Equity Valuation

Question 1

What is intrinsic value or fundamental value?

Answer 1

The rational value investors would place on an asset if they had full knowledge of the asset’s characteristics.

Question 2

What do analysts use valuation models for?

Answer 2

To estimate the intrinsic values of stocks and compare them to market prices.

Question 3

What does it indicate if the market price deviates significantly from intrinsic value?

Answer 3

Analysts who estimate intrinsic value better than the market can earn abnormal profits.

Question 4

What increases the likelihood of an investor taking a position based on intrinsic value?

Answer 4

A larger percentage difference between market prices and estimated values.

Question 5

What is the impact of investor confidence in the valuation model?

Answer 5

The more confident the investor is, the more likely they are to invest in overvalued or undervalued stocks.

Question 6

What must an analyst consider when deciding to act on differences between model values and market prices?

Answer 6

The sensitivity of a model value to each of its inputs.

Question 7

What are the two basic types of multiplier models?

Answer 7

• Price to fundamentals (e.g., P/E ratio) * Enterprise value to EBITDA or revenue

Question 8

How is intrinsic value estimated in asset-based models?

Answer 8

As total asset value minus liabilities and preferred stock.

Question 9

What are cash dividends?

Answer 9

Payments made to shareholders in cash, either regularly scheduled or special dividends.

Question 10

What are stock dividends?

Answer 10

Dividends paid out in new shares of stock rather than cash.

Question 11

What is a stock split?

Answer 11

A division of existing shares into multiple shares, resulting in more shares but a lower price per share.

Question 12

What is a reverse stock split?

Answer 12

A reduction in the number of shares outstanding, resulting in a higher stock price.

Question 13

What is a share repurchase?

Answer 13

A transaction where a company buys outstanding shares of its own stock.

Question 14

What is the declaration date in dividend payment chronology?

Answer 14

The date the board of directors approves payment of a dividend.

Question 15

What is the ex-dividend date?

Answer 15

The first day on which a share purchaser will not receive the next dividend.

Question 16

What is the holder-of-record date?

Answer 16

The date on which all owners of shares become entitled to receive the dividend payment.

Question 17

What is the payment date?

Answer 17

The date dividend checks are mailed to holders of record.

Question 18

What is the rationale for using present value models to value equity?

Answer 18

The intrinsic value of stock is the present value of its future dividends.

Question 19

What is the formula for the dividend discount model (DDM)?

Answer 19

V0 = ∑(Dt / (1 + ke)^t)

Question 20

What does FCFE stand for?

Answer 20

Free cash flow to equity.

Question 21

What is the formula for calculating FCFE?

Answer 21

FCFE = net income + depreciation − increase in working capital − fixed capital investment − debt principal repayments + new debt issues.

Question 22

What is the capital asset pricing model (CAPM)?

Answer 22

A model that estimates the required rate of return for a security based on its systematic risk.

Question 23

What is the value of preferred stock with a fixed dividend?

Answer 23

Preferred stock value = Dp / kp

Question 24

What is a special dividend?

Answer 24

A one-time cash payment to shareholders in addition to regular dividends.

Question 25

True or False: Stock splits change the overall wealth of shareholders.

Answer 25

False

Question 26

Fill in the blank: The _______ date is the first day on which a share purchaser will not receive the next dividend.

Answer 26

ex-dividend

Question 27

What is the formula for the value of preferred stock?

Answer 27

Value = Dp / kP ## Footnote Dp is the annual dividend and kP is the required return on preferred stock.

Question 28

How do you calculate the value of a preferred stock that pays a $5.00 annual dividend with a required return of 8%?

Answer 28

Value = $5.00 / 0.08 = $62.50

Question 29

What is the Gordon growth model?

Answer 29

V0 = D0(1 + gc) / (ke - gc) ## Footnote gc is the constant growth rate of dividends, D0 is the dividend just paid, and ke is the required return on equity.

Question 30

What are the assumptions of the Gordon growth model?

Answer 30

* Dividends measure shareholder wealth * Constant dividend growth rate and required return * ke must be greater than gc

Question 31

If D0 is $1.50 and dividends are expected to grow at 8% indefinitely with a required return of 12%, what is the stock's value?

Answer 31

Value = $1.62 / (0.12 - 0.08) = $40.50

Question 32

True or False: The value of a stock increases as the difference between ke and gc narrows.

Answer 32

True

Question 33

What is the sustainable growth rate formula?

Answer 33

sustainable growth = (1 − dividend payout ratio) × ROE

Question 34

Calculate the sustainable growth rate for a firm with a 25% dividend payout ratio and an ROE of 21%.

Answer 34

g = (1 - 0.25) × 21% = 15.75%

Question 35

How do you estimate the current value of a stock that pays no dividends but is expected to pay a dividend in Year 4?

Answer 35

Calculate D4 from earnings, then use the Gordon growth model to find value at Year 3, and discount back to present.

Question 36

What is the multistage dividend growth model?

Answer 36

Value = D1/(1 + ke) + D2/(1 + ke)^2 + ... + Dn/(1 + ke)^n + Pn/(1 + ke)^n

Question 37

What are the steps in using the multistage model?

Answer 37

* Determine discount rate, ke * Project high initial growth, g* * Estimate dividends during high-growth * Estimate constant growth rate, gc * Calculate stock value at end of high-growth

Question 38

What characterizes companies suitable for the constant growth model?

Answer 38

Stable, mature, non-cyclical, dividend-paying firms

Question 39

What is a critique of price multiples?

Answer 39

They often reflect only past performance due to historical data usage.

Question 40

List common price multiples used for valuation.

Answer 40

* Price-to-earnings (P/E) * Price-to-sales (P/S) * Price-to-book value (P/B) * Price-to-cash flow (P/CF)

Question 41

What is the justified P/E based on the Gordon growth model?

Answer 41

P0/E1 = D1/E1 / (k - g)

Question 42

Calculate the P/E ratio if the stock price is $40 and earnings per share is $4.

Answer 42

P/E = $40 / $4 = 10

Question 43

What is the Gordon growth valuation model formula?

Answer 43

P0 = D1 / (k - g)

Question 44

What does the leading P/E ratio represent?

Answer 44

The leading P/E ratio is based on expected earnings next period.

Question 45

What is a justified P/E ratio?

Answer 45

A justified P/E ratio is based on the present value of future cash flows.

Question 46

What are the components that affect the P/E ratio?

Answer 46

* D1 / E1 = expected dividend payout ratio * k = required rate of return on the stock * g = expected constant growth rate of dividends

Question 47

How is the fundamental (justified) leading P/E ratio calculated with a 30% payout ratio, 13% required return, and 6% growth rate?

Answer 47

0.3 / (0.13 - 0.06) = 4.3

Question 48

What does a higher actual P/E ratio than justified indicate?

Answer 48

The stock would be considered overvalued.

Question 49

What are the factors that can lead to a higher P/E ratio?

Answer 49

* Higher dividend payout rate * Higher growth rate * Lower required rate of return

Question 50

What is the relationship referred to as when increasing the dividend payout ratio affects growth?

Answer 50

Dividend displacement of earnings.

Question 51

What is the law of one price in valuation?

Answer 51

Two identical assets should sell at the same price.

Question 52

What are common benchmarks used in price multiple comparables?

Answer 52

* Historical average of the stock * Similar stocks and industry averages

Question 53

What are the disadvantages of using price multiples based on comparables?

Answer 53

* A stock may appear overvalued by one method and undervalued by another * Different accounting methods can result in non-comparable multiples * Cyclical firms' multiples may be affected by economic conditions

Question 54

What are the calculated ratios for Renee's Bakery in 20X3?

Answer 54

* P/E: 15.9 * P/CF: 2.9 * P/S: 0.7 * P/B: 0.9

Question 55

What does a lower P/E ratio compared to industry averages suggest?

Answer 55

Renee's Bakery is undervalued.

Question 56

What does enterprise value (EV) measure?

Answer 56

Total company value.

Question 57

What is the formula for calculating enterprise value?

Answer 57

EV = market value of common and preferred stock + market value of debt - cash and short-term investments

Question 58

What is a common denominator used for EV multiples?

Answer 58

EBITDA (earnings before interest, taxes, depreciation, and amortization)

Question 59

What is the disadvantage of using EBITDA in valuation?

Answer 59

It often includes non-cash revenues and expenses.

Question 60

What is the formula to calculate EV/EBITDA?

Answer 60

EV/EBITDA = Total Enterprise Value / EBITDA

Question 61

What is an asset-based valuation model?

Answer 61

A model based on the market or fair value of assets minus liabilities.

Question 62

What is the challenge of valuing intangible assets in asset-based models?

Answer 62

Measuring the effect of the loss of current owners' talents and customer relationships on forward earnings.

Question 63

What is the adjusted equity value calculation based on net assets?

Answer 63

Market value of assets - Market value of liabilities.

Question 64

What are the advantages of discounted cash flow models?

Answer 64

* Based on discounted present value * Well grounded in finance theory * Widely accepted in the analyst community

Question 65

What are the disadvantages of discounted cash flow models?

Answer 65

* Inputs must be estimated * Value estimates are sensitive to input values

Question 66

What is a potential benefit of using comparable valuation with price multiples?

Answer 66

Provides evidence that some price multiples are useful for valuation.

Question 67

What is the adjusted equity value per share if $144,000 is divided by 2,000?

Answer 67

$72

Question 68

What is a fundamental concept of discounted cash flow models?

Answer 68

Discounted present value

Question 69

List two advantages of discounted cash flow models

Answer 69

* Based on discounted present value * Widely accepted in the analyst community

Question 70

What is a major disadvantage of discounted cash flow models?

Answer 70

Inputs must be estimated

Question 71

Why are price multiples considered useful in comparable valuation?

Answer 71

Evidence that some price multiples are useful for predicting stock returns

Question 72

List three advantages of using price multiples in valuation

Answer 72

* Widely used by analysts * Readily available * Can be used in time series and cross-sectional comparisons

Question 73

What is an advantage of EV/EBITDA multiples?

Answer 73

Useful when comparing firm values independent of capital structure

Question 74

What is a disadvantage of comparable valuation using price multiples?

Answer 74

Lagging price multiples reflect the past

Question 75

What can affect the comparability of price multiples across firms?

Answer 75

Different size, products, and growth

Question 76

Why might a stock appear overvalued by the comparable method?

Answer 76

It may be undervalued by a fundamental method or vice versa

Question 77

What issue arises from different accounting methods in price multiples?

Answer 77

Result in price multiples that are not comparable across firms

Question 78

What happens when there is a negative denominator in a price multiple?

Answer 78

Results in a meaningless ratio

Question 79

What is a key advantage of price multiple valuations based on fundamentals?

Answer 79

Based on theoretically sound valuation models

Question 80

What is a disadvantage of price multiple valuations based on fundamentals?

Answer 80

Very sensitive to the inputs (especially the k − g denominator)

Question 81

List two advantages of asset-based models

Answer 81

* Provide floor values * Reliable for firms with tangible short-term assets

Question 82

What is a disadvantage of asset-based models?

Answer 82

Market values are often difficult to obtain

Question 83

When are asset-based models most reliable?

Answer 83

When the firm has primarily tangible short-term assets or is being liquidated

Question 84

What can make asset values difficult to value?

Answer 84

Periods of hyperinflation

Question 85

Why might market values differ from book values in asset-based models?

Answer 85

Market values are usually different than book values

Question 86

What is one key factor that can lead to inaccuracies in asset-based models?

Answer 86

High proportion of intangible assets or future cash flows not reflected