Deck 13: Common Stock Valuation

Question 1

The required rate of return on a common stock investment is also known as the:

A) prevailing market rate of interest.
B) the anticipated dividend yield.
C) the minimum expected rate of return.
D) expected capital gains yield.

Answer 1

the minimum expected rate of return.

Question 2

The following terms are interchangeable except for:

A) discount rate.
B) capital gains rate.
C) required rate of return.
D) capitalization rate.

Answer 2

capital gains rate.

Question 3

The intrinsic value of common stock is calculated by:

A) present value of all expected cash flows.
B) present value of all capital gains.
C) future value of all dividend payments.
D) present value of all dividend payments.

Answer 3

present value of all expected cash flows.

Question 4

Earnings are important in stock valuation for all of the following reasons except:

A) a company without earnings does not have a positive value.
B) dividends are paid out of earnings.
C) stock price is directly affected by earnings.
D) fundamental analysis relies on earnings.

Question 5

Which of the following is a problem in using the dividend discount model (DDM) to value common stock?

A) The model does not consider the riskiness of the stock.
B) The model does not consider the present value of the dividends.
C) The model does not value firms which do not pay dividends.
D) The model does not account for small dividends.

Question 6

Which of the following is not one of the dividend growth rate models?

A) the infinite growth model
B) the zero growth model
C) the constant growth model
D) a negative but still constant growth model

Question 7

The constant growth dividend model is also known as the:

A) Black-Scholes Model.
B) the Capital Asset Pricing Model.
C) the Gordon's Model.
D) the Binomial Model.

Question 8

The zero-growth dividend model:

A) provides higher values for common stocks than a positive constant growth.
B) is the most accurate model to use.
C) is equivalent to the valuation model for preferred stocks and perpetual bonds.
D) assumes the highest required return possible.

Question 9

The variant of the dividend discount model that is most appropriate for a start-up company that pays smaller dividends early in its life but is expected to increase them after several years would be the:

A) zero-growth model.
B) constant growth model.
C) expansion growth model.
D) multiple growth model.

Question 10

Which of the following statements regarding intrinsic value and market price is true?

A) If intrinsic value is greater than the current market price, the stock should be avoided or, if already held, sold since it is overvalued.
B) If intrinsic value is less than the current market price, the stock is undervalued and should be bought.
C) If intrinsic value is equal to the current market price, the stock is correctly valued and is in equilibrium.
D) If the intrinsic value is greater than the current market price, the stock is considered too speculative to be purchased.

Question 11

The intrinsic value of any stock is its:

A) present value of future dividends.
B) current market price.
C) future value of expected dividends.
D) current dividend yield.

Question 12

Which of the following statements regarding dividend discount models is not true?

A) Different investors often use different discount rates in their calculation.
B) Future benefits are uncertain and must be estimated.
C) Few money managers use the model to estimate intrinsic value.
D) The models are based on estimates.

Question 13

Which of the following is not true for the P/E ratio?

A) It is also known as the earnings multiple.
B) It is the number of times investors value earnings as expressed in the stock price.
C) Analysts use this model more often than the DDM .
D) All of the above are true for the P/E ratio.

Question 14

An investor planning to sell stock at the end of two years can still use the DDM to value the stock because the anticipated selling price is:

A) too risky to be considered a variable within the model.
B) irrelevant to the analysis since it does not consider future dividends.
C) built into the model as the selling price in two years would be simply the present value of anticipated dividends.
D) worth little as the present value of the price in two years would be close to zero.

Question 15

Which of the following relationships in the P/E ratio should not hold, other things being equal?

A) The higher the expected dividend payout ratio D₁/E₁, the higher the P/E.
B) The higher the expected growth rate, g, the higher the P/E.
C) The higher the required rate of return, k, the lower the P/E.
D) All of the relationships should hold.

Question 16

A firm has net income of $1 million with 250,000 shares outstanding with a total market value of $16 million. What is its P/E ratio?

A) 64
B) 4
C) 32
D) 16

Question 17

If interest rates rise and other factors remain constant, the P/E ratio of a company will:

A) become negative.
B) increase.
C) decrease.
D) become more volatile.

Question 18

Which of the following variables does not have a direct relationship with the P/E ratio?

A) dividend payout ratio
B) expected growth rate of dividends
C) expected growth rate of earnings
D) the required rate of return for the company's stock

Question 19

Which of the following changes will likely lead to a lower P/E, assuming other factors are equal?

A) An increase in the dividend payout ratio.
B) A decrease in growth rate of earnings.
C) A decrease in the required rate of return.
D) An increase in the dividend yield.

Question 20

Which of the following statements regarding P/E ratios is true?

A) Generally, the riskier a stock, the higher its P/E ratio.
B) Over the long term, low P/E ratio stocks tend to have higher returns than high P/E ratio stocks.
C) As the level of interest rates increase, P/E ratios are expected to decline.
D) Higher growth prospects for a firm do not lead to higher P/E ratios.

Question 21

The yields on preferred stock tend to most often mirror the yields on:

A) common stock.
B) derivatives.
C) bonds.
D) risk-free securities.

Question 22

A stock that is currently experiencing low demand in the market would likely have a:

A) high P/E ratio.
B) low P/E ratio.
C) high earnings multiple.
D) low required rate of return.

Question 23

The book value of equity is:

A) simply another name for market value.
B) a technique that provides more accurate valuations than the dividend models.
C) the accounting value of the firm as reflected in the financial statements.
D) the same as intrinsic valuation.

Question 24

A company has a price to sales ratio of 1.10, annual sales of $2 billion and 100 million shares of common stock outstanding. Its stock price is:

A) $20.00
B) $18.18
C) $17.52
D) $22.00

Question 25

The justified M/B ratio can be estimated by comparing with all of the following except:

A) comparisons with industry ratios.
B) comparisons with aggregate market ratios.
C) comparisons with past trends.
D) technical indicators in the DDM.

Question 26

Which of the following is not true about the price/sales ratio?

A) Sales are relatively insensitive to accounting decisions and are never negative.
B) Sales figures provide useful information about corporate decisions such as the impact of pricing and credit policies.
C) Sales are not as volatile as earnings levels, hence, P/S ratios are generally less volatile than P/E multiples.
D) Sales impart a large amount of information about cost control and profit margins making it an important measure of corporate performance.

Question 27

The Economic Value Added (EVA) Model:

A) is defined the multiple of price-to-cash flow (P/CF).
B) is a model which ignores residual cash flow.
C) is a technique that focuses on a firm's excess between its actual return on capital and its WACC to determine if shareholders are rewarded.
D) is a model where a negative amount means that shareholders are being rewarded.

Question 28

What is the estimated value of a stock with a required rate of return of 10 percent, a projected constant growth rate of dividends of 5 percent and expected dividend of $2.00?

A) $4
B) $40
C) $44
D) $20

Question 29

XYZ Company has expected earnings of $3.00 for next year and usually retains 40 per cent for future growth. Its dividends are expected to grow at a rate of 10 per cent indefinitely. If an investor has a required rate of return of 16 per cent, what price would he be willing to pay for XYZ stock?

A) $12.50
B) $25.00
C) $30.00
D) $40.00

Question 30

WWW Company currently (t = 0) earns $4.00 per share, and has a payout of 40 per cent. Dividends are expected to grow at a constant rate of 8 per cent per year. The required rate of return is 15 per cent. The price of this stock would be estimated at:

A) $57.14.
B) $22.86.
C) $10.67.
D) $24.69.

Question 31

Tyler Toys currently earns $3.00 per share and currently pays $1.20 per share in dividends. It is expected to have a constant growth rate of 7 per cent per year. The required rate of return is 14 per cent. What is the intrinsic value of this stock?

A) $42.86
B) $18.34
C) $17.14
D) $40.05

Question 32

If the intrinsic value of stock is less than the current stock price, the stock is overvalued and should be sold or shorted.

Question 33

The valuation models count the earnings reinvested in the company as well as the earnings paid out as dividends.

Question 34

The P/E model can value common stocks when a firm does not pay dividends.

Question 35

EVA analysis reflects an emphasis on return on capital.

Question 36

In practice, security analysts tend to use the price-to-book value approach the most.

Question 37

Why are dividends the foundation of valuation for common stock?

Question 38

What is one limiting factor regarding the expected dividend growth rate in the dividend discount model?

Question 39

Why do the yields on preferred stock tend to mirror the yields on bonds?

Question 40

According to the DDM, at a trough in the stock market, the prices of stocks can be expected to rally. Why?
Div

Question 41

The directors of MJ Inc. expect to pay a dividend of $2.00 (annual) a year from today. It is estimated that during the next four years (i.e. years 2 through 5), the dividend will grow at an annual rate of 16 per cent (i.e. g₁ = 16 per cent). After that, the growth rate (g₂) will be equal to 12 per cent per year and continue at that rate indefinitely. Calculate the present value of the MJ's stock if the required rate of return is 15 per cent.

Question 42

Contemporary Casuals, Inc., (CCI) has a beta of 1.15, an expected dividend of $2.30, and an expected dividend growth rate of 5 per cent for the foreseeable future. The S&P/TSX Composite Index expected return is 18 per cent, and the Treasury bill rate is 6 per cent.
(a) Calculate the required return on Contemporary stock.
(b) Calculate the price of Contemporary stock.

Question 43

Use the following information to answer Problems


-Answer the following questions based on the financial data given above:
I) Calculate ROE for the year 2000 using the 3 stage DuPont formula.
ii. Calculate the sustainable rate of growth.
iii. Calculate the current value of a share of ABC stock using a two-stage dividend discount model.
iv. Calculate the amount of FCFE per share for the year 2000.
V) Briefly explain how to calculate the current value of a share of ABC stock using the two-stage FCFE model.
vi. Calculate the P/E ratio using the long run growth rate of 13%.
vii. Describe one limitation of the two-stage DDM model that is addressed by using the two-stage FCFE model.
viii. Describe one limitation of the two-stage DDM model that is not addressed by using the two-stage FCFE model.

Question 44

Use the following information to answer Problems

-Identify, within the context of the constant dividend growth model, how each of the following fundamental factors would affect the P/E ratio.
i. The riskiness (beta) of ABC increases substantially.
ii. The estimated growth rate of ABC's earnings and dividends increases.
iii. The dividend payout ratio of ABC increases.
iv. The market risk premium increases.

Question 45

Use the following information to answer Problems

-Explain why an increase in the dividend payout ratio may not have the effect that the constant dividend growth P/E ratio model suggests.

Question 46

Grubb State Power and Light's free cash flow next year will be $100 million and it is widely expected to grow at a 4 percent annual rate indefinitely. The company's weighted average cost of capital is 10 percent, the market value of its liabilities is $1 billion, and it has 20 million shares outstanding. Estimate the price per share of Grubb's common stock.