Topic Quiz 9 Flashcards
The upper bound on the value of shares in a company will be based on the comparny’s:
a. Replacement Value
b. Market Value
c. Liquidation Value
a. Replacement Value
The CAPM can be used in a dividend discount model to estimate the:
a. Growth Rate
b. Dividend Size
c. Discount Rate
a. Growth Rate
Which of the following statements is TRUE?
a. A value of a company’s shares will increase when its plowback rate increases.
b. The value of a company’s shares will only be positive when it has a negative present value of growth opportunity.
c. The discount rate can be less than the growth rate in a multi-stage DDM.
a. A value of a company’s shares will increase when its plowback rate increases. (FALSE - b increase, then dividend output decreases and value of share decreases)
b. The value of a company’s shares will only be positive when it has a negative present value of growth opportunity. (FALSE)
c. The discount rate can be less than the growth rate in a multi-stage DDM.
What are some weaknesses of using a price to earnings ratio to value a company?
The denominator is earnings and subject to several issues. It is an accounting measure and accounting rules can be used to distort the earnings reported by the company. Earnings might also not be a good indicator of future performance when they are very volatile and move with the business cycle.
Also, firms can improve their earnings (short-term) by making value-destroying decisions such as firing high salaried and high performing members of the sales team.
What is the biggest limitation of dividend discount models and the multi-stage dividend discount model?
Share prices estimated by dividend discount models are very sensitive when the discount rate is very close to the growth rate. An additional limitation of the multi-stage dividend discount model is having to define the exact length of the different growth stages, which is difficult to forecast. DMM works better for firms with a stable dividend policy.
Dividends are paid from the earnings of a company. Why might a company not pay all of its earnings to shareholders as dividends?
When the company wants to invest the earnings in new or existing projects that will generate high growth in the future.
The board of directors could also be conservative and want to pay a stable dividend rather than one that changes every year.
Identify two items that could decrease the growth rate of a company?
The growth rate will decrease when the percentage of earnings paid out as dividends increases. This means the company will reinvest less of its earnings back into the company. So it will have a lower plowback rate. The growth rate will also decrease when the reinvestment earns a lower return on equity.
According to the constant dividend discount model, when will shares in a company have a lower value?
When the latest dividend is smaller, the market capitalisation rate is higher and the expected dividend growth rate is lower.
What are two sources of error that could arise when estimating share prices using the constant growth dividend discount model?
The CAPM estimate of the equity discount rate might not be correct due to the beta, expected market return and/or risk free rate not being appropriate.
Another potential error is that the growth rate might not correctly reflect the dividend growth rate of the company.
How do you calculate the intrinsic value of shares in a company?
The present value of the future cash flows of a company are used to calculate the company’s intrinsic value.
The cash flows being future dividends and capital gains/losses (when closing the equity position) and the equity discount rate being estimated using the CAPM.
How can you calculate the present value of a companies growth opportunities?
It would be the difference between the value of the company when it does not reinvest earnings back into the company and the current share price of the company.
Provide one reason why it might be better to use a multi-stage dividend discount model instead of a constant dividend discount model to value a company’s shares.
The multi-stage dividend discount model could be more suitable if the company has several growth phases over its lifecycle.
During its earlier years, the growth rate might be higher and then stabilise once it matures. This allows k>g during the years of high growth.
It is difficult to estimate the exact intrinsic value of the shares in a company. What would be the lowest and highest possible intrinsic value of the shares?
The share price reflecting the liquidation value of the company would be the lowest possible price (lower bound).
The share price reflecting the replacement value of the company would be the highest possible price (higher bound).
