Chapter 8
The common stock of Peachtree Paper, Inc., is currently selling for $40 a share. A dividend of $2.00 per share was just paid. You are estimating that this dividend will grow at a constant rate of 10%. (a) Using the constant growth DVM model, what is your required rate of return if $40 is a reasonable trading price? (Show all work.) (b) If Peachtree Papers is a new company that produces a relatively unknown product, is the constant growth model a good valuation method for a potential investor to use? Justify your answer.
(a) Required rate of returnr = [$2.00(1.10)/$40] + 0.10r = 15.50% (b) No, it is not. The constant growth DVM is suited only for mature companies with strong track records. It is unlikely that the firm can continue increasing their dividends by 10% annually over the long term.
List the key variables that affect the P/E ratio and explain the relationship between each variable and the P/E ratio.
(a) growth rate in earnings; the higher the growth rate, the higher the P/E ratio (b) general state of the economy; the better the economic outlook, the higher the P/E (c) amount of debt in a company's capital structure; the lower the debt ratio, the higher the P/E (d) current and projected rate of inflation; the lower the inflation, the higher the P/E (e) level of dividends; the lower the dividend payout, the higher the P/E
Martin's Inc. is expected to pay annual dividends of $2.50 a share for the next three years. After that, dividends are expected to increase by 3% annually. What is the current value of this stock to you if you require a 9% rate of return on this investment? A) $39.47 B) $40.11 C) $41.81 D) $42.92
A) $39.47
Walpurg, Inc. paid $1.30 as an annual dividend per share last year. The company is expected to increase their annual dividends by 6% each year. How much should you pay to purchase one share of this stock if you require a 9% rate of return on this investment? A) $45.93 B) $11.44 C) $23.39 D) $22.96
A) $45.93
Commonly used multiples for determining a stock's value include I. price to earnings. II. price to sales. III. price to cash flow. IV. price to dividends. A) I, II and III only B) I, III and IV only C) II, III and IV only D) I, II, III and IV
A) I, II and III only
In applying the variable-growth dividend valuation model to a company's stock, analysts frequently define the growth rate, g, as equal to A) ROE multiplied by the firm's retention rate. B) ROE divided by the dividend payout ratio. C) the dividend payout ratio multiplied by the firm's retention rate. D) P/E multiplied by the dividend payout ratio.
A) ROE multiplied by the firm's retention rate.
High P/E ratios can be expected when investors expect A) a high rate of growth in earnings. B) low earnings. relative to market prices. C) high interest rates. D) a bear market.
A) a high rate of growth in earnings.
When using the constant-growth dividend valuation model, which of the following will lower the value of the stock? A) an increase in the required rate of return B) a decrease in the required rate of return C) an increase in the dividend payout ratio D) an increase in the growth rate of the dividends
A) an increase in the required rate of return
P/E ratios could rise even as earnings fall if A) earnings fall at a faster rate than stock prices. B) earnings fall at a slower rate than stock prices. C) investors expect lower stock prices to be permanent. D) investors expect lower earnings to be permanent.
A) earnings fall at a faster rate than stock prices.
The value of a stock is a function of A) future returns. B) historic dividend growth rate. C) most recent earnings per share. D) past returns.
A) future returns.
The intrinsic value of a stock provides a purchase price for the stock A) that is reasonable given the associated level of risk. B) which will assuredly yield the anticipated capital gain. C) which will guarantee the expected rate of return. D) that is always below the market value but yet yields the expected rate of return.
A) that is reasonable given the associated level of risk.
In general, the higher the retention ratio A) the higher the future growth rate of the company. B) the higher the dividends per share of common stock. C) the higher the future debt-equity ratio. D) the lower the future book value per share.
A) the higher the future growth rate of the company.
ABC Company stock currently has a market value equivalent to its intrinsic value. Marco perceives that ABC Company is increasing its level of risk and therefore Marco increases his required rate of return on ABC stock. This change in the required rate of return A) will reduce the intrinsic value of ABC stock to Marco. B) will increase the intrinsic value of ABC stock to Marco. C) will change the intrinsic value but the direction of the change cannot be determined. D) is a signal to Marco that he should buy more ABC Company stock.
A) will reduce the intrinsic value of ABC stock to Marco.
Global Warning's EPS for the current year is $2.75 and its current P/E ratio is 50. You have forecasted that EPS will grow by 10% but the P/E ratio will fall to 40. What do you expect the price of a share of GW's stock to be at the end of next year? A) $110 B) $121 C) $137.50 D) $151.25
B) $121
Zephyr Inc. sells wind based systems for generating electricity. The company pays no dividends, but you estimate the stock will be worth $50 per share 5 years from now and you require a 15% rate of return for stock investments of this type. What price should you be willing to pay for this stock? A) $12.50 B) $24.86 C) $43.48 D) $57.50
B) $24.86
MBA Inc. will pay a dividend for the first time at the end of 2016. It projects the following dividend per share: 2016 $1.50 2017 $2.00 2018 $2.50 Beginning with 2016 dividends will grow at 4% per year. The required rate of return is 12%. The intrinsic value of MBA shares is A) $25.37. B) $27.85. C) $28.96. D) $38.50.
B) $27.85.
Lindor Inc.'s $100 par value preferred stock pays a dividend fixed at 8% of par. To earn 12% on an investment in this stock, you need to purchase the shares at a per share price of A) $9.60. B) $66.67. C) $96.00. D) $150.00.
B) $66.67.
Which one of the following is a correct equation to calculate earnings per share? A) (ROA)(book value per share) B) (profit margin)(total asset turnover)(equity multiplier)(book value per share) C) (profit margin)(equity multiplier)(book value per share) D) (profit margin)(book value per share)
B) (profit margin)(total asset turnover)(equity multiplier)(book value per share)
Most analysts would not feel comfortable forecasting a firm's future earnings for more than A) the next quarter. B) 1 to 3 years. C) 4 or 5 years. D) the next business cycle.
B) 1 to 3 years.
The risk-free rate of return is 2.2 percent, the expected market return is 11 percent, and the beta for Solstice, Inc. is 1.12. What is Solstice's required rate of return? A) 8.80% B) 12.05% C) 13.20% D) 14.30%
B) 12.05%
Which of the following will affect the firm's future cash flows? I. state of the economy II. state of the industry III. the firm's recent and current earnings IV. new products in the firm's pipeline A) I, II and III only B) I, II and IV only C) I, III and IV only D) I, II, III and IV
B) I, II and IV only
Which of the following contributes to high P/E ratios? A) high dividend payout ratios B) high rate of earnings growth C) periods of high inflation D) high debt ratios
B) high rate of earnings growth
The variable-growth dividend valuation model A) develops the value of a stock using the future value of dividends minus a rate of capital gain growth. B) is valuable because it accounts for the general growth patterns of most companies. C) is invalid if at any point in time the growth rate exceeds the required rate of return. D) assumes the rate of dividend growth will vary indefinitely.
B) is valuable because it accounts for the general growth patterns of most companies.
Heather believes that by carefully examining a company's fundamentals and by applying the best valuation models she can identify stocks whose market prices are lower than their intrinsic values. In order for this to be true A) she needs an accurate estimate of future earnings and dividends. B) some stocks must be incorrectly priced. C) betas must be stable over time. D) P/E ratios for both the stock and the market must be stable over time.
B) some stocks must be incorrectly priced.
An investor should purchase a stock when A) the market price exceeds the intrinsic value. B) the expected rate of return equals or exceeds the required return. C) the capital gains rate is less than the required return and no dividends are paid. D) the market price is greater than the justified price.
B) the expected rate of return equals or exceeds the required return.
Columbus Co.'s sales revenue for the most recent quarter was $2.5 million and cost of goods sold was $1.5 million. If sales grow by 15% in the next quarter and all ratios remain the same, gross profit will be A) $2.25 million. B) $1.725 million. C) $1.15 million. D) $1.375 million.
C) $1.15 million.
The common stock of Rob's Discount Furniture is currently selling at $65.20 a share. The company adheres to a 60% dividend payout ratio and has a P/E ratio of 19. There are 42,000 shares of stock outstanding. What is the amount of the annual net income for the firm? A) $42,338 B) $36,032 C) $144,126 D) $72,064
C) $144,126
The current annual sales of Flower Bud, Inc. are $178,000. Sales are expected to increase by 4% next year. The company has a net profit margin of 5% which is expected to remain constant for the next couple of years. There are 10,000 shares of common stock outstanding. The market multiple is 16.4 and the relative P/E of the firm is 1.21. What is the expected market price per share of common stock for next year? A) $15.18 B) $17.66 C) $18.37 D) $19.29
C) $18.37
Markhem Enterprises is expected to earn $1.34 per share this year. The company has a dividend payout ratio of 40% and a P/E ratio of 18. What should one share of common stock in Markhem Enterprises be selling for in the market? A) $9.65 B) $14.47 C) $24.12 D) $33.77
C) $24.12
If the market multiple is 20.24 and the P/E ratio of a company is 24.5, then the stock's relative P/E is A) 0.83. B) 1.19. C) 1.21. D) 4.26.
C) 1.21.
What is the required rate of return on a common stock that is expected to pay a $0.75 annual dividend next year if dividends are expected to grow at 2 percent annually and the current stock price is $8.59? A) 8.73% B) 8.91% C) 10.73% D) 11.38%
C) 10.73%
Newton, Inc. just paid an annual dividend of $0.95. Their dividends are expected to increase by 4% annually. Newton Company stock is selling for $11.54 a share. What is the required rate of return on this stock implied by the dividend-growth model? A) 8.23% B) 12.2% C) 12.6% D) 13.9%
C) 12.6%
GLOO stock's P/E ratio is 45 at a time when the market's P/E ratio is 15. GLOO's relative P/E ratio is A) 30. B) -30. C) 3. D) .33.
C) 3.
The Hopkinton Company just paid $2.25 as its annual dividend. The dividends have been increasing at a rate of 5% annually and this trend is expected to continue. The stock is currently selling for $63.60 a share. What is the rate of return on this stock? A) 3.60% B) 3.70% C) 8.7% D) 11.8%
C) 8.7%
The risk free rate is 2%. The expected rate of return on the market is 12%. Beta and the expected rate of return for four stocks are as follows.: ABC .8 , 10%; DEF 1, 12%; GHI 1.2 , 13%, and JKL 2, 22%. Which of these stocks should not be purchased? A) ABC B) DEF C) GHI D) JKL
C) GHI
Which of the following are key inputs to determining the intrinsic value of an asset? I. the required rate of return II. future cash flows III. current stock price IV. timing of future cash flows A) I and II only B) I and III only C) I, II and IV only D) II, III and IV only
C) I, II and IV only
Which of the following statements concerning the constant-growth dividend valuation model is (are) correct? I. One simple method of estimating the dividend growth rate is to analyze the historical pattern of dividends. II. The expected total return equals the return from capital gains plus the return from dividends paid. III. The model is applicable to growth firms with initially high growth rates. IV. The intrinsic value calculated using this method can change from one investor to another if their risk-return payoffs differ. A) I and IV only B) II and III only C) I, II and IV only D) I, II and III only
C) I, II and IV only
Which of the following statements concerning the Price to Cash-Flow approach to stock valuation are true? I. The Price to Cash-Flow method works just as well for non-dividend paying stocks as it does for dividend-paying stocks. II. The Price to Cash-Flow calculate s the intrinsic value of a stock as the present value of future cash flows. III. The Price to Cash-Flow ratio divides the market price of one share of stock by cash flow per share. IV. The Price to Cash-Flow method does not directly calculate the intrinsic value of a share. A) I and II only B) III and IV only C) I, III and IV only D) I, II and III only
C) I, III and IV only
John requires a 12% rate of return on EG stock at a time when investors, on average, are requiring an 11% rate of return on the same stock. Which of the following will happen? A) John will have to pay more for the stock than he was willing to pay. B) Investors with different required rates of return will pay different prices for the stock. C) John will not be able to buy the stock unless the price changes. D) John will buy the stock at a lower price.
C) John will not be able to buy the stock unless the price changes.
The dividend valuation model (DVM) cannot accommodate which of the following assumptions? A) constant dividends B) a constant growth rate of dividends less than the required rate of return C) a constant growth rate of dividends greater than the required rate of return D) dividends growing at a variable rate
C) a constant growth rate of dividends greater than the required rate of return
Which of the following will lead to an increase in earnings per share? A) an increase in the P/E ratio. B) an increase in the dividend payout ratio. C) an increase in return on equity if book value per share stays the same. D) a decrease in the number of shares if return on equity stays the same.
C) an increase in return on equity if book value per share stays the same.
The single most important issue in the stock valuation process is a company's A) past earnings record. B) historic dividend growth rate. C) expected future returns. D) capital structure.
C) expected future returns.
The most uncertain value used in the Capital Asset Pricing Model is A) beta. B) the risk-free rate. C) expected return on the market. D) all are equally uncertain.
C) expected return on the market.
Even if a company does not officially follow a fixed-dividend policy, dividend payments are A) extremely difficult to predict. B) very volatile and subject to economic conditions. C) fairly stable from one time period to another. D) directly tied to a company's P/E ratio.
C) fairly stable from one time period to another.
A company that wants to maintain both a constant growth rate in dividends and a constant payout ratio will have to A) grow earnings faster than dividends. B) increase assets at the same rate as dividends. C) grow earnings at the same rate as dividends. D) increase stockholders' equity at the same rate as dividends.
C) grow earnings at the same rate as dividends.
Which one of the following is is most likely to increase the price of a stock? A) rapid growth in sales B) rapid decrease in the company's debt levels C) rapid growth in earnings D) rapid increases in bond interest rates
C) rapid growth in earnings
Which of the following variables used in determining a stock's intrinsic value can be known with the greatest level of confidence?A) future earnings B) expected return on the market C) the risk free rate of return D) future dividends
C) the risk free rate of return
The intrinsic value of a stock is greater than its current market price if A) The market price is higher than the present value of expected future cash flows. B) the stock's P/E ratio is higher than the market's average P/E ratio. C) the stock's IRR exceeds the required rate of return. D) the stock's P/CF ratio is higher than the market's average P/CF ratio.
C) the stock's IRR exceeds the required rate of return.
The constant-growth dividend valuation model is best suited for use with A) stocks of new or emerging companies. B) small-cap stocks within growing industries. C) the stocks of mature, dividend-paying companies. D) the stocks of cyclical companies.
C) the stocks of mature, dividend-paying companies.
DMC3 Inc. will pay no dividend for 2016 or 2017. At the end of 2018, it will pay a dividend of $1.50.Thereafter dividends will grow at 4% per year. The required rate of return is 10%. The intrinsic value of DMC3 shares is (assume you are at the beginning of 2016) A) $34.61. B) $26.00 C) $24.91. D) $20.66.
D) $20.66.
The Merry Co. has current annual sales of $350,000 and a net profit margin of 6%. Sales are expected to increase by 5% annually while the profit margin is expected to remain constant. What is the projected after-tax earnings for two years from now? A) $19,294 B) $22,050 C) $23,100 D) $23,153
D) $23,153
Michelak's Maritime Industries has relatively stable earnings and pays an annual dividend of $3.00 per share. This dividend has remained constant over the past few years and is expected to remain constant for some time to come. If you want to earn 11% on an investment in the common stock of Michelak's, how much should you pay to purchase each share of stock? A) $12.50 B) $18.88 C) $20.83 D) $27.27
D) $27.27
A company has an annual dividend growth rate of 5% and a retention rate of 40%. The company's dividend payout ratio is A) 35%. B) 40%. C) 45%. D) 60%.
D) 60%.
Which of the following variables affect the P/E ratio? I. capital structure of a firm II. amount of dividends to be paid III. inflation rate IV. earnings rate of growth A) I, II and III only B) I, II and IV only C) I, III and IV only D) I, II, III and IV
D) I, II, III and IV
In the Capital Asset Pricing Model, which of the following factors are used to determine the required rate of return? I. the risk-free interest rate II. future cash flows III. expected return on the market portfolio IV. beta A) I and II only B) I, II and III only C) II, III and IV only D) I, III and IV only
D) I, III and IV only
James is willing to settle for a 10% rate of return on EG stock at a time when investors, on average, are requiring an 11% rate of return on the same stock. Which of the following will happen? A) James will be have to pay more for the stock than he was willing to pay. B) Investors with different required rates of return will pay different prices for the stock. C) James will not be able to buy the stock unless the price changes. D) James will be happy to buy the stock for less than he was willing to pay.
D) James will be happy to buy the stock for less than he was willing to pay.
The required rate of return necessary for the dividend valuation model can be estimated using A) the Capital Asset Pricing Model. B) comparisons to the rates of return on stocks of similar risk. C) a subjective assessment of the return required over and above less risky investments such as government bonds. D) any or all of the above.
D) any or all of the above.
One stock valuation model holds that the value of a share of stock is a function of its future dividends, and that the dividends will increase at an annual rate which will remain unchanged over time. This stock valuation model is known as the A) approximate yield model. B) holding period return model. C) dividend reinvestment model. D) constant growth dividend valuation model.
D) constant growth dividend valuation model.
Which of the following will most directly influence a company's market value? A) the state of the economy B) the book value of its assets C) the use of financial leverage D) its future cash flows
D) its future cash flows
The major forces behind earnings per share are A) return on assets and total asset value. B) gross revenue and the stock price. C) growth and the number of shares outstanding. D) net income and the number of shares outstanding.
D) net income and the number of shares outstanding.
Over the last year, a firm's earnings per share increased from $1.20 to $1.40, its dividends per share increased from $0.50 to $0.60, and its share price increased from $21 to $24. The firm maintained a relative P/E of 1.10 over the entire time period. Given this information, it follows that the A) stock experienced an increase in its P/E ratio. B) company had a decrease in its dividend payout ratio. C) current P/E of the overall market is 26.4. D) overall market P/E is declining.
D) overall market P/E is declining.
A stock will be an attractive investment if the required rate of return exceeds the expected rate of return. True or False
FALSE
A temporary decline in earnings per share usually results in a temporary reduction of dividends. True or False
FALSE
Companies with high P/E ratios tend to also have high dividend payout ratios. True or False
FALSE
If the annual dividend on a stock never changes, its price will never change. True or False
FALSE
One of the easiest aspects of the dividend valuation model (DVM) is specifying the appropriate growth rate for a firm's dividends over time. True or False
FALSE
Stocks trading at high price to book value multiples may be especially attractive to bargain hunters. True or False
FALSE
The dividend valuation model estimates the value of a share of stock as the future value of all dividends. True or False
FALSE
The first step in predicting a stock's future price is to forecast profits. True or False
FALSE
The greater the perceived risk of an asset, the lower the expected rate of return. True or False
FALSE
The investor's internal rate of return is always equal to the firm's rate of return on equity. True or False
FALSE
The most important factors influencing a stock's current price are its past earnings and dividends. True or False
FALSE
The rate of dividend growth can be estimated by multiplying the return on equity rate by the dividend payout ratio. True or False
FALSE
The required rate of return estimated by the Capital Asset Pricing Model is not suitable for use in dividend valuation models. True or False
FALSE
The value of a stock using the price to cash flow approach is to multiply the P/E ratio times operating cash flow divided by the number of shares outstanding. True or False
FALSE
WaterCo is a manufacturer of boat parts and has been in business only a few years. Its board of directors decided to start paying a dividend to help boost the attractiveness of its stock. The dividend will be $0.50 per share next year. After that dividends will increase by 4 percent per year. The company has a beta of 1.6. The market rate of return is 8% and the T-bill rate is 3%. Should you purchase shares in this firm at the current market price of $6.98 per share?
Required rate of return = 3% + [1.6 (8% - 3%)]= 3% + [1.6 (5%)]= 11.0%The value of a share using the constant growth dividend valuation model = $0.50/(0.11 - 0.04) = $7.14. Yes, you should buy the stock as it is currently priced at $6.98 per share while the intrinsic value is $7.14 per share.
A company's estimated future earnings and its P/E ratio can be used to estimate the stock's future price. True or False
TRUE
A decline in earnings that investors expect to be temporary may actually increase a firm's P/E ratio. True or False
TRUE
A stock's internal rate of return (IRR) is the discount rate that cause the present value of future dividends and the price at which a stock is expected to be sold to equal the current price of the stock. True or False
TRUE
A stock's value depends on future cash flows. True or False
TRUE
Both beta and the expected return on the market portfolio incorporate risk into the Capital Asset Pricing Model. True or False
TRUE
High price/sales multiples often go with high profit margins. True or False
TRUE
If net income rises, but the number of shares outstanding remains the same, EPS will rise. True or False
TRUE
Neither the P/E approach nor the cash flow to equity approach rely on dividends as the key input into the valuation of a stock. True or False
TRUE
One method of estimating the dividend growth rate is to calculate the discount rate that equates today's dividend with the dividend paid several years ago. True or False
TRUE
The approach to stock valuation which holds that the value of a share of stock is a function of its future dividends is known as the dividend valuation model (DVM). True or False
TRUE
The common-size income statement expresses every item on the income statement as a percentage of sales. True or False
TRUE
The dividend valuation model (DVM) is very sensitive to the growth rate (g) being used, because it affects both the model's numerator and its denominator. True or False
TRUE
The efficient market hypothesis holds that a stock's intrinsic value and market value are essentially the same. True or False
TRUE
The estimated price of a stock in the future is important because it includes the projected capital gain on the stock. True or False
TRUE
The free cash flow to equity approach does not require that a stock pay dividends. True or False
TRUE
The growth rate of dividends cannot be permanently greater than the required rate of return. True or False
TRUE
The intrinsic value of a zero-growth stock can be found simply by dividing the dividend by the required rate of return. True or False
TRUE
The intrinsic value of an asset equals the present value of all future cash flows at a given discount rate. True or False
TRUE
The key to the future financial success of a company lies in the sales growth and the net profit margin. True or False
TRUE
The rate of growth can exceed the required return during the variable-growth period without invalidating the variable growth dividend valuation model. True or False
TRUE
The required rate of return denotes the minimum rate of return an investor should expect. True or False
TRUE
The sales forecast depends on factors both internal and external to the firm. True or False
TRUE
There is no assurance that the actual rate of return on an asset will be similar to the projected rate of return. True or False
TRUE
Explain how the time value of money concept is used in stock valuation.
The intrinsic value of a stock is based on the current discounted value of all future dividends plus the discounted value of the sale price of the stock at a future point in time.
