Equity Valuation pt. 2

An equity analyst has been asked to estimate the intrinsic value of the com-mon stock of Omega Corporation, a leading manufacturer of automobile seats. Omega is in a mature industry, and both its earnings and dividends are expected to grow at a rate of 3 percent annually. Which of the following is most likely to be the best model for determining the intrinsic value of an Omega share? A) Gordon growth model. B) Free cash flow to equity model. C) Multistage dividend discount model.

A) Gordon growth model. The company is a mature company with a steadily growing dividend rate. The two-stage (or multistage) model is unnecessary because the dividend growth rate is expected to remain stable. Although an FCFE model could be used, that model is more often chosen for companies that currently pay no dividends.

An analyst estimates the intrinsic value of a stock to be in the range of €17.85 to €21.45. The current market price of the stock is €24.35. This stock is most likely: A) overvalued. B) undervalued. C) fairly valued.

A) overvalued. The current market price of the stock exceeds the upper bound of the analyst's estimate of the intrinsic value of the stock.

In the free cash flow to equity (FCFE) model, the intrinsic value of a share of stock is calculated as: A) the present value of future expected FCFE. B) the present value of future expected FCFE plus net borrowing. C) the present value of future expected FCFE minus fixed capital investment.

A) the present value of future expected FCFE. In the FCFE model, the intrinsic value of stock is calculated by discounting expected future FCFE to present value. No further adjustments are required.

An analyst determines the intrinsic value of an equity security to be equal to $55. If the current price is $47, the equity is most likely: A) undervalued. B) fairly valued. C) overvalued.

A) undervalued. The market price is less than the estimated intrinsic, or fundamental, value.

A Canadian life insurance company has an issue of 4.80 percent, $25 par value, perpetual, non-convertible, non-callable preferred shares outstanding. The required rate of return on similar issues is 4.49 percent. The intrinsic value of a preferred share is closest to: A) $25.00. B) $26.75. C) $28.50.

B) $26.75 The expected annual dividend is 4.80% × $25 = $1.20. The value of a preferred share is $1.20/0.0449 = $26.73.

An analyst is attempting to calculate the intrinsic value of a company and has gathered the following company data: EBITDA, total market value, and market value of cash and short-term investments, liabilities, and preferred shares. The analyst is least likely to use: A) a multiplier model. B) a discounted cash flow model. C) an asset-based valuation model.

B) a discounted cash flow model. To use a discounted cash flow model, the analyst will require FCFE or dividend data. In addition, the analyst will need data to calculate an appropriate discount rate.

An analyst who bases the calculation of intrinsic value on dividend-paying capacity rather than expected dividends will most likely use the: A) dividend discount model. B) free cash flow to equity model. C) cash flow from operations model.

B) free cash flow to equity model. The FCFE model assumes that dividend-paying capacity is reflected in FCFE.

The Gordon growth model can be used to value dividend-paying companies that are: A) expected to grow very fast. B) in a mature phase of growth. C) very sensitive to the business cycle.

B) in a mature phase of growth. The Gordon growth model (also known as the constant growth model) can be used to value dividend-paying companies in a mature phase of growth. A stable dividend growth rate is often a plausible assumption for such companies.

Two analysts estimating the value of a non-convertible, non-callable, perpetual preferred stock with a constant dividend arrive at different estimated values. The most likely reason for the difference is that the analysts used different: A) time horizons. B) required rates of return. C) estimated dividend growth rates.

B) required rates of return. The required rate of return, r, can vary widely depending on the inputs and is not unique. A preferred stock with a constant dividend would not have a growth rate to estimate, and the investor's time horizon would have no effect on the calculation of intrinsic value.

Hideki Corporation has just paid a dividend of ¥450 per share. Annual dividends are expected to grow at the rate of 4 percent per year over the next four years. At the end of four years, shares of Hideki Corporation are expected to sell for ¥9000. If the required rate of return is 12 percent, the intrinsic value of a share of Hideki Corporation is closest to: A) ¥5,850. B) ¥7,220. C) ¥7,670.

B) ¥7,220.

An analyst is attempting to value shares of the Dominion Company. The com-pany has just paid a dividend of $0.58 per share. Dividends are expected to grow by 20 percent next year and 15 percent the year after that. From the third year onward, dividends are expected to grow at 5.6 percent per year indefinitely. If the required rate of return is 8.3 percent, the intrinsic value of the stock is closest to: A) $26.00. B) $27.00. C) $28.00.

C) $28.00.

The Beasley Corporation has just paid a dividend of $1.75 per share. If the required rate of return is 12.3 percent per year and dividends are expected to grow indefinitely at a constant rate of 9.2 percent per year, the intrinsic value of Beasley Corporation stock is closest to: A) $15.54. B) $56.45. C) $61.65.

C) $61.65. P0 = D1/(r - g) = 1.75(1.092)/(0.123 - 0.092) = $61.65.

An investor is considering the purchase of a common stock with a $2.00 annual dividend. The dividend is expected to grow at a rate of 4 percent annually. If the investor's required rate of return is 7 percent, the intrinsic value of the stock is closest to: A) $50.00. B) $66.67. C) $69.33.

C) $69.33. According to the Gordon growth model, V0 = D1/(r - g). In this case, D1 = $2.00 × 1.04 = $2.08, so V0 = $2.08/(0.07 - 0.04) = $69.3333 = $69.33.

Which of the following is most likely used in a present value model? A) Enterprise value. B) Price to free cash flow. C) Free cash flow to equity.

C) Free cash flow to equity. FCFE can be used in a form of present value, or discounted cash flow, model. Both EV and price to free cash flow are forms of multiplier models.

With respect to present value models, which of the following statements is most accurate? A) Present value models can be used only if a stock pays a dividend. B) Present value models can be used only if a stock pays a dividend or is expected to pay a dividend. C) Present value models can be used for stocks that currently pay a dividend, are expected to pay a dividend, or are not expected to pay a dividend.

C) Present value models can be used for stocks that currently pay a dividend, are expected to pay a dividend, or are not expected to pay a dividend. Dividend discount models can be used for a stock that pays a cur-rent dividend or a stock that is expected to pay a dividend. FCFE can be used for both of those stocks and for stocks that do not, or are not expected to, pay dividends in the near future. Both of these models are forms of present value models.

Book value is least likely to be considered when using: A) a multiplier model. B) an asset-based valuation model. C) a present value model.

C) a present value model. Multiplier valuation models (in the form of P/B) and asset-based valuation models (in the form of adjustments to book value) use book value, whereas present value models typically discount future expected cash flows.

In asset-based valuation models, the intrinsic value of a common share of stock is based on the: A) estimated market value of the company's assets. B) estimated market value of the company's assets plus liabilities. C) estimated market value of the company's assets minus liabilities.

C) estimated market value of the company's assets minus liabilities. Asset-based valuation models calculate the intrinsic value of equity by subtracting liabilities from the market value of assets.

An investor expects to purchase shares of common stock today and sell them after two years. The investor has estimated dividends for the next two years, D1 and D2, and the selling price of the stock two years from now, P2. According to the dividend discount model, the intrinsic value of the stock today is the present value of: A) next year's dividend, D1. B) future expected dividends, D1 and D2. C) future expected dividends and price—D1, D2 and P2.

C) future expected dividends and price—D1, D2 and P2. According to the dividend discount model, the intrinsic value of a stock today is the present value of all future dividends. In this case, the intrinsic value is the present value of D1, D2, and P2. Note that P2 is the present value at Period 2 of all future dividends from Period 3 to infinity.

The best model to use when valuing a young dividend-paying company that is just entering the growth phase is most likely the: A) Gordon growth model. B) two-stage dividend discount model. C) three-stage dividend discount model.

C) three-stage dividend discount model. The Gordon growth model is best suited to valuing mature companies. The two-stage model is best for companies that are transitioning from a growth stage to a mature stage. The three-stage model is appropriate for young companies just entering the growth phase.

An analyst gathers or estimates the following information about a stock: Current price per share 22.56 Current annual dividend per share 1.60 Annual dividend growth rate for Years 1-4 9.00% Annual dividend growth rate for Years 5+ 4.00% Required rate of return 12% Based on a dividend discount model, the stock is most likely: A) undervalued. B) fairly valued. C) overvalued.

The current price of €22.56 is less than the intrinsic value (V0) of €24.64; therefore, the stock appears to be currently undervalued. According to the two-stage dividend discount model: D1 = 1.60 * 1.09 = 1.744 D2 = €1.60 × (1.09)2 = €1.901 D3 = €1.60 × (1.09)3 = €2.072 D4 = €1.60 × (1.09)4 = €2.259 D5 = [€1.60 × (1.09)4](1.04) = €2.349 V4 = €2.349/(0.12 - 0.04) = €29.363 V0 = 24.64 (1.557 + 1.515 + 1.475 + 1.436 + 18.661)