6.1 Stock Valuation Methods Flashcards
The corporation just paid a dividend of $2.00 per common share. Historical data indicate dividends grow at a steady rate of 5% per year. The required rate of return for investing in such stock is 18%. The current value of one share of the corporation’s common stock is
A. $16.15
B. $15.38
C. $11.67
D. $11.11
A. $16.15
Next Dividend = $2.00 x 1.05 = $2.10
Using the constant growth dividend discount model
Dividend per share / (Discount rate - Dividend growth rate)
$2.10 / (18% cost of capital - 5% dividend growth rate) = $16.15
A financial analyst is using the two-stage model of dividend growth to value a corporation that paid an annual dividend last year of $4 per share. The annual dividend is assumed to grow at 10% per year for the next 3 years and then grow at 5% per year thereafter. A 12% required return is assumed. Which change in one of the assumptions would cause the analyst to find a higher value for the stock?
A. The required return is changed from 12% to 14%.
B. The growth rate is changed from 5% to 4%.
C. The 3-year assumption is changed to 5 years.
D. The 10% growth rate is changed to 8%.
C. The 3-year assumption is changed to 5 years.
A company is projecting an annual growth rate for the foreseeable future of 9%. The most recent dividend paid was $3.00 per share. New common stock can be issued at $36 per share. Using the constant growth model, what is the approximate cost of capital for retained earnings?
A. 9.08%
B. 17.33%
C. 18.08%
D. 19.88%
C. 18.08%
The cost of capital can be found using the dividend discount model. In the calculation below, x is the cost of capital.
Price = Next period dividend ÷ (Cost of capital – Dividend growth rate)
Price = [Current period dividend × (1 + Growth rate)] ÷ (Cost of capital – Dividend growth rate)
$36 = ($3.00 × 1.09) ÷ (x – 9%)
$36x – $3.24 = $3 × 1.09
$36x – $3.24 = $3.27
$36x = $6.51
x = 18.08333 or 18.08%
Price = Next period dividend ÷ (Cost of capital – Dividend growth rate)
Price = [Current period dividend × (1 + Growth rate)] ÷ (Cost of capital – Dividend growth rate)
$36 = ($3.00 × 1.09) ÷ (x – 9%)
$36x – $3.24 = $3 × 1.09
$36x – $3.24 = $3.27
$36x = $6.51
x = 18.08333 or 18.08%
A public company’s shareholders expect to receive a dividend 1 year from now of $20 per share. Immediately after the dividend payout, analysts are expecting that the stock will trade at $244 per share. If the investors have a required rate of return of 20%, what is the current value of the stock?
A. $220
B. $224
C. $244
D. $264
A. $220
One method of valuing stock is shareholder return, which measures the return on a purchase of stock. Shareholder return is equal to the required rate of return. In this case, the current value of the stock is equal to the beginning stock price. In the calculation below, x is the beginning stock price.
Shareholder return = (Ending stock price – Beg. stock price + Annual dividends per share) ÷ Beg. stock price
20% = ($244 – x + $20) ÷ x
0.2x = $264 – x
1.2x = $264
x = $220
The common stock of a company is currently selling at $80 per share. The leadership of the company intends to pay a $4 per share dividend next year. With the expectation that the dividend will grow at 5% perpetually, what will the market’s required return on investment be for the common stock?
A. 5%
B. 5.25%
C. 7.5%
D. 10%
D. 10%
The dividend growth model estimates the cost of retained earnings using the dividends per share, the market price, and the expected growth rate. The current dividend yield is 5% ($4 ÷ $80). Adding the growth rate of 5% to the yield of 5% results in a required return of 10%.
A firm has been growing at a rate of 10% per year and expects this growth to continue and produce earnings per share of $4.00 next year. The firm has a dividend payout ratio of 35% and a beta value of 1.25. If the risk-free rate is 7% and the return on the market is 15%, what is the expected current market value of the firm’s common stock?
A. $28.00
B. $14.00
C. $16.00
D. $20.00
D. $20.00
The first step is to determine the required rate of return on the firm’s stock. The capital asset pricing model can be used:
Required rate of return = risk-free rate + beta(market rate - risk free rate)
= 0.07 + 1.25(0.15 - 0.07)
= 0.07 + 0.10
= 0.17
The second step is to calculate the next dividend.
Next dividend = projected EPS x Dividend payout ratio
= $4 x .35
= $1.40
Now the dividend growth model can be used to calculate the expected current market value of the firm’s common stock:
Current market value = next dividend / (required rate of return - dividend growth rate)
= $1.40 / (.17-.10)
= $1.40 / 0.07
= $20
What return on equity do investors seem to expect for a firm with a $50 share price, an expected dividend of $5.50, a β of .9, and a constant growth rate of 4.5%?
A. 16.72%
B. 15.50%
C. 15.05%
D. 15.95%
B. 15.50%
Dividing the $5.50 dividend by the $50 share price produces an 11% dividend yield. Adding the 11% yield to the 4.5% growth rate produces a total return of 15.5%. The beta coefficient is irrelevant.
Current-year earnings are $2.00 per share. Using a discounted cash flow model, the controller determines that the common stock is worth $14 per share. Assuming 5% long-term growth rate, the required rate of return is which one of the following?
A. 7%
B. 10%
C. 15%
D. 20%
D. 20%
The current-year earnings per share are $2.00. In order to calculate the correct dividend per share amount when given only the amount of last annual dividend paid, it is necessary to adjust to the expected dividend using the growth rate of the company. Thus, the dividend per share equal = $2.10 [$2 x (1+0.5)].
The dividend discount model (also known as the dividend growth model) is a method of arriving at the value of a stock by using expected dividends per share and discounting them back to present value. The formula is as follows:
Dividend per share / (cost of capital - dividend growth rate)
The rate of return can now be solved for as follows:
$2.10 ÷ (x - 0.05) = $14
$2.10 = $14x - 0.7
2.80 = 14x
x = 20%
A manufacturer of printers is attempting to determine its cost of common equity for cost of capital purposes. The manufacturer’s long-term debt is rated AA by Standard & Poor’s. The manufacturer’s common shares trade on the NASDAQ and the current market price is $26.87. The most recent yearly common share dividend paid common shareholders was $1.04. The consensus forecast of security analysts who follow the manufacturer’s common shares is that earnings growth will average 12.5% over the long term. The manufacturer’s marginal income tax rate is 40%. Using the dividend discount model, what is the manufacturer’s cost of equity for cost of capital purposes?
A. 9.82%
B. 16.85%
C. 10.11%
D. 16.37%
B. 16.85%
Under the dividend growth model, the cost of equity equals the expected growth rate plus the quotient of the next dividend and the current market price. The next dividend is calculated as $1.17 [$1.04 dividend x (1 + .125 growth)]. Thus, the cost of equity capital is 16.85% [12.5% + ($1.17 / $26.87)]. This model assumes that the payout ratio, retention rate, and the earnings per share growth rate are all constant.
The common stock of a beverage company has a current market price of $34. The beverage company is estimated to earn $2 per share in the next year. The average price/earnings ratio of companies in the beverage industry is 15. Using the price/earnings ratio as the comparable valuation method, the beverage company’s stock is
A. $2 undervalued.
B. $3 undervalued.
C. $2 overvalued.
D. $4 overvalued.
D. $4 overvalued.
The starting point is to determine what the beverage company’s stock price should be using the average price/earnings (PE) ratio of the beverage industry (15). Next, this amount is compared to the beverage company’s current stock price ($34). The beverage company’s stock price is overvalued by the excess of its current stock price over the industry adjusted stock price and vice-versa.
Industry P/E ratio = market price ÷ Earning per share
15 = market price ÷ $2
market price = 15 x $2
market price $30
Thus, the beverage company’s stock is $4 overvalued ($34 current market price - $30 industry adjusted market price).
Stock A is currently trading at $50 per share. A financial analyst has collected the following historical and current data for the stock.
Year, Dividend paid during the year
20X1, $2.00
20X2, 2.20
20X3, 2.42
The stock has a cost of equity capital of 15% and plans to maintain a 100% dividend payout while maintaining the dividend trend in the future as well. Using the constant growth dividend discount valuation model, the analyst concludes that the value of Stock A in 20X3 would be
A. $48.40
B. $53.24
C. $44.00
D. $40.00
B. $53.24
The constant growth dividend discount model is a method that arrives at the value of a stock by using expected dividends per share and discounting them back to present value. The formula involves dividing the expected dividends per share by the discount rate minus the dividend growth rate. The dividends are expected to increase by 10% each year ($2.20 / 2.00 = 110%; $2.42 / 2.20 = 110%). Accordingly, the calculation would be to divide the expected dividend of $2.662 [$2.42 x (1+.10)] by a rate of 5% (15% - 10%). Thus the value of Stock A in 20X3 is $53.24 ($2.662 / 0.05).
By using the dividend growth model, estimate the cost of capital for a firm with a stock price of $30.00, an estimated dividend at the end of the first year of $3.00 per share, and an expected growth rate of 10%.
A. 20.0%
B. 12.2%
C. 21.1%
D. 11.0%
A. 20.0%
Under the dividend growth model, the cost of equity equals the expected growth rate plus the quotient of the next dividend and the current market price. Thus, the cost of equity capital is 20% [10% + ($3 / $30)]. This model assumes that the payout ratio, retention rate, and the earnings per share growth rate are all constant.
