Business 6: Financial Valuation

Question 1

What is an annuity?

Answer 1

Series of equal CFs to be received over a # of periods

Question 2

How do you calculate the PV of an annuity?

Answer 2

= PMT

* ( 1 - [ 1 / (1+r)^t ] / r)

Question 3

Does does an annuity due occur?

Answer 3

Beginning of period

Question 4

When does an ordinary annuity occur?

Answer 4

End of period

Question 5

A perpetuity is also known as what?

Answer 5

Zero growth stock

Question 6

What is a perpetuity?

Answer 6

Period CFs paid by an annuity that lasts forever

Question 7

How do you calculate a perpetuity?

Answer 7

= stock value per share
= price
= dividend / required return

Question 8

What is another name for the Gordon model?

Answer 8

• Dividend Discount Model (DDM)

- Constant Growth DDM

Question 9

What model assumes that the dividend payments are the CFs of an equity security and that the intrinsic value of the company’s stock is the PV of the expected future dividends?

Answer 9

Gordon model

Question 10

How do you calculate the price of the stock using the Gordon model?

Answer 10

= D1

/ (R-G)

Question 11

How do you determine the required rate of return?

Answer 11

CAPM

= Rf + B (Rm - Rf)

Question 12

What do price multiples represent?

Answer 12

Ratios of a stock’s market price to another measure of fundamental value per share

Question 13

What do investors use price multiples to evaluate?

Answer 13

• Price of stock AND

- Determine if it undervalued, fairly valued, or overvalued

Question 14

Why is the P/E ratio the most widely used multiple when valuing equity securities?

Answer 14

• Earnings is key driver of investment value

- Changes in company’s P/E tied to long run stock performance of that company

Question 15

How do you calculate the P/E ratio?

Answer 15

= P0 / E1

= Price today / EPS expected in one year

Question 16

How do you value the stock with the P/E ratio?

Answer 16

= [P0/E1] * E1

Question 17

When past earnings are used in the P/E ratio, what is the name of the ratio calculated?

Answer 17

Trailing P/E

Question 18

When expected earnings are used in the P/E ratio, what is the name of the ratio calculated?

Answer 18

Forward P/E

Question 19

When is the trailing P/E the preferred calculation method?

Answer 19

When co. forecasted earnings unavailable

Question 20

When is the forward P/E the preferred calculation method?

Answer 20

When co. historical earnings not representative of its future earnings

Question 21

How do you calculate the trailing P/E ratio?

Answer 21

= P0 / E0

= Price today / EPS for the past year

Question 22

What does the PEG ratio show?

Answer 22

Price-earnings growth

• effect of earnings growth on a co. P/E
• assuming a linear relationship b/w P/E and growth

Question 23

True or false.

Generally stocks with higher PEG ratios are more attractive to investors than stocks with lower PEG ratios.

Answer 23

FALSE (lower PEG = more attractive)

Question 24

How do you calculate the PEG ratio?

Answer 24

= (P0 / E1) / G
= (Price today / Expected earnings in a year)
/ (100 * expected growth rate)

Question 25

How would you value stock with the PEG ratio?

Answer 25

= PEG * E1 * G
= PEG
* Expected earnings in one year
* (100 * Expected growth rate)

Question 26

Which ratio is more volatile: price to sales ratio OR P/E ratio?

Answer 26

P/E ratio

Question 27

Which is more subject to manipulation: earnings OR sales?

Answer 27

Earnings

Question 28

How do you calculate the price-to-sales ratio?

Answer 28

= P0 / S1

= Price today / Expected sales in a year

Question 29

How do you value equity with the price-to-sales ratio?

Answer 29

= (P0 / S1) * S1

Question 30

What does empirical research show about changes in a company’s P/CF ratios over time?

Answer 30

Positively related to changes in a co. LT stock returns

Question 31

How do you calculate the P/CF ratio?

Answer 31

= P0 / CF1

= Price today / Expected CF in a year

Question 32

How do you value equity with the P/CF ratio?

Answer 32

= (P0 / CF1 ) * CF1

Question 33

Which price multiple is used by analysts that focus on the B/S versus the I/S or statement of CF?

Answer 33

Price-to-book ratio

Question 34

What is the rationale for using the P/B ratio?

Answer 34

• firm’s BV of common equity is more stable that EPS

- esp. when firm’s EPS is extremely high or low for a given period

Question 35

How do you calculate the P/B ratio?

Answer 35

= P0 / B01

= Price today / BV of common equity today

Question 36

How do you value equity with the P/B ratio?

Answer 36

= (P0 / B01) * B0
= (Price today / BV of common equity today)
* Book value of common equity today

Question 37

What type of finance examines investor behavior and how this behavior affects financial markets?

Answer 37

Behavioral finance

Question 38

Behavioral biases often distort what?

Answer 38

Judgement

Question 39

What is the name of this behavioral bias:

“erroneous belief that the financial manager has control over valuation outcomes that are ultimately the result of market forces”

Answer 39

Illusion of contrl

Question 40

What is the most common model used for valuing options?

Answer 40

Black-Scholes Model

Question 41

David wants to buy shares of Epoch Corporation. If he uses a zero growth model, a desired rate of return of 20% and a dividend of $10, what was Epoch’s price?

Answer 41

$50
= Dividend / Required return
= $10 / 0.20

Question 42

A company’s PEG ratio is 4x and its current EPS is $10. Growth is expected to be 2.5%. What’s the projected stock price?

Answer 42

$102.50
( = PEG * E1 * G)
( = 4 * 10.25 * 2.5)

Question 43

Which valuation technique can be adapted to start up companies and other situations where earnings are very low?

Answer 43

Price-Sales ratio

Question 44

What formula should be used to calculate the economic rate of return on CS?

Answer 44

(Dividends + change in price)

Divided by beginning price