Valuation of Bonds and Stocks

Question 1

Efficient Market Hypothesis (EMH)

Answer 1

all information about an investment is known to the market

Question 2

Capitalization of income method of valuation

Answer 2

security’s value is equal to the value of its future payments and its principal discounted for present value.

Question 3

Net Present Value (NPV)

Answer 3

Difference between intrinsic and market value/purchase price

Question 4

Intrinsic value of bond

Answer 4

Present value of the bond discounted by the appropriate yield to maturity or required rate of return.

Question 5

Intrinsic value of stock

Answer 5

Sum of present values of expected cash flows

Question 6

IRR

Answer 6

Implied return, if greater than required return or market capitalization rate, then favorable.

Question 7

Zero-growth model

Answer 7

future dividend remain at fixed amount, eg high grade preferred stock

Question 8

Constant-growth model

Answer 8

dividends will grow at the same rate: D1=Dividend (D0 x (1+g))

Question 9

How do analysts determine whether stock is under/overvalued?

Answer 9

-Underpriced if P/E <normal V/E
-Overpriced if P/E >normal V/E

Question 10

How are Earnings per share (Et) related to dividends per share (Dt)?

Answer 10

Payout Ratio: Pt
Dt=(Pt)(Et)

Question 11

Sustainable Growth Rate

Answer 11

ROE x Retention rate
g (sustainable growth rate) = Roe x b(retention ratio: 1-payout ratio)
Highest ROE and retention rate = greatest sustainable growth

Question 12

What are the common developmental stages of a company with relation to earnings?

Answer 12

• Growth: rapidly expanding sales, high profit margins, high earnings per share
• Transitional: increased competition, reduced profit margins, slower earnings growth
• Maturity: new investment offers slightly attractive returns as earnings growth rate, payout ratio and return on equity stabilize

Question 13

Estimate Intrinsic Value

Answer 13

PV of cash flows from growth stage + PV of cash flows of transition stage + PV of cash flows of maturity stage, where maturity stage would be constant growth model

Question 14

When calculating the intrinsic value of a stock using expected earnings, which variables are used to replace dividends?

Answer 14

Payout ratio and expected earnings

Question 15

What factor would be most consistent with a relatively high growth rate of firm earnings and dividends, with all other things being equal?

Answer 15

Low dividend payout ratio: Assuming that no new capital is obtained externally and no shares are repurchased, the portion of earnings not paid to stockholders as dividend will be used to pay for the firm’s new investments. The portion not paid out is the retention ratio. Growth rate depends on the proportion of earnings that are retained and the average return on equity for the earnings that are retained.

Question 16

a stock’s “normal” price/earnings ratio will be higher if the following conditions are satisfied

Answer 16

The greater the expected payout ratios,
The greater the expected growth rates in earnings per share, and
The smaller the required rate of return.

Question 17

Liquidity ratios

Answer 17

• Working Capital: current assets- current liabilities
• Current Ratio: current assets/current liabilities
• Quick Ratio (acid test): (current assets-inventory)/current liabilities
• Cash Ratio: (cash+marketable securities)/current liabilities

Question 18

Activity ratios

Answer 18

• Inventory Turnover: COGS/Ave Inventory
• Days to Sell Inventory: 365/ Inventory Turnover
• A/R Turnover: Sales/Ave A/R
• Receivable Collection Period: 365/A/R Turnover
• Working Capital Turnover: Sales/Ave Working Capital
• Total Asset Turnover: Sales/Ave Total Assets
• Fixed (Net) Asset Turnover: Sales/Ave Fixed Assets
• Equity Turnover: Sales/Ave Equity

Question 19

Profitability Ratios

Answer 19

• Gross Profit Margin: Gross Profit/Sales
• Operating Profit Margin: EBIT/Sales
• Net After Tax Profit Margin: EAT/Sales
• Net Before Tax Profit Margin: EBT/Sales
• Return on Assets (ROA)= EAT/Total Assets
• Return on Total Capital (ROTC)= (EAT + I)/Total Capital I=Interest expense and Total Capital=Total Assets?
• Return on Equity (ROE) = EAT/Equity

Question 20

Debt/Solvency Ratios

Answer 20

• Total Debt to Equity: Total Liabilities/Equity
• Debt to Equity: Total LT Debt/ Equity
• Assets to Equity (leverage multiplier)= Total Assets/Equity
• Times Interest Earned - EBIT/I (I=Int Exp)

Question 21

Decomposition of ROE (DuPont Method)

Answer 21

• Assets to Equity: Total Assets/Equity
• Asset Turnover: Sales/Total Assets
• Net After Tax Profit Margin: EAT/Sales

Question 22

Three determinants of P/E ratio

Answer 22

A risk-adjusted discount rate that exceeds the stock’s average growth rate, k
A growth rate, g
A cash dividend payout ratio, D1/E1

Question 23

Free cash flow

Answer 23

Company’s cash earnings from operations (net income + depreciation + amortization, adjusted for working capital changes) - plant, property and equipment purchases and dividend payouts: Gives clear idea of how much cash is available after capital spending

Question 24

Price/Sales Ratio

Answer 24

Company’s price/sales or revenue
Good for analyzing large cap companies, less appropriate for service companies that don’t have sales

Question 25

Price/Earnings Growth (PEG)

Answer 25

P/E / Projected expected earnings growth rate as a percent- works better for smaller/growth companies; however it is dependent on earnings estimates which are less reliable than free cash and revenue

Question 26

Book value of company stock

Answer 26

(assets - liabilities)/common stock shares

Question 27

Price to Book Value Ratio

Answer 27

Price/Book value ratio=Market price per share for stock i at time t/book value per share for stock i at time t (higher ROE increases stock’s PBV ratio) good for new company that is not publicly traded

Question 28

Under the _____________________, the focus is on a time in the future (denoted by T), after which dividends are expected to grow at a constant rate (g)

Answer 28

Under the Multiple-Growth Model, the focus is on a time in the future (denoted by T), after which dividends are expected to grow at a constant rate (g).

Question 29

The ______ of a company is forecasted based on the results of the Multiple Growth Model calculation.

Answer 29

Once investment analysts calculate a required rate of return, it is easy to compute various values required for determining the Multiple Growth Model. The intrinsic value of a company is forecasted based on these figures.