CH 7 - Equity Valuation

Question 1

What is equity?

Answer 1

An equity investment is money invested in a company by purchasing shares of that company.

Investment is not paid back like debt, instead profit is shared with shareholders, this is called a dividend.

Question 2

What are dividends?

Answer 2

Share of profit given to the shareholders (owners) of a company.
• Not all companies pay dividends
• Dividends are paid periodically and can fluctuate in value

Question 3

What are the two types of equity investments?

Answer 3

(1) Preferred shares

(2) Common shares

Question 4

What are preferred shares?

Answer 4

Receive a constant dividend

o Do not benefit from the growth in market value of the company

o Do not have voting rights

o Have priority over common shares when dividends are paid during the liquidation
of a company.

Question 5

What are common shares?

Answer 5

Dividends can fluctuate
o Benefit from the growth in the market value of the company
o Have voting rights
o Are last in line for dividends and during liquidation of the company.

Question 6

Describe the dividend discount model

Answer 6

The price of a stock is the present value of all future dividends

• The current dividend is not included in the price of the stock.
• If a company does not pay dividends, free cash flow is used in their place.

This model is best suited for:
o Company’s that pay dividends based on a stable dividend-payout history o Growing at a steady and sustainable rate

Question 7

What is the growth rate?

Answer 7

Maximum growth rate that can be sustained indefinitely by the company.

Growing a dividend at a higher rate will cause retained earnings to deplete.

• Growth rate is also the capital gain yield on a stock

Question 8

What is the price-earnings ratio?

Answer 8

Ratio of market price per share and earnings per share

Tells us at what multiple earnings is the company valued at