Chapter 10

COMMON STOCK VALUATION

Multiple Choice Questions

Overview

1. All of the following are relative valuation techniques except:

a. P/E ratio.
b. Price/book value ratio
c. Price/sales ratio
d. Price/dividend ratio

(d, moderate)

Discounted Cash Flow Techniques

2. The estimated value of common stock is the:

a. present value of all expected cash flows.

b. present value of all capital gains.
c. future value of all dividend payments.
d. present value of all dividend payments.

(a, moderate)

3. Discounted cash flow techniques used in valuing common stock are based
on:

a. future value analysis.

b. present value analysis.
c. the CAPM.
d. the APT.

(b, easy)

The Dividend Discount Model

4. All of the following are interchangeable terms except for:

a. discount rate
b. coupon rate
c. required rate of return
d. capitalization rate

(b, moderate)

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Chapter Ten 120
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 The Dividend Discount Model

5. Which of the following is a problem using the dividend discount model to

value common stock?

a. The model does not account for the risk of the stock.
b. The model does not consider the present value of the dividends.
c. The model does not consider that dividends may not be paid
d. The model does not account for small dividends.

(c, moderate)

6. Which of the following is not one of the dividend growth rate models?

a. the infinite growth model

b. the zero growth model
c. the constant growth model
d. the multiple growth model

(a, moderate)

7. The constant growth dividend model uses the:

a. historical growth rate in dividends.

b. historical growth rate in earnings.
c. estimated growth rate in dividends.
d. estimated growth rate in earnings.

(c, moderate)

8. The zero-growth dividend model:

a. gives the highest value for a common stock.

b. is the most accurate model to use.
c. is equivalent to the valuation model for preferred stock.
d. assumes the highest required return possible.

(c, easy)

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 9. The dividend model that is most appropriate for a young company that
pays small dividends now but is expected to increase dividends in
a few years is the:

a. zero-growth model.
b. constant growth model.
c. expansion growth model.
d. multiple growth model.

(d, moderate)

10. Under the multiple growth model, at least ------ different growth rates are
used.

a. two
b. three
c. four
d. five

(a, easy)

11. The constant growth rate model of the DDM implies that:

a. earnings are not relevant to stock prices.

b. dividends remain constant from now to infinity.
c. the stock price grows at the same rate as dividends.
d. all of the above are implied by the model

(c, difficult)

12. Which of the following is not one of the reasons two investors both using
the constant-growth version of the DDM on the same stock might arrive at
different estimates of the stock's value?

a. They used different expected returns.

b. They used different growth rates of dividends.
c. They used different required returns.
d. All of the above are possible reasons they might arrive at different values.

(a, moderate)

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 13. What is the estimated value of a stock with a required rate of return of 15
percent, a projected constant growth rate of dividends of 10 percent and
expected dividend of $2.00
.
a. $4 Solution: P0 = D1/(k – g)
b. $40 = 2/(.15 - .10)
c. $44 = $40
d. $20

(b, moderate)

14. XYZ Company has expected earnings of $3.00 for next year and usually
retains 40 percent for future growth. Its dividends are expected to grow at
a rate of 10 percent indefinitely. If an investor has a required rate of return
of 16 percent, what price would he be willing to pay for XYZ stock?

a. $12.50 Solution: Dividends = $3(1 - .4)

b. $25.00 = $1.80
c. $30.00 P0 = D1/(k – g)
d. $40.00 = 1.80/(.16 - .1)
= $30
(c, moderate)

15. WWW Company currently (t = 0) earns $4.00 per share, and has a payout
of 40 percent. Dividends are expected to grow at a constant rate of 8
percent per year. The required rate of return is 15 percent. The price of
this stock would be estimated at

a. $57.14. Solution: D0 = $4 x .4 = $1.60

b. $22.86. D1 = 1.60(1.08) = 1.73
c. $10.67. P0 = D1/(k – g) = 1.73/(.15 - .08) =
d. $24.69. $24.69

(d, moderate)

16. Tyler Toys currently earns $3.00 per share and currently pays $1.20 per
share in dividends. It is expected to have a constant growth rate of 7
percent per year. The required rate of return is 14 percent. What is the
intrinsic value of this stock?

a. $42.86 Solution: D0 = $1.20

b. $18.34 D1 = 1.20(1.07) = 1.28
c. $17.14 P0 = = 1.28/(.14 - .07) =
d. $40.05 $18.34

(b, moderate)

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 Other Discounted Cash Flow Approaches

17. Which of the following statements regarding intrinsic value and market
price is true?

a. If intrinsic value is greater than the current market price, the stock should
be avoided or, if already held, sold.
b. If intrinsic value is less than the current market price, the stock is
undervalued.
c. If intrinsic value is equal to the current market price, the stock is correctly
valued.
d. If the intrinsic value is greater than the current market price, the stock is
considered speculative.

(c, moderate)

18. Analysts often use a ________% rule in security valuation in recognition

of the fact that estimating a security's value is an inexact process.

a. 5
b. 10
c. 15
d. 20

(c, difficult)

19. In the Streetsmart Guide to Valuing a Stock, the discount rate used is the:

a. risk-free rate.
b. risk-free rate plus a risk premium.
c. after-tax weighted average cost of capital.
d. before-tax weighted average cost of capital.

(c, difficult)

20. Which of the following situations indicates a signal to sell a stock?

a. IV > CMP
b. IV < CMP
c. IV = CMP
d. Impossible to determine.

(b, easy)

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 21. A major difference between the dividend discount model (DDM) and the
free cash flow to equity model (FCFE) is that the FCFE:

a. accounts for potential capital gains and the DDM does not.
b. measures what a firm could pay out in dividends and the DDM measures
what is actually paid.
c. measures both dividend growth and stability and the DDM only measures
the dividend growth.
d. bases its calculations on future value techniques while the DDM uses
present value calculations.

(c, difficult)

22. Which of the following models incorporates debt financing, including

both the repayment and interest on existing debt as the sale of new debt, as
well as preferred stock financing?

a. FCFE model
b. FCFF model
c. constant growth rate model
d. multiple growth rate model

(b, difficult)

Relative Valuation Techniques

23. Under the P/E model, stock price is a product of:

a. EPS and DPS

b. P/E ratio and EPS
c. EPS and required return
d. P/E ratio and required return

(b, easy)

24. A firm has net income of $1 million with 250,000 shares outstanding with
a total market value of $16 million. What is its P/E ratio?

a. 64 Solution: 1 mil/250,000 = $4 EPS

b. 4 16 mil/250,000 = $64 MPS
c. 32 64/4 = 16 P/E RATIO
d. 16

(d, moderate)

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 25. If interest rates rise and other factors remain constant, the P/E ratio of a
company will:

a. become negative.
b. increase.
c. decrease.
d. become more volatile.

(c, moderate)

26. Which of the following variables has an inverse relationship with the P/E
ratio?

a. payout ratio
b. expected growth rate of dividends
c. expected growth rate of earnings
d. required rate of return

(d, difficult)

27. Which of the following changes will likely lead to a higher P/E, assuming
other factors are equal?

a. A decrease in the dividend payout ratio

b. An increase in growth rate of earnings
c. An increase in the required rate of return
d. A decrease in the dividend yield

(b, moderate)

28. Which of the following statements regarding P/E ratios is true?

a. Generally, the riskier the stock, the higher the P/E ratio.
b. In recent years, the small capitalization stocks had the highest P/E ratios.
c. As interest rates increase, P/E ratios are expected to decline.
d. Growth prospects often lead to higher P/E ratios.

(b, difficult)

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 29. Economic value added is the difference between:

a. operating profits and cost of capital.

b. operating profits and cost of equity.
c. net profits and cost of capital.
d. net profits and cost of equity.

(a, difficult)

30. A stock that is currently enjoying a strong demand by investors would

likely to have:

a. a high dividend yield.

b. a high P/E ratio
c. a high payout ratio
d. a high required return

(b, moderate)

31. Book value is:

a. the same as market value.

b. a more accurate valuation technique than the dividend models.
c. the accounting value of the firm as reflected in the financial statements.
d. the same as liquidation value.

(c, easy)

32. A company has a price to sales ratio of 1.10, annual sales of $2 billion and
100 million shares of common stock outstanding. Its stock price is:

a. $20 Solution: 2 billion/100 million = $20 Sales

per share
b. $18.18 $20 x 1.10 PSR = $22 MPS
c. $17.52
d. $22.00

(d, moderate)

33. The price to book value ratio tends to be close for:

a. high-tech companies.
b. banks.
c. utilities.
d. service companies.

(b, moderate)

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 34. Which of the following statements concerning price to book value is true?

a. There is an inverse relationship between price to book values and market

prices.
b. It is calculated as the ratio of price to the book value of assets.
c. There is supporting evidence that stocks with low price to book values
significantly outperform the market.
d. Price to book value ratios for many stocks range from 5.5 to 10.5.

(c, difficult)

35. The price/sales ratio indicates:

a. the amount of risk in the firm’s operations.

b. what the market is willing to pay for a firm’s revenues.
c. the price advantage a company has for its brand names.
d. what the analysts see as the breakup value of the firm.

(b, moderate)

36. A relatively new valuation technique that emphasizes the difference

between a firm’s operating profits and its cost of capital is called:

a. the discounted dividend model.

b. the capital asset pricing model.
c. economic value added model.
d. the market capitalization model.

(c, moderate)

37. It is recommended that investors interested the EVA approach should seek
companies that have a return of capital in excess of ------- because this will
likely exceed the cost of capital and the company is, therefore, adding
value.

a. 10
b. 20
c. 30
d. 40

(b, difficult)

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 True-False Questions

The Dividend Discount Model

1. Earnings per share is an accounting concept whereas dividends represent

actual cash payments.

(T, easy,)

2. Relatively small changes in the inputs used in the DDM can change the
estimated value by large percentage amounts.

(T, moderate)

3. If all investors use the constant growth dividend model to value the same
stock, they will all arrive at the same estimate of value.

(F, difficult)

4. Unlike the discounted cash flow techniques, the relative valuation

approach does not require that an estimate of the stock's value be made.

(T, moderate)

5. If the growth rate in dividends is greater than the required rate of return,
the price found under the constant growth model will be negative.

(T, difficult, p. 10-10)

6. Under the zero-growth dividend model, expected dividends are the same
as current dividends.

(T, easy)

Other Discounted Cash Flow Approaches

7. If the intrinsic value of stock is greater than the current stock price, the
stock is overvalued and should be sold short.

(F, moderate)

Relative Valuation

8. Other things equal, the lower the required return, the lower the P/E.

(F, moderate)

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 9. EVA analysis reflects an emphasis on return on capital.

(T, moderate)

10. Firms with significant intellectual property tend to have a high book value.

(F, difficult)

11. Declining interest rates in the market should send P/E ratios, on average,
higher.

(T, easy)

12. You would expect a lower PSR for a retail company than for a
biotechnology company.

(T, moderate)

11. The recent corporate scandals should send a message that investors want
disclosure of important financial information.

(T, easy)

Bursting the Bubble on New Economy Stocks - A Lesson in Valuation

12. The "New Economy" stocks of the 1990s proved conclusively that the old
valuation principles do not apply today.

(F, easy)

Which Approach to Use?

13. Relative valuation methods tend to be more sophisticated, more formal

and less intuitive than discounted cash flow techniques.

(F, moderate)

14. Morningstar reports a "fair value" for stocks based on a discounted cash
flow analysis.

(T, moderate)

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 Short-Answer Questions

1. Why are dividends the foundation of valuation for common stock?

Answer: They are the only cash payments a stockholder receives directly
from a company. Like bond interest, they represent expected
future benefits from the investment.

(easy)

2. The higher the payout ratio, the higher the P/E is expected to be, other
things being equal. However, other things might not be equal. Give an
example of something that might not be equal and how it would affect the
P/E.

Answer: A higher payout would lead to a higher dividend and higher price
in the DDM. If the higher payout caused the growth to decrease
because of lower earnings retention, the price and P/E might
increase less or fall. The point is that the variables are not
necessarily independent, and changing one may change others.

(difficult)

3. The financial newscaster comments that the Stock X is overvalued at an

earnings multiple of 60. What could cause a P/E this high?

Answer: Either the price could be high relative to normal earnings or the
earnings could be low with very high growth expectations.

(moderate)

4. What are the implications for the usefulness of the P/E ratio if a
company’s earnings are very low (like a few cents) or negative?

Answer: Either very low or negative earnings cause P/E ratios to be

distorted. Earnings per share of one cent make a $5 stock to have a
P/E of 500. Negative earnings per share would cause a negative
P/E, which doesn't make sense.

(difficult)

5. What variables must be estimated to use the dividend discount model?

The P/E model?

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 Answer: To use the DDM the analyst must project the growth rate at which
the dividends are expected to grow ad infinitum. With this growth
rate the next expected dividend can be projected. The investor’s
required rate of return must also be estimated. To use the P/E
model the analyst must project the next period earnings and the
P/E ratio.

(moderate)

6. You calculate the intrinsic value of a stock to be $27. You check The
Wall Street Journal and find the actual price to be $30. What could differ
in your analysis and the market’s valuation? If you are confident about
your analysis, should you buy or not?

Answer: Factors that could differ include the discount rate required by
investors, the future dividend growth rate, and the next expected
dividend. If you are confident about your valuation of $27, you
should not buy the stock, which is overvalued.

(difficult)

7. Why did investors favor large cap stocks in the mid to late 1990s?

Answer: They were perceived as less risky during a time when an

economic slowdown was predicted and they showed strong
earnings growth.

(moderate)

Critical Thinking/Essay Questions

1. Often “high-flyer” stocks have high P/E ratios, yet some analysts seek low
P/E stocks. Are high or low P/E ratios more reliable as tools for valuation
of stocks?

Answer: Low P/E ratios are likely to be more stable than high P/Es, and,
therefore, more reliable in valuation models. High P/Es may be
distorted by temporarily high demand for a particular stock rather
than by economically justified pricing. High P/Es can also be
caused by temporarily depressed earnings. High P/Es, then, are
subject to greater swings as prices fluctuate without any realistic
tie to earnings potential.

(difficult)

2. Explain how (a) the payout rate, (b) the expected dividend growth rate,
and (c) the required rate of return affect the P/E ratio.

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 Answer: To answer this question, substitute the DDM into the P/E formula.

P/E = P0 = D1/(k – g) = D1/E1

E1 E1 k–g
From the above formulation, one can see that (a) a higher payout will
increase D1 causing a higher P/E, (b) a higher growth rate, g, will cause a
higher P/E, and (c) the higher required rate of return, k, will cause a lower
P/E.

(moderate)

Problems

1. The Crazy Horse Corporation's stock is trading at $75. The firm paid out
$2.20 in dividends during the last year. If the payout ratio of the firm is 45
percent, what is its price earnings ratio?

Solution: Payout ratio = DPS/EPS

.45 = 2.20/EPS
EPS = 4.89

P/E = 75/4.89 = 15.34

(moderate)

2. A. T. Edwards paid an annual dividend of $1.25 last year. Investors

expect the dividends to grow at a rate of 6 percent per year over the
foreseeable future. If the required rate of return for this stock is 12
percent, what is its intrinsic value today?

Solution: P0 = [D0 (1+g)]/ (k-g)

= [(1.25)(1.06)]/(.12-.06) = 1.325/.06 = $22.08

(moderate)

3. Bronco Inc.'s common stock is currently selling for $42 and paying a
dividend of $3. If the investors expect dividends to double in 8 years,
what is the required rate of return for Western Inc?

Solution: In order for dividends to double in 9 years the annual compound

growth rate (g) must be:

(1 + g)8 = 2
g = 21/8 - 1 = 0.0905 or 9.05 percent

P0 = [D0 (1+g)]/ (k-g)

Therefore,

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 k = D1/P0 + g = 3(1.0905)/42 + .0905
= 0.1684 or 16.84 percent

(moderate)

4. The current market price of the stock of a company, Stryker Ltd. is $30
per share. The dividends for the next year are expected to be $4.00 per
share and the investor is confident that the selling price of the stock will be
$35 at the end of one year. What is the implied rate of return assuming
dividends are growing at a constant rate?

Solution: P0 = $30; D1 = $4; P1 = $35

P0 = D1 / (k-g)
Therefore,
(k – g) = D1/ P0 = 4/30 = 0.1333

Now,
P1 = D1(1 + g)/(k – g)
35 = 4(1 + g)/(0.1333)
(1 + g) = 1.1667
g = 1.1667 – 1
g = 0.1667

As determined previously,
(k – g) = 0.1333
k = 0.1333 + g
k = 0.1333 + 0.1667 = 0.2999 or 29.99 percent

(difficult)

5. The directors of MJ Inc. expect to pay a dividend of $2.00 (annual) a year

from today. It is estimated that during the next four years (i.e. years 2
through 5), the dividend will grow at an annual rate of 16 percent (i.e. g1 =
16 percent). After that, the growth rate (g2) will be equal to 12 percent per
year and continue at that rate indefinitely. Calculate the present value of
the MJ's stock if the required rate of return is 15 percent.

Solution: Price of stock = (Sum of the Present value of dividends received

in years 1-5) +
(Present value of the price at the end of year 5)

Year Growth rate Expected dividend PVIF,15%,n Present value

1
.16 2.00 .869565 1.73913
2
.16 2.32 .756144 1.75425
3
.16 2.6912 .657516 1.76951

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 4
.16 3.1217 .571753 1.78484
5
.16 3.6212 .497177 1.80038
Sum = 8.84611

P5 = D5(1 + g2)/( k – g2)

= 3.6212(1 + .12)/(.15 - .12) = $135.19

Present value of P5 = $135.19(0.497177) = $67.21

P0 = $8.85 + 67.21 = $76.06

(difficult)

6. Brotech Unlimited sells at $40 per share, and its latest 12 month earnings
were $8 per share, of which $3.20 per share were paid as dividends.

(a) What is Brotech's current P/E ratio?

(b) If Brotech's earnings are expected to grow by 9 percent per year, what is
the projected price for next year assuming that the P/E ratio remains
constant?
(c) If you had a required rate of return of 15 percent, expected the dividend
payout ratio to remain constant, and dividends to grow at a rate of 9
percent, would you buy this stock? Explain your answer.

Solution: (a) Current P/E = Current Price/Current earnings =

40/8 = 5

(b) P1 = E1 x P/E = 8(1.09) x 5 = $43.60

(c) P0 = D1/(k - g) = 3.20(1.09)/(.15 - .09)

= $58.13

Yes, I would buy this stock since its intrinsic value of $58.13 is greater than its
current price of $40.

(moderate)

7. Contemporary Casuals, Inc., (CCI) has a beta of 1.15, an expected

dividend of $2.30, and an expected dividend growth rate of 5 percent for
the foreseeable future. The S&P500 expected return is 18 percent, and the
Treasury bill rate is 6 percent.

(a) Calculate the required return on Contemporary stock.

(b) Calculate the price of Contemporary stock.

Solution: (a) kCCI = RF + CCI[E(RM) - RF]

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 = .06 + 1.15[.18 - .06] = 0.198
or 19.8 percent

(b) P0 = D1/(k - g)
= 2.30/(0.198 - .06) = $16.67

(moderate)

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