CHAPTER 7

1. Should the present value of a share depend on how long the investor plans to own that share? Explain why.

Answer:

The value of a share does not rely on the holding period of the stock. They rather rely on the growth rate of a
firm. If the dividend distributed remains constant and there is no significant change in the growth rate of the
firm, then irrespective of the holding period of the stock by an investor the value of the stock remains
unchanged provided the required rate of return always be more than the growth rate offered by the firm.

2. How can a company with a high ROE have a low P/E ratio?

Answer:

A company with a high ROE may have a low price and PE ration when cost of equity capital is high, when
expected growth of book value is low, and when expected future ROE is low.

3. What types of companies have:

a. A high P/E ratio and a low market-to-book ratio?
b. A high P/E ratio and a high market-to-book ratio?
c. A low P/E and a high market-to-book ratio?
d. A low P/E and a lo market-to-book ratio?

Answer:

a. Recovering firms are expected to rebound from temporarily low earnings levels but will not be able to
return to an abnormally high level of ROE due to competition. PE ratio looks high due to low current
earnings.
b. Rising stars type of companies which are expected to grow at high rate and remain stable with that growth
rate in the future.
c. Companies in the category of falling stars enjoy high return on investment but do not grow fast.
d. Companies in the category of dog’s experience low earnings as well as growth because these do not
generate cash nor have any prospect for profits in future.
4. Janet Stringer argues: ‘The DCF valuation method has increased managers’ focus on short-term rather than
long-term performance, since the discounting process places much heavier weight on short-term cash flows
than long-term ones.’ Comment.
Answer:
While it is true that DCF valuation places more weight on earlier cash flows than on later ones, this reflects the
time value of money. A dollar in one year is more valuable than a dollar in five years’ time. However, this does
not imply that the long-term is less important than the short term. Typical DCF valuations show that the value of
cash flows beyond, say, five years is a substantial fraction of the overall firm value. If managers believe that long-
term performance of the firm is the most significant driver of value, they will certainly focus appropriately on
making sure that they do not underemphasize the long-term. DCF valuation helps a manager understand the
tradeoffs between short-term and long-term actions. Consider management’s decision if it has a choice between
two mutually exclusive investments that generate equivalent cash flows, one with a short horizon and the other
with a long horizon. DCF analysis implies that firm value will increase more if the management takes the short-
term versus long-term considerations. Once concern often raised about DCF analysis is that if focuses attention
on quantifiable costs and benefits from investing. It is probably more difficult to quantify long-term costs and
benefits than short-term ones. If management ignores these types of costs and benefits, they may end up
making decisions that have a short-term focus. However, this is not the fault of DCF as a method. It is simply an
indication of the difficulty in making decisions with highly uncertain payoffs