41 - Equity Valuation Flashcards
An advantage of the price/sales ratio is that it is meaningful even for distressed firms. Why?
The P/S ratio is meaningful even for distressed firms, since sales revenue is always positive. This is not the case for the P/E and P/BV ratios, which can be negative.
Because of dividend displacement of earnings, the net effect on firm value of increasing the dividend payout ratio is:
The net effect on firm value of increasing the dividend payout ratio is ambiguous because the positive effect of larger dividends may be offset by a negative effect on the firm’s sustainable growth rate. If increasing the payout ratio always increased firm value, all firms would have 100% payout ratios.
Dividend will affect the numerator and denominator oppositely.
General, Inc., has net income of $650,000 and one million shares outstanding. The profit margin is 6 percent and General, Inc., is selling for $30.00. The price/sales ratio is equal to:
6% profit margin = $650,000/x; x (sales) = $10,833,333.
Sales per share = $10.83 M/1,000,000 = $10.83 per share.
P/Sales = $30.00/$10.83 = 2.77.
(Module 41.3, LOS 41.k)
What value would be placed on a stock that currently pays no dividend but is expected to start paying a $1 dividend five years from now? Once the stock starts paying dividends, the dividend is expected to grow at a 5 percent annual rate. The appropriate discount rate is 12 percent.
(careful with the N)
P4 = D5/(k-g) = 1/(.12-.05) = 14.29
P0 = [FV = 14.29; n = 4; i = 12] = $9.08.
(Module 41.2, LOS 41.h)
Related Material
An analyst gathered the following data for the Parker Corp. for the year ended December 31, 2005:
EPS2005 = $1.75
Dividends2005 = $1.40
BetaParker = 1.17
Long-term bond rate = 6.75%
Rate of return S&P500 = 12.00%
The firm has changed its dividend policy and now plans to pay out 60% of its earnings as dividends in the future. If the long-term growth rate in earnings and dividends is expected to be 5%, the appropriate price to earnings (P/E) ratio for Parker will be:
Required rate of return on equity will be 12.89% = 6.75% + 1.17(12.00% - 6.75).
P/E Ratio = 0.60 / (0.1289 - 0.0500) = 7.60.
(Module 41.3, LOS 41.k)
Which of the following is least likely an advantage of using price-to-book value (PBV) multiples in stock valuation?
A)
Book values are highly useful measures for firms in service industries.
B)
PBV ratios can be compared across similar firms if accounting standards are consistent.
C)
Book value is often positive, even when earnings are negative.
Book values tend not to be useful valuation measures for firms in service industries because they typically have fewer tangible assets on their balance sheets than firms in other industries.
Two of the advantages of using P/BV ratios for equity valuation are that P/BV ratios can be compared across similar firms if accounting standards are consistent, and that book value is typically positive even when earnings are negative and P/E ratios are not meaningful.
(Module 41.3, LOS 41.f)
A stock has a required return of 14% percent, a constant growth rate of 5% and a retention rate of 60%. The firm’s P/E ratio should be:
P/E = (1 - RR) / (k - g) = 0.4 / (0.14 - 0.05) = 4.44
A company last paid a $1.00 dividend, the current market price of the stock is $20 per share and the dividends are expected to grow at 5 percent forever. What is the required rate of return on the stock?
D0 (1 + g) / P0 + g = k
1.00 (1.05) / 20 + 0.05 = 10.25%.
Pay attention to word like “last paid”
The required rate of return on equity used as an input to the dividend discount model is influenced by each of the following factors EXCEPT:
A stock’s required rate of return is equal to the nominal risk-free rate plus a risk premium. The nominal risk-free rate is approximately equal the real risk-free rate plus expected inflation.
(Module 41.2, LOS 41.h)
