future market rate of return.

Question 7

Which of the following will most directly influence a company's market value?

A) the state of the economy
B) the book value of its assets
C) the use of financial leverage
D) its future cash flows

Question 8

The most important factors influencing a stock's current price are its past earnings and dividends.

Question 9

If net income rises, but the number of shares outstanding remains the same, EPS will rise.

Question 10

The first step in predicting a stock's future price is to forecast profits.

Question 11

A company's growth rate is a function of its return on equity and dividend payout ratios.

Question 12

A decline in earnings that investors expect to be temporary may actually increase a firm's P/E ratio.

Question 13

Which of the following variables affect the P/E ratio?
I) capital structure of a firm
II) amount of dividends to be paid
III) inflation rate
IV) earnings rate of growth

A) I, II and III only
B) I, II and IV only
C) I, III and IV only
D) I, II, III and IV

Question 14

A company's P/E ratio will be influenced by

A) P/E ratios for the overall market.
B) the rate of growth in earnings.
C) investors' optimism or pessimism about the future state of the economy.
D) all of the above.

Question 15

High P/E ratios can be expected when investors expect

A) a high rate of growth in earnings.
B) low earnings. relative to market prices.
C) high interest rates.
D) a bear market.

Question 16

A comparison of common-size income statements in consecutive years will show a change in profit margin, but not a change in revenues.

Question 17

A company's estimated future earnings and its P/E ratio can be used to estimate the stock's future price.

Question 18

When evaluating a firm's stock, past performance

A) is useless since investors are only concerned with future returns.
B) can provide insight about the firm's future direction.
C) is only important if the firm is in a stable industry.
D) is not used by stock analysts.

Question 19

A stock's value depends on future cash flows.

Question 20

The single most important issue in the stock valuation process is a company's

A) past earnings record.
B) historic dividend growth rate.
C) expected future returns.
D) capital structure.

Question 21

The forecast of of a a company's future free cash flows will not be affected by

A) investments in working capital.
B) investments in fixed assets.
C) changes in depreciation and amortization.
D) all of these changes will impact free cash flows.

Question 22

There is no assurance that the actual rate of return on an asset will be similar to the projected rate of return.

Question 23

The common stock of Rob's Discount Furniture is currently selling at $65.20 a share. The company adheres to a 60% dividend payout ratio and has a P/E ratio of 19. There are 42,000 shares of stock outstanding. What is the amount of the annual net income for the firm?

A) $42,338
B) $36,032
C) $144,126
D) $72,064

Question 24

Which one of the following is a correct equation to calculate earnings per share?

A) (ROA) × (book value per share)
B) (profit margin) × (total asset turnover) × (equity multiplier) × (book value per share)
C) (profit margin) × (equity multiplier) × (book value per share)
D) (profit margin) × (book value per share)

Question 25

Even if a company does not officially follow a fixed-dividend policy, dividend payments are

A) extremely difficult to predict.
B) very volatile and subject to economic conditions.
C) fairly stable from one time period to another.
D) directly tied to a company's P/E ratio.

Question 26

Which one of the following is is most likely to increase the price of a stock?

A) rapid growth in sales
B) rapid decrease in the company's debt levels
C) rapid growth in earnings
D) rapid increases in bond interest rates

Question 27

If the growth rate of dividends increases and the required rate of return stays the same, the stock price will

A) the effect of such a change depends on other factors.
B) decline.
C) rise.
D) stay the same.

Question 28

The Lincoln Corporation has current annual sales of $700,000 and a net profit margin of 5%. Sales are expected to increase by 6% annually while the profit margin is expected to remain constant. What is the projected after-tax earnings for two years from now?

A) $46,305
B) $44,100
C) $37,100
D) $39,326

Question 29

Over the last year, a firm's earnings per share increased from $1.20 to $1.40, its dividends per share increased from $0.50 to $0.60, and its share price increased from $21 to $24. The firm maintained a relative P/E of 1.10 over the entire time period. Given this information, it follows that the

A) stock experienced an increase in its P/E ratio.
B) company had a decrease in its dividend payout ratio.
C) current P/E of the overall market is 26.4.
D) overall market P/E is declining.

Question 30

Global Warning's EPS for the current year is $2.75 and its current P/E ratio is 50. You have forecasted that EPS will grow by 10% but the P/E ratio will fall to 40. What do you expect the price of a share of GW's stock to be at the end of next year?

A) $110
B) $121
C) $137.50
D) $151.25

Question 31

P/E ratios could rise even as earnings fall if

A) earnings fall at a faster rate than stock prices.
B) earnings fall at a slower rate than stock prices.
C) investors expect lower stock prices to be permanent.
D) investors expect lower earnings to be permanent.

Question 32

Which of the following will lead to an increase in earnings per share?

A) an increase in the P/E ratio
B) an increase in the dividend payout ratio
C) an increase in return on equity if book value per share stays the same
D) a decrease in the number of shares if return on equity stays the same

Question 33

Columbus Co.'s sales revenue for the most recent quarter was $2.5 million and cost of goods sold was $1.5 million. If sales grow by 15% in the next quarter and all ratios remain the same, gross profit will be

A) $2.25 million.
B) $1.725 million.
C) $1.15 million.
D) $1.375 million.

Question 34

If the market multiple is 20.24 and the P/E ratio of a company is 24.5, then the stock's relative P/E is

A) 0.83.
B) 1.19.
C) 1.21.
D) 4.26.

Question 35

A stock will be an attractive investment if the required rate of return exceeds the expected rate of return.

Question 36

To calculate earnings per share (EPS) you must know

A) return on assets and total asset value.
B) gross revenue and the stock price.
C) growth and the number of shares outstanding.
D) net income and the number of shares outstanding.

Question 37

The greater the perceived risk of an asset, the higher the required rate of return.

Question 38

Washington Enterprises had net income of $1,000,000, invested $150,000 in fixed assets, paid $50,000 in dividends, and took depreciation expense of $80,000? Free cash flow was

A) $770,000.
B) $880,000.
C) $930,000.
D) $720,000.

Question 39

In an efficient market, differences between intrinsic value and market value should be small.

Question 40

The economic forecast will influence the sales forecast in most cases.

Question 41

Both beta and the expected return on the market portfolio incorporate risk into the Capital Asset Pricing Model.

Question 42

In the Capital Asset Pricing Model, which of the following factors are used to determine the required rate of return?
I) the risk-free interest rate
II) future cash flows
III) expected return on the market portfolio
IV) beta

A) I and II only
B) I, II and III only
C) II, III and IV only
D) I, III and IV only

Question 43

The growth rate of dividends cannot be permanently greater than the required rate of return.

Question 44

The required rate of return denotes the minimum rate of return an investor should expect.

Question 45

Which of the following are key inputs to determining the intrinsic value of an asset?
I) the required rate of return
II) future cash flows
III) current stock price
IV) timing of future cash flows

A) I and II only
B) I and III only
C) I, II and IV only
D) II, III and IV only

Question 46

A stock's required rate of return as determined by the capital asset pricing model is influenced by

A) the risk-free rate.
B) the expected return on the market.
C) the standard deviation of past returns.
D) A and B, but not C.

Question 47

The approach to stock valuation which holds that the value of a share of stock is a function of its future dividends is known as the dividend valuation model (DVM).

Question 48

If a stock's market price is greater than its intrinsic value then

A) its internal rate of return to be lower than its required rate of return.
B) its internal rate of return to be higher than its required rate of return.
C) its internal rate of return to equal its required rate of return.
D) its future cash flows to have a present value higher than the market price when discounted at the required rate of return.

Question 49

The risk free rate is 3%. The expected rate of return on the market is 10%. Betas and the expected rates of return for four stocks are as follows.: BWI 0.9 , 10%; ORH 1.0, 10%; ORL 1.4 , 12.6%, and DEL 1.5, 18%. Based on a comparison of each stock's expected return versus its required return, which of these stocks should not be purchased?

A) BWI
B) ORH
C) ORL
D) DEL

Question 50

Explain how the time value of money concept is used in stock valuation.

Question 51

The risk-free rate of return is 2.2 percent, the expected market return is 11 percent, and the beta for Solstice, Inc. is 1.12. What is Solstice's required rate of return?

A) 8.80%
B) 12.06%
C) 13.20%
D) 14.30%

Question 52

The intrinsic value of an asset equals the present value of all future cash flows at a given discount rate.

Question 53

The required rate of return estimated by the Capital Asset Pricing Model is not suitable for use in dividend valuation models.

Question 54

The most uncertain value used in the Capital Asset Pricing Model is

A) beta.
B) the risk-free rate.
C) expected return on the market.
D) all are equally uncertain.

Question 55

The dividend valuation model estimates the value of a share of stock as the future value of all dividends.

Question 56

The dividend valuation model (DVM) is very sensitive to the growth rate (g) being used, because it affects both the model's numerator and its denominator.

Question 57

If the growth rate declines while the dividend and required rate of return stay the same, the value of the stock will also decline.

Question 58

An investor should purchase a stock when

A) the market price exceeds the intrinsic value.
B) the expected rate of return equals or exceeds the required return.
C) the capital gains rate is less than the required return and no dividends are paid.
D) the market price is greater than the justified price.

Question 59

One of the easiest aspects of the dividend valuation model (DVM) is specifying the appropriate growth rate for a firm's dividends over time.

Question 60

Heather believes that by carefully examining a company's fundamentals and by applying the best valuation models she can identify stocks whose market prices are lower than their intrinsic values. In order for this to be true

A) she needs an accurate estimate of future earnings and dividends.
B) some stocks must be incorrectly priced.
C) betas must be stable over time.
D) P/E ratios for both the stock and the market must be stable over time.

Question 61

A company that wants to maintain both a constant growth rate in dividends and a constant payout ratio will have to

A) grow earnings faster than dividends.
B) increase assets at the same rate as dividends.
C) grow earnings at the same rate as dividends.
D) increase stockholders' equity at the same rate as dividends.

Question 62

One method of estimating the dividend growth rate is to calculate the discount rate that equates today's dividend with the dividend paid several years ago.

Question 63

Home Renu Inc.'s most recent dividend was $0.25. The company plans to double it's dividend every year for the next four years, then increase it at a constant rate of 5% per year. To estimate the intrinsic value of this stock using the dividend-growth model, the required rate of return must be

A) greater than 52.5%.
B) equal to or greater than 100%.
C) greater than 5%.
D) The dividend-growth model is not appropriate for valuing this stock.

Question 64

Treehouse Inc.'s $50 par value preferred stock pays a dividend fixed at 8% of par. To earn 9% on an investment in this stock, you need to purchase the shares at a per share price of

A) $4.00.
B) $44.44.
C) $50.00.
D) $56.25.

Question 65

Clinton Inc paid dividends of $2.10 in 2016,, 2.20 in 2017, 2.37 in 2018, and $2.50 in 2019. A reasonable estimate for the dividend growth rate is 6%.

Question 66

ABC Company stock currently has a market value equivalent to its intrinsic value. Marco perceives that ABC Company is increasing its level of risk and therefore Marco increases his required rate of return on ABC stock. This change in the required rate of return

A) will reduce the intrinsic value of ABC stock to Marco.
B) will increase the intrinsic value of ABC stock to Marco.
C) will change the intrinsic value but the direction of the change cannot be determined.
D) is a signal to Marco that he should buy more ABC Company stock.

Question 67

Allston Inc. just paid an annual dividend of $1.00. The expected dividend next year $1.50, and the year after that, $2.00. After the third year, dividends will grow at a constant rate of 5% per year. If your required rate of return for Allston is 10%, what is the most you should pay for this stock.

A) $31.05
B) $36.73
C) $37.73
D) $45.50

Question 68

In applying the variable-growth dividend valuation model to a company's stock, analysts frequently define the growth rate, g, as equal to

A) ROE multiplied by the firm's retention rate.
B) ROE divided by the dividend payout ratio.
C) the dividend payout ratio multiplied by the firm's retention rate.
D) P/E multiplied by the dividend payout ratio.

Question 69

John requires a 12% rate of return on EG stock at a time when investors, on average, are requiring an 11% rate of return on the same stock. Which of the following will happen?

A) John will have to pay more for the stock than he was willing to pay.
B) Investors with different required rates of return will pay different prices for the stock.
C) John will not be able to buy the stock unless the price changes.
D) John will buy the stock at a lower price.

Question 70

One stock valuation model holds that the value of a share of stock is a function of its future dividends, and that the dividends will increase at an annual rate which will remain unchanged over time. This stock valuation model is known as the

A) approximate yield model.
B) holding period return model.
C) dividend reinvestment model.
D) constant growth dividend valuation model.

Question 71

The Hopkinton Company just paid $2.25 as its annual dividend. The dividends have been increasing at a rate of 5% annually and this trend is expected to continue. The stock is currently selling for $63.60 a share. What is the rate of return on this stock?

A) 3.60%
B) 3.70%
C) 8.7%
D) 11.8%

Question 72

What is the required rate of return on a common stock that is expected to pay a $0.75 annual dividend next year if dividends are expected to grow at 2 percent annually and the current stock price is $8.59?

A) 8.73%
B) 8.91%
C) 10.73%
D) 11.38%

Question 73

FWP Co.'s P/E ratio is 13. The stock's beta is 1.3; the risk free rate is 2%; the expected market rate of return is 11%. The last dividend was $1.80 and dividends are expected to grow at 3% annually for the foreseeable future. To find the intrinsic value of this stock, we should

A) multiply $1.80 by 13.
B) divide $1.80 by 0.137.
C) multiply $1.85 by 10.
D) divide $1.85 by 0.107.

Question 74

The rate of dividend growth can be estimated by multiplying the return on equity rate by the dividend payout ratio.

Question 75

When using the constant-growth dividend valuation model, which of the following will lower the value of the stock?

A) an increase in the required rate of return
B) a decrease in the required rate of return
C) an increase in the dividend payout ratio
D) an increase in the growth rate of the dividends

Question 76

Walpurg, Inc. paid $1.30 as an annual dividend per share last year. The company is expected to increase their annual dividends by 6% each year. How much should you pay to purchase one share of this stock if you require a 9% rate of return on this investment?

A) $45.93
B) $11.44
C) $23.39
D) $22.96

Question 77

James is willing to settle for a 10% rate of return on EG stock at a time when investors, on average, are requiring an 11% rate of return on the same stock. Which of the following will happen?

A) James will have to pay more for the stock than he was willing to pay.
B) Investors with different required rates of return will pay different prices for the stock.
C) James will not be able to buy the stock unless the price changes.
D) James will be happy to buy the stock for less than he was willing to pay.

Question 78

The rate of growth can exceed the required return during the variable-growth period without invalidating the variable growth dividend valuation model.

Question 79

The dividend valuation model (DVM) cannot accommodate which of the following assumptions?

A) constant dividends
B) a constant growth rate of dividends less than the required rate of return
C) a constant growth rate of dividends greater than the required rate of return
D) dividends growing at a variable rate

Question 80

The constant-growth dividend valuation model is best suited for use with

A) stocks of new or emerging companies.
B) small-cap stocks within growing industries.
C) the stocks of mature, dividend-paying companies.
D) the stocks of cyclical companies.