Chapter 7: Valuing Stocks

The type of market efficiency that asserts that investors cannot earn superior returns through a study of information available to other investors is

semi-strong form efficiency

In addition to paying a dividend, a firm can return cash to its equity investors through a

stock repurchase

The type of market efficiency that asserts that no investor, including firm insiders, can earn superior returns is

strong form efficiency

The firm's growth rate if it plows back a constant fraction of earnings, maintains a constant return on equity, and keeps its debt ratio constant is the firm's

sustainable growth rate

The constant-growth formula does not work when there is a case of:

temporary rapid growth

the book value of a firm's equity is equal to ?

the firms assets minus the firms liabilities

The type of market efficiency that asserts that investors cannot make superior returns by searching for patterns in past returns is

weak form efficiency

A firm has a payout ratio of .3, plowback ratio of .7 and a return on equity of .13. What is the firm's growth rate?

9.1% Growth Rate = plowback ratio x ROE = .7 x 13 = .091

The method of valuation by comparables to determine the share price of a firm may not give an accurate estimate of the firm's share price because ___.

The PE ratio and market/book ratio can vary considerably from stock to stock among firms in the same business

In a market where stocks are fairly valued, stock prices follow

a random walk

The field of behavioral finance shows that _________ caused investors to pile more and more money into tech companies, causing the dot-com bubble.

attitudes toward risk

A ________________ is characterized by prices that are at levels in excess of what would be justified economically

bubble

True or false: a market "bubble" is characterized by stock prices that are at levels in excess of what would be justified by expected dividends and earnings. In short, the market is seriously overpriced for some class of stocks

True

True or false: the dividend yield is an indicator of how much dividend income you will receive for every $100 you invest in the stock.

True

Smithfield Hams is forecasted to pay a dividend of $1.50 for the following year and expects dividends to grow at a rate of 3 percent into the future. If investors require an 11 percent rate of return from Smithfield, what should its current share price be?

$18.75 Reason: $1.50/(.11 - .03) = $18.75

Androscoggin Copper is increasing next year's divident to $1.50 per share (DIV 1). The forecast stock price next year is $105 (P 1). Equally risky stocks of other companies offer expected rates of return of 10% (r). What is the intrinsic value (V 0) of the stock?

V0 = (DIV 1 + P 1)/(1+r) = 106.5/1.10 = $96.82

A firm that examines a competitor's market-to-book and P/E ratios is in the beginning stages of ___.

Valuation by comparables

Companies that grow rapidly for several years before settling down to a stable growth rate should use the ___________ for stock valuation.

non-constant growth model

Behavioral finance has shown that most investors are _________ in their ability to pick stocks that will offer superior returns

overconfident

A stock that pays out a perpetual stream of constant dividends can be valued as a(n)

perpetuity

The expected rate of return for a stock whose next dividend is "DIV1", that has a required rate of return "r" and expects to grow its future dividends at a rate of "g" is

r = (DIV1/P0) + g

The dividend discount model implies that investors who agree about the firm's ___ and ___ will also agree about its ___.

Future dividends; risk; current share price

When a firm sells its shares to the public for the first time, this is called a(n) ___.

Initial Public Offering (IPO)

The present value of the cash payoffs anticipated by the investor in a stock is called the share's ___.

Intrinsic value

Which of the following statements are correct about the book value of a firm's equity?

It can be calculated from the balance sheet as assets minus liabilities It is generally less than the market value of the firm's equity

Which of the following is true regarding the market value of the firm?

It is affected by the earnings a firm can generate by current tangible and intangible assets It includes investors' expectations of future earnings power It treats the firm as a going concern

Which of the following statements are correct about the book value of a firms equity?

It is generally less than the market value of the firm's equity It can be calculated from the balance sheet as assets minus liabilities

Which of the following statements are true regarding the intrinsic value of a stock?

It is the present value of the cash payoffs anticipated by the investor who buys the stock. It is the price that should be observed in a well-functioning stock market.

Which of the following is true regarding the market value of the firm?

It treats the firm as a going concern It is affected by the earnings a firm can generate by current tangible and intangible assets It includes investors' expectations of future earnings power

To determine a firm's sustainable growth rate, which three figures must remain constant?

Long-term debt ratio Return on equity Plowback ratio

Which of the following values accounts for both present earnings and future earning power?

Market value

The sale of new securities by corporations take place in the ___.

Primary Market

If a company earns a constant return on equity and plows back a constant proportion of earnings, then its growth rate, g, is:

ROE x plowback ratio

In the constant growth dividend discount model, the expected return is equal to

dividend yield + growth rate

The expected return on a stock can be calculated as the sum of the ___ and the ___.

dividend yield; capital gain

The random walk of stock prices dictates that a stock's price on any given day

do not depend on previous stock price movement

A firm that is experiencing rapid __________may see its free cash flow be zero or negative since it is reinvesting all of its earnings into new investments.

growth

Stock repurchases are an attractive alternative to dividends because

investors interpret dividends as repeated cash distributions

Free cash flow may be _________ for rapidly growing businesses that are reinvesting all of their earnings into new investments.

negative

Using the dividend discount model for a no-growth stock, what is the value of a stock that pays a $3 dividend and has a discount rate of 10%? $3

$30 Reason: Value of a no-growth stock = DIV1/r = $3/.1=$30

Helena Handbaskets expects to pay a dividend of $0.50 at year end and expects that dividend to grow at a rate of 6 percent per year thereafter. If investors require a 15 percent return on Helena's stock, what should the current share price be?

$5.56 Reason: $0.50/(0.15-0.06)=$5.56

A firm has $1 million in earnings. It has a payout ratio of 40%. How much will the firm plow back into the firm?

$600,000 If the payout ratio is 40%, the plowback ratio will be 60%, which means the firm will plow back $1 million x 0.6 = $600,000.

Which of the following statements are correct regarding the method of valuation by comparables?

A firm's market value can be estimated by multiplying its earnings per share by the P/E ratio for a similar firm A firm's market value can be estimated by multiplying its book value by the market/book ratio for a similar firm

Which of the following is true in well-functioning stock markets?

All securities of the same risk are priced to offer the same rate of return.

Many investors hold ___ or ___ that track the entire stock market instead of searching for individual stocks or funds in the hope of getting superior investment returns.

Extend-traded portfolios (ETFs) Index funds

Which of the factors listed below contribute to the market value of a going concern?

Extra earning power Value of future investments Intangible assets

The fraction of earnings reinvested in the firm is called the:

The plowback ratio

The payout ratio is defined as:

The proportion of earnings to be paid out as dividends

The terminal value is defined as __________.

The stock price at the start of the year in which constant dividend growth begins

The secondary market is where investors:

Trade shares among other investors

An investor who purchases ______ receives ownership shares in a publicly held corporation.

common stock

When growth estimates are difficult to make, as in the case of Facebook during its IPO, investors often use valuation by ___ instead of discounted cash flow analysis.

comparables

The current yield on a bond is similar to the __________ on a stock in that both ignore prospective capital gains and losses.

dividend yield