Chapter 7: Valuing Stocks

Question 1

What is the definition of common stock?

Answer 1

Ownership shares in a publicly held corporation.

Question 2

What is the definition of an IPO?

Answer 2

First offering of stock to the general public.

Question 3

What is the definition of a primary offering?

Answer 3

The corporation sells shares in the firm on the primary market (post-IPO).

Question 4

What is the primary market?

Answer 4

A market for the sale of new securities by corporations.

Question 5

What is the secondary market?

Answer 5

A market in which previously issued securities are traded among investors.

Question 6

What is the P/E ratio

Answer 6

Ratio of stock price to earnings per share, also known as the price-earnings multiple. It is a key tool of stock market analysts.

Question 7

What is book value?

Answer 7

The value shown in the firm’s balance sheet.

Question 8

What is liquidation value?

Answer 8

The net proceeds that could be realised by selling the firm’s assets and paying off its creditors.

Question 9

What is going-concern value?

Answer 9

Market value treats the firm as a going concern. Includes 3 factors: (1) the extra earning power of a company; (2) the company’s intangible assets that are not on the balance sheet; (3) the value of future investments.

Question 10

What is the definition of intrinsic value?

Answer 10

The PV of future cash payoffs from a stock or other security (V_0).

Question 11

What is the formula for intrinsic value (aka PV of cash payoffs expected)?

Answer 11

V_0 = (DIV_1 + P_1) / (1 + r)

Question 12

What is the formula for expected rate of return on stocks?

Answer 12

Expected rate of return = expected dividend yield + expected capital gain
OR
Expected rate of return = DIV_1/P_0 + (P_1 -P_0)/P_0

Question 13

In a well-functioning market, how are equally risky securities priced?

Answer 13

Priced to offer the same expected rate of return; this is a fundamental characteristic of prices in competitive markets.

Question 14

What is the definition of the dividend discount model (DDM)?

Answer 14

Discounted C.F. model that states that today’s stock price equals the PV of all expected future dividends.

Question 15

What is the formula for DDM?

Answer 15

P = [DIV_1 / (1+r)] + [DIV_2 / (1+r)^2] + … [DIV_H / (1+r)^H

Question 16

What happens to the DDM formula if the horizon is infinitely far away?

Answer 16

Forget about the final horizon price, and simply say:

Stock price = PV (of all future dividends per share)

Question 17

What does the DDM formula look like with No Growth?

Answer 17

Value of a no-growth stock = P = DIV_1/r

Question 18

What does the DDM formula look like with Constant Growth (aka the Gordon Growth model)?

Answer 18

P=DIV_1/(r-g)
OR rearrange as:
r=DIV_1/P_0 + g, which is the dividend yield + growth rate

Question 19

What is the sustainable growth rate?

Answer 19

The firm’s growth rate if it plows back a constant fraction of earnings, maintains a constant return on equity, and keeps its debt ratio constant.

Question 20

What is the payout rate?

Answer 20

Fraction of earnings paid out as dividends.

Question 21

What is the plowback ratio?

Answer 21

Fraction of earning retained by the firm.

Question 22

What is the formula for the plowback ratio?

Answer 22

plowed-back earnings / total earnings

Question 23

What is the formula for growth rate?

Answer 23

plowed-back earnings / total earnings x total earnings / initial equity

Question 24

Does plowing back earnings into new investments result in (a) growth in earnings, (b) growth in dividends, or (c) growth in current stock price.

Answer 24

It results in (a) and (b). It may result in a growth in (c) if investors are convinced that the reinvested earnings will earn a higher rate of return.

Question 25

What is the Present Value of Growth Opportunities (PVGO)?

Answer 25

The net present value of a firm’s future investments. The value of assets in place + the present value of growth opportunities (PVGO) = Total Value of Stock

Question 26

What is free cash flow (FCF)?

Answer 26

Cash flow available for distribution to investors after firm pays for new investments or additions to working capital

Question 27

What information is included in stock trading reports?

Answer 27

Large companies usually arrange for their stocks to be traded on a stock exchange. The stock listings report the stock’s price, price change, volume, dividend yield, and price earnings ratio.

Question 28

How can stock-price information about other firms be used to help you value a particular firm?

Answer 28

To value a stock, financial analysts often start by identifying similar firms and looking at how much investors in these companies are prepared to pay for each dollar of earnings or book assets.

Question 29

How can one calculate the PV of a stock given forecasts of future dividends and future stock price?

Answer 29

Stockholders generally expect to receive (1) cash dividends and (2) capital gains or losses. The rate of return that they expect over the next year is defined as the expected dividend per share (DIV) plus the expected increase in price P(1) - P(0), all divided by the price at the beginning of the year P(0). The PV of a share is equal to the stream of expected dividends per share up to some horizon date plus the expected price at this date, all discounted at the return that investors require. This is the DDM.

Question 30

How can stock valuation formulas be used to infer the value of an entire business?

Answer 30

Similar valuation methods can be used to est the value of an entire business. You need to forecast and discount the free C.F.s provided by the business. These are the C.F.s not plowed back into the business but can be used to pay dividends or repurchase stock.

Question 31

How do a company’s growth opportunities show up in its stock price and price-earnings ratio?

Answer 31

If forecast dividends grow at a constant rate, g, then the value of a stock is P(0) = DIV(1)/(r-g). This is the constant-growth DDM. The share’s value is the sum of two parts: value of the assets in place and present value of growth opportunities (PVGO). The P/E ratio is a reflection of the market’s assessment of a firm’s growth opportunities.

Question 32

How does competition among investors lead to efficient markets?

Answer 32

Competition between investors will tend to produce an efficient market – that is, a market in which prices rapidly reflect new information and investors have difficulty making consistently superior returns.