Chapter 10 COMMON STOCK VALUATION Multiple Choice QuestionsOverview 1. a. b. c. d. All of the following are relative valuation techniques except: P/E ratio. Price/book value ratio Price/sales ratio Price/dividend ratio (d, moderate) Discounted Cash Flow Techniques 2. a. b. c. d. The estimated value of common stock is the: present value of all expected cash flows. present value of all capital gains. future value of all dividend payments. present value of all dividend payments. (a, moderate) 3. a. b. c. d. Discounted cash flow techniques used in valuing common stock are based on: future value analysis. present value analysis. the CAPM. the APT. (b, easy) The Dividend Discount Model 4. a. b. c. d. All of the following are interchangeable terms except for: discount rate coupon rate required rate of return capitalization rate (b, moderate) Chapter Ten Common Stock Valuation 119 The constant growth dividend model uses the: historical growth rate in dividends. is the most accurate model to use. easy) Chapter Ten Common Stock Valuation 120 . c. d. Which of the following is a problem using the dividend discount model to value common stock? The model does not account for the risk of the stock. d. b. estimated growth rate in dividends. c. c. b. a. d. The model does not consider that dividends may not be paid The model does not account for small dividends. c. a. moderate) 8. b. d. is equivalent to the valuation model for preferred stock. moderate) 6. estimated growth rate in earnings. historical growth rate in earnings. (c. a. assumes the highest required return possible. The model does not consider the present value of the dividends. b. a. Which of the following is not one of the dividend growth rate models? the infinite growth model the zero growth model the constant growth model the multiple growth model (a.The Dividend Discount Model 5. (c. The zero-growth dividend model: gives the highest value for a common stock. moderate) 7. (c. Which of the following is not one of the reasons two investors both using the constant-growth version of the DDM on the same stock might arrive at different estimates of the stock's value? They used different expected returns. a. b. b. (a. easy) 11. They used different growth rates of dividends. (d. They used different required returns. difficult) 12. multiple growth model.9. Under the multiple growth model. d. All of the above are possible reasons they might arrive at different values. all of the above are implied by the model (c. The dividend model that is most appropriate for a young company that pays small dividends now but is expected to increase dividends in years is the: zero-growth model. a. moderate) 10.different growth rates are used. c. b. two three four five (a. at least -----. dividends remain constant from now to infinity. b. c. d. a. moderate) Chapter Ten Common Stock Valuation 121 . The constant growth rate model of the DDM implies that: earnings are not relevant to stock prices. d. c. d. a few a. the stock price grows at the same rate as dividends. expansion growth model. constant growth model. c. and has a payout of 40 percent. moderate) 14.. Tyler Toys currently earns $3.15 .20(1.1) = $30 a. What is the estimated value of a stock with a required rate of return of 15 percent.14 $40.73 P0 = D1/(k – g) = 1. What is the intrinsic value of this stock? $42. c. $4 Solution: P0 = D1/(k – g) $40 = 2/(.. $24.4 = $1. b.60 D1 = 1.34 $17.07) = 1. The price of this stock would be estimated at $57. (b. moderate) 16.20 per share in dividends. XYZ Company has expected earnings of $3.20 D1 = 1.10) $44 = $40 $20 (b.28 P0 = = 1. c. $10. Solution: D0 = $4 x . d.86.80/(.00 per share. moderate) 15.13. If an investor has a required rate of return of 16 percent.00 .69. d.07) = $18. (c. Dividends are expected to grow at a constant rate of 8 percent per year.00 $30. (d.15 .86 $18.60(1.50 $25. c. WWW Company currently (t = 0) earns $4. The required rate of return is 15 percent.00 per share and currently pays $1.00 Solution: Dividends P0 = = = = $3(1 . b. c. Its dividends are expected to grow at a rate of 10 percent indefinitely.14 . what price would he be willing to pay for XYZ stock? $12...80 D1/(k – g) 1. a.14. b.34 a. d.4) $1.69 a. b.05 Solution: D0 = $1. moderate) Chapter Ten Common Stock Valuation 122 .00 for next year and usually retains 40 percent for future growth. d.00 $40.28/(.16 .08) = $24..08) = 1.67. It is expected to have a constant growth rate of 7 percent per year. $22. a projected constant growth rate of dividends of 10 percent and expected dividend of $2. The required rate of return is 14 percent.73/(. difficult) 19. d. If intrinsic value is less than the current market price. a. risk-free rate plus a risk premium. if already held. a. Analysts often use a ________% rule in security valuation in recognition of the fact that estimating a security's value is an inexact process. (b. the stock is correctly valued. IV = CMP d. the discount rate used is the: risk-free rate. c. 5 10 15 20 (c. b. Impossible to determine. If intrinsic value is equal to the current market price. In the Streetsmart Guide to Valuing a Stock. b. before-tax weighted average cost of capital. Which of the following situations indicates a signal to sell a stock? a. b. c. Which of the following statements regarding intrinsic value and market price is true? If intrinsic value is greater than the current market price.Other Discounted Cash Flow Approaches 17. the stock is considered speculative. (c. easy) Chapter Ten Common Stock Valuation 123 . the stock should be avoided or. IV > CMP b. d. d. difficult) 20. (c. moderate) 18. sold. a. IV < CMP c. c. the stock is undervalued. If the intrinsic value is greater than the current market price. after-tax weighted average cost of capital. c. as well as preferred stock financing? FCFE model FCFF model constant growth rate model multiple growth rate model a.21. A firm has net income of $1 million with 250. d. a. c.000 shares outstanding with a total market value of $16 million. d. measures what a firm could pay out in dividends and the DDM measures what is actually paid. b. including both the repayment and interest on existing debt as the sale of new debt. difficult) Relative Valuation Techniques 23. (c. measures both dividend growth and stability and the DDM only measures the dividend growth. Which of the following models incorporates debt financing. d. difficult) 22. b. moderate) Chapter Ten Common Stock Valuation 124 . a.000 = $4 EPS 16 mil/250. b. (b. easy) 24. A major difference between the dividend discount model (DDM) and the free cash flow to equity model (FCFE) is that the FCFE: accounts for potential capital gains and the DDM does not. Under the P/E model. c.000 = $64 MPS 64/4 = 16 P/E RATIO (d. What is its P/E ratio? 64 4 32 16 Solution: 1 mil/250. c. bases its calculations on future value techniques while the DDM uses present value calculations. stock price is a product of: EPS and DPS P/E ratio and EPS EPS and required return P/E ratio and required return (b. d. b. a. d. increase. Which of the following changes will likely lead to a higher P/E. As interest rates increase. b. (c. Which of the following statements regarding P/E ratios is true? Generally. Growth prospects often lead to higher P/E ratios. the higher the P/E ratio. a. If interest rates rise and other factors remain constant. the P/E ratio of a company will: become negative. the small capitalization stocks had the highest P/E ratios. moderate) 28. In recent years. decrease. difficult) 27. (b. a. become more volatile.25. c. b. b. assuming other factors are equal? A decrease in the dividend payout ratio An increase in growth rate of earnings An increase in the required rate of return A decrease in the dividend yield (b. P/E ratios are expected to decline. d. d. c. a. a. difficult) Chapter Ten Common Stock Valuation 125 . moderate) 26. Which of the following variables has an inverse relationship with the P/E ratio? payout ratio expected growth rate of dividends expected growth rate of earnings required rate of return (d. b. c. d. the riskier the stock. c. a. b. b. b. service companies. a. moderate) 31. c. A company has a price to sales ratio of 1. net profits and cost of equity. a high P/E ratio a high payout ratio a high required return (b. c. net profits and cost of capital. c. d. difficult) 30. b. banks. utilities. a. a. the same as liquidation value. c.10.18 $17. easy) 32. moderate) Chapter Ten Common Stock Valuation 126 .29. a more accurate valuation technique than the dividend models. Economic value added is the difference between: operating profits and cost of capital. the accounting value of the firm as reflected in the financial statements. a. operating profits and cost of equity. annual sales of $2 billion and 100 million shares of common stock outstanding. b. d. Book value is: the same as market value. Its stock price is: $20 per share $18. (a. The price to book value ratio tends to be close for: high-tech companies. A stock that is currently enjoying a strong demand by investors would likely to have: a high dividend yield. c.10 PSR = $22 MPS (d. d. d.00 Solution: 2 billion/100 million = $20 Sales $20 x 1. (b. d. (c. moderate) 33.52 $22. difficult) Chapter Ten Common Stock Valuation 127 . a. (c. what the market is willing to pay for a firm’s revenues. moderate) 37. c. d. (c.5. 10 20 30 40 a. what the analysts see as the breakup value of the firm. It is recommended that investors interested the EVA approach should seek companies that have a return of capital in excess of ------. There is supporting evidence that stocks with low price to book values significantly outperform the market.34. b. therefore. d. c. d. moderate) 36. difficult) 35. (b. b. the market capitalization model. Which of the following statements concerning price to book value is true? There is an inverse relationship between price to book values and market prices. Price to book value ratios for many stocks range from 5. c. a. the price advantage a company has for its brand names. a. b. b. adding value. (b. c. The price/sales ratio indicates: the amount of risk in the firm’s operations. d. A relatively new valuation technique that emphasizes the difference between a firm’s operating profits and its cost of capital is called: the discounted dividend model.5 to 10. It is calculated as the ratio of price to the book value of assets. the capital asset pricing model. economic value added model.because this will likely exceed the cost of capital and the company is. (T.) 2. easy. (F. difficult. (T. they will all arrive at the same estimate of value. Under the zero-growth dividend model. p. 10-10) 6. (F.True-False Questions The Dividend Discount Model 1. the price found under the constant growth model will be negative. the stock is overvalued and should be sold short. moderate) 3. Other things equal. If the intrinsic value of stock is greater than the current stock price. Earnings per share is an accounting concept whereas dividends represent actual cash payments. expected dividends are the same as current dividends. the lower the required return. the lower the P/E. (T. easy) Other Discounted Cash Flow Approaches 7. moderate) Relative Valuation 8. If the growth rate in dividends is greater than the required rate of return. the relative valuation approach does not require that an estimate of the stock's value be made. (F. (T. If all investors use the constant growth dividend model to value the same stock. Relatively small changes in the inputs used in the DDM can change the estimated value by large percentage amounts. moderate) Chapter Ten Common Stock Valuation 128 . difficult) 4. moderate) 5. Unlike the discounted cash flow techniques. (T. 9. (T. moderate) 14. (T. Firms with significant intellectual property tend to have a high book value. moderate) Chapter Ten Common Stock Valuation 129 . on average. moderate) 11. easy) Which Approach to Use? 13. (F. difficult) 11. You would expect a lower PSR for a retail company than for a biotechnology company. easy) Bursting the Bubble on New Economy Stocks . (F. The "New Economy" stocks of the 1990s proved conclusively that the old valuation principles do not apply today. moderate) 10. Relative valuation methods tend to be more sophisticated. easy) 12.A Lesson in Valuation 12. (T. more formal and less intuitive than discounted cash flow techniques. (F. Declining interest rates in the market should send P/E ratios. higher. (T. Morningstar reports a "fair value" for stocks based on a discounted cash flow analysis. (T. The recent corporate scandals should send a message that investors want disclosure of important financial information. EVA analysis reflects an emphasis on return on capital. The higher the payout ratio. However. Answer: (easy) 2. the higher the P/E is expected to be. Give an example of something that might not be equal and how it would affect the P/E. other things being equal. they represent expected future benefits from the investment. other things might not be equal. and changing one may change others. Earnings per share of one cent make a $5 stock to have a P/E of 500. Answer: (difficult) 3. The financial newscaster comments that the Stock X is overvalued at an earnings multiple of 60. A higher payout would lead to a higher dividend and higher price in the DDM. What could cause a P/E this high? Either the price could be high relative to normal earnings or the earnings could be low with very high growth expectations. Like bond interest. What are the implications for the usefulness of the P/E ratio if a company’s earnings are very low (like a few cents) or negative? Either very low or negative earnings cause P/E ratios to be distorted. If the higher payout caused the growth to decrease because of lower earnings retention. Answer: (moderate) 4. which doesn't make sense. Answer: (difficult) 5. What variables must be estimated to use the dividend discount model? The P/E model? Chapter Ten Common Stock Valuation 130 . Why are dividends the foundation of valuation for common stock? They are the only cash payments a stockholder receives directly from a company. the price and P/E might increase less or fall.Short-Answer Questions 1. Negative earnings per share would cause a negative P/E. The point is that the variables are not necessarily independent. and (c) the required rate of return affect the P/E ratio. (b) the expected dividend growth rate. then. Chapter Ten Common Stock Valuation 131 . (moderate) 6. Are high or low P/E ratios more reliable as tools for valuation of stocks? Low P/E ratios are likely to be more stable than high P/Es. High P/Es may be distorted by temporarily high demand for a particular stock rather than by economically justified pricing. Answer: (difficult) 2. are subject to greater swings as prices fluctuate without any realistic tie to earnings potential. You calculate the intrinsic value of a stock to be $27. the future dividend growth rate. What could differ in your analysis and the market’s valuation? If you are confident about your analysis. therefore. Explain how (a) the payout rate.Answer: To use the DDM the analyst must project the growth rate at which the dividends are expected to grow ad infinitum. If you are confident about your valuation of $27. you should not buy the stock. With this growth rate the next expected dividend can be projected. (moderate) Critical Thinking/Essay Questions 1. High P/Es can also be caused by temporarily depressed earnings. Answer: Why did investors favor large cap stocks in the mid to late 1990s? They were perceived as less risky during a time when an economic slowdown was predicted and they showed strong earnings growth. You check The Wall Street Journal and find the actual price to be $30. High P/Es. should you buy or not? Factors that could differ include the discount rate required by investors. Often “high-flyer” stocks have high P/E ratios. To use the P/E model the analyst must project the next period earnings and the P/E ratio. more reliable in valuation models. and the next expected dividend. yet some analysts seek low P/E stocks. and. Answer: (difficult) 7. The investor’s required rate of return must also be estimated. which is overvalued. Answer: To answer this question. what is the required rate of return for Western Inc? Solution: In order for dividends to double in 9 years the annual compound growth rate (g) must be: (1 + g)8 = g P0 Therefore. (moderate) Problems 1.20/EPS 4.34 Solution: P0 = [D0 (1+g)]/ (k-g) = [(1. one can see that (a) a higher payout will increase D1 causing a higher P/E.25)(1. what is its price earnings ratio? Solution: Payout ratio .325/. will cause a higher P/E. Edwards paid an annual dividend of $1.'s common stock is currently selling for $42 and paying a dividend of $3. what is its intrinsic value today? = $22. will cause a lower P/E.0905 or 9.1 = = 0. substitute the DDM into the P/E formula.89 75/4. If the payout ratio of the firm is 45 percent. If the required rate of return for this stock is 12 percent.06 (moderate) 3.06)]/(. k.06) = 1.12-. g.89 = 15. Bronco Inc. and (c) the higher required rate of return. Investors expect the dividends to grow at a rate of 6 percent per year over the foreseeable future.08 = = = = DPS/EPS 2.20 in dividends during the last year. P/E = P0 = D1/(k – g) = D1/E1 E1 E1 k–g From the above formulation. The Crazy Horse Corporation's stock is trading at $75. (b) a higher growth rate.05 percent [D0 (1+g)]/ (k-g) Chapter Ten Common Stock Valuation 132 . 2 = 21/8 . T. The firm paid out $2.25 last year. If the investors expect dividends to double in 8 years. A.45 EPS P/E (moderate) 2. 6912 3.1333 + 0.497177 1. P1 = 35 = (1 + g) = g = g = D1(1 + g)/(k – g) 4(1 + g)/(0.78484 .32 2.869565 1. = D1/P0 + g = 0.0905 The current market price of the stock of a company.1333 0.e.00 2.80038 Sum = 8.75425 . Calculate the present value of the MJ's stock if the required rate of return is 15 percent.1667 = 0.16 Expected dividend 2.15%. the dividend will grow at an annual rate of 16 percent (i.1684 or 16.16 .16 .1667 – 1 0.0905)/42 + . The dividends for the next year are expected to be $4.16 . It is estimated that during the next four years (i. the growth rate (g2) will be equal to 12 percent per year and continue at that rate indefinitely.6212 PVIF.1217 3. expect to pay a dividend of $2. Solution: Price of stock = (Sum of the Present value of dividends received in years 1-5) + (Present value of the price at the end of year 5) Year 1 2 3 4 5 Growth rate . Stryker Ltd. years 2 through 5). g1 = 16 percent). (k – g) = Now.1667 1.n Present value .756144 1. After that. (k – g) = 0. D1 = $4.1333 + g 0.00 (annual) a year from today.99 percent (difficult) 5.1333) 1.73913 .571753 1. What is the implied rate of return assuming dividends are growing at a constant rate? P0 = $30.1667 k k = = As determined previously.16 .e. P1 = $35 P0 = D1 / (k-g) D1/ P0 = 4/30 = 0.76951 . is $30 per share.84 percent 3(1.k = (moderate) 4.1333 Solution: Therefore.657516 1.2999 or 29.84611 Chapter Ten Common Stock Valuation 133 .00 per share and the investor is confident that the selling price of the stock will be $35 at the end of one year. The directors of MJ Inc. 6212(1 + . what is the projected price for next year assuming that the P/E ratio remains constant? If you had a required rate of return of 15 percent.P5 = = D5(1 + g2)/( k – g2) 3. Calculate the price of Contemporary stock. The S&P500 expected return is 18 percent. (CCI) has a beta of 1.85 + 67. and dividends to grow at a rate of 9 percent.15[. an expected dividend of $2. I would buy this stock since its intrinsic value of $58.21 Brotech Unlimited sells at $40 per share. (a) kCCI = = RF + β CCI[E(RM) .67 Chapter Ten Common Stock Valuation 134 .198 or 19. and an expected dividend growth rate of 5 percent for the foreseeable future.20 per share were paid as dividends.19 $67.06) = $16.60 Solution: (b) P1 D1/(k .g) = 2.30. What is Brotech's current P/E ratio? If Brotech's earnings are expected to grow by 9 percent per year.497177) = $76..20(1. and the Treasury bill rate is 6 percent.15 .30/(0.12)/(.21 Present value of P5 P0 (difficult) 6. Contemporary Casuals. (a) (b) Solution: Calculate the required return on Contemporary stock.15.19(0..15 .12) = $135.g) 3. (a) 40/8 = (c) = Current P/E = Current Price/Current earnings = 5 E1 x P/E P0 = $58. (a) (b) (c) = $8.09)/(.06 = = $135.8 percent (b) P0 = D1/(k . Inc. (moderate) 7... of which $3.06 + 1.13 is greater than its current price of $40..198 .06] = 0.09) x 5 = = = $43. and its latest 12 month earnings were $8 per share.RF] . would you buy this stock? Explain your answer.09) Yes.18 .13 = 8(1. expected the dividend payout ratio to remain constant. (moderate) Chapter Ten Common Stock Valuation 135 .