Chapter 9 - Stock Valuation

earnings

A growth in dividends requires that there is a growth in a company's....

proxy

Agent, substitute, person authorized to act on behalf of another

b

Based on your understanding of stock prices and intrinsic values, which of the following statements is true? The intrinsic value of a stock is based only on the perceived risk in the company. A stock's intrinsic value is based on the fundamental cash flows and the company's risk.

Class A stock

Class of stock that would be held by a select group 1 vote per share, public

classified stocks

Common stock that is given a special designation such as Class A or Class B to meet special needs of the company.

common stock

Corporation's basic ownership share; also generically called capital stock. - the most basic form of ownership, including voting rights on major issues, in a company

supernormal growth

Dividend growth is not consistent initially, but settles down to constant growth eventually

true

Firms can use different classes of common stock to meet specific needs of the company. Founders' shares are one such class. They are shares owned by the firm's founders that enable them to maintain control over the company without having to own a majority of stock. True or false?

dividend yield + capital gains yield

How do you calculate total return?

true

Preferred stock is a "hybrid" security. Preferreds typically pay a fixed dividend, so they are a fixed-income security like a bond. However, the directors can omit the preferred dividend without throwing the company into bankruptcy. True or false?

ROE is greater than the equity cost of capital

Retention/reinvestment is only good as long as...

proxy fight

attempts by a person or group that wants to take over control of a firm by getting the firms' stockholders to give their voting proxies to the new group.

D1

expected dividend, next year's dividend

expected rate of return

the annual rate of return that a firm expects to obtain through a capital investment

dividend yield

the percentage of how much of the stock's return is received as dividends.

terminal value

the sale price at the end of the expected holding period

horizon value

the value at the horizon date of all dividends expected thereafter

c

Silva Motors just paid a dividend of $2.00, i.e., D0 = $2.00. The dividend is expected to grow by 100% during Year 1, by 50% during Year 2, and then at a constant rate of 5% thereafter. If Silva's required rate of return is rs = 12%, what is the value of the stock today? a. $82.36 b. $74.24 c. $80.10 d. $76.15 e. $78.20

realized rate of return

The actual interest rate earned on an investment in a financial security.

c

Walter Utilities is a dividend-paying company and is expected to pay an annual dividend of $0.65 at the end of the year. Its dividend is expected to grow at a constant rate of 9.00% per year. If Walter's stock currently trades for $14.00 per share, what is the expected rate of return? 946.43% 904.26% 13.64% 824.29%

a

Walter Utilities is a dividend-paying company and is expected to pay an annual dividend of $0.65 at the end of the year. Its dividend is expected to grow at a constant rate of 9.50% per year. If Walter's stock currently trades for $12.00 per share, what is the expected rate of return? 14.92% 1,006.88% 954.95% 921.67%

c

Walter Utilities is a dividend-paying company and is expected to pay an annual dividend of $1.65 at the end of the year. Its dividend is expected to grow at a constant rate of 6.00% per year. If Walter's stock currently trades for $19.00 per share, what is the expected rate of return? 608.19% 660.79% 14.68% 1,108.42%

b

Walter's dividend is expected to grow at a constant growth rate of 9.00% per year. What do you expect to happen to Walter's expected dividend yield in the future? It will decrease. It will stay the same. It will increase.

constant fixed dividend constant dividend growth supernormal growth

What are the 3 ways to evaluate dividends to come up with a price of a stock?

net earnings/equity

What is the formula for return on equity?

(1-payout rate)*ROE

What is the formula for the growth rate?

a

Which of the following conditions must hold true for the constant growth valuation formula to be useful and give meaningful results? The required rate of return, rss, must be greater than the long-run growth rate. The company's stock cannot be a zero growth stock The company's growth rate needs to change as the company matures.

a, b, and d

Which of the following describe the reason(s) why maximization of intrinsic stock value benefits society? People like to work for companies that minimize operating costs. Most people have an important stake in the stock market. Most investors appreciate the risk companies take to maximize their stocks. Successful companies benefit consumers.

b, c, d

Which of the following describe the reason(s) why maximization of intrinsic stock value benefits society? Workers prefer companies that minimize operating costs. The owners of stock are society. Consumers benefit when companies rise prices beyond reasonable levels. Successful companies attract more talent.

c

Which of the following statements accurately describes the relationship between earnings and dividends when all other factors are held constant? Growth in earnings requires growth in dividends. Long-run earnings growth occurs primarily because firms pay dividends to reward their shareholders for investing in the company. Retaining a higher percentage of earnings will result in a higher growth rate.

c

Which of the following statements accurately describes the relationship between earnings and dividends when all other factors are held constant? Retaining a higher percentage of earnings will result in a lower growth rate. Long-run earnings growth will decrease when firms retain earnings and reinvest them in the business. All else being equal, growth in dividends requires growth in earnings.

a

Which of the following statements best describes how a change in a firm's stock price would affect a stock's capital gains yield? The capital gains yield on a stock that the investor already owns has a direct relationship with the firm's expected future stock price. The capital gains yield on a stock that the investor already owns has an inverse relationship with the firm's expected future stock price.

c

Which of the following statements is CORRECT? a. The realized rate of return is denoted simply as a lower-case r. It represents a statistical calculation of what will happen with the stock's future return. b. The required rate of return is denoted simply as a lower-case r with a straight line on top. This rate of return doesn't represent speculation about a stock's future return but represents the actual return you receive from the stock. c. The required return represents the return an investor requires to invest in the stock; the expected return is based on a statistical calculation of what will happen with the future value of the stock; and the realized rate of return is the actual, historic return earned on the stock. d. The actual values of the expected rate of return, the required rate of return, and the realized rate of return must be identical for financial markets to operate. e. None of the statements above are correct.

free cash flow

firm's after-tax operating income less the net capital investment

true

A stock's price is simply the current market price, and it is easily observed for publicly traded companies. By contrast, intrinsic value, which represents the "true" value of the company's stock, cannot be directly observed and must instead be estimated. True or false?

corporate valuation model

A valuation model used as an alternative to the discounted dividend model to determine a firm's value, especially one with no history of dividends, or the value of a division of a larger firm. The corporate model first calculates the firm's free cash flows, then finds their present values to determine the firm's value.

corporation valuation model

Also called the free cash flow method. Suggests the value of the entire firm equals the present value of the firm's free cash flows (which is the MV of its operations) plus the market value of its non-operating assets.

false

If a firm goes bankrupt and must be liquidated, and if less money is available than the balance sheet values of bonds, preferred stock, and common equity, then some security holders will receive less than the book values of their investments. The priority system under our bankruptcy laws allocates funds first to preferred stock because of its preference, then to bonds, and then to common stockholders (only if there are funds left over after paying preferred stockholders and bondholders). True or false?

discounted dividend model

The dividend yield, the capital gains yield, and the total return are three key components of the

constant dividend growth

The firm will increase the dividend by a constant percent every period:

constant fixed dividend

The firm will pay a constant dividend forever This is like preferred stock: no growing perpetuity

growth rate

The more a company retains or reinvests, the higher the _________ ____________ will be

nonconstant growth

The part of the life cycle of a firm in which its growth is either much faster or much slower than that of the economy as a whole.

capital gains yield

The percentage change in the market price of a bond over some period of time.

dividend

The portion of corporate profits paid out to stockholders

true

The total return is equal to the dividend yield plus the capital gains yield

true

The value of a share of stock can be estimated by using the PV of future dividends. An alternative valuation procedure, called the "corporate valuation model," calls for finding the expected future free cash flows, discounting those cash flows at the weighted average cost of capital, summing the PVs of the free cash flows, subtracting the market values of debt and preferred to calculate the value of the common equity, and then dividing by the number of shares outstanding to find the value of a share of common stock. In theory, the two methods should produce the same stock price. Is this statement true or false?

true

To estimate the value of a nonconstant growth stock, we can estimate the value of each dividend during the period of nonconstant growth, find the PVs of these dividends, find the value of the stock at the horizon date, find the PV of the horizon value, and then sum these PVs to find the value of the stock today. True or false?

b

Vara Technologies' is expected to pay a dividend of $2.00 per share one year from today. Vara's required rate of return is rs = 11%. If the expected growth rate is 5%, at what price should the stock sell? a. $34.16 b. $33.33 c. $35.89 d. $35.02 e. $36.79

c

Vara Technologies' is expected to pay a dividend of $2.00 per share one year from today. Vara's required rate of return is rs = 11%. What would Vara's price be if the expected growth rate were g = 0%? a. $17.28 b. $16.43 c. $18.18 d. $17.73 e. $16.85

stockholder

An owner of one or more shares of a corporation

c

If you were analyzing the consumer goods industry, for which kind of company in the industry would the constant growth model work best? All companies Young companies with unpredictable earnings Mature companies with relatively predictable earnings

b

Investors expect Bae Corporation to pay a dividend of D1 = $1.50 and to grow at a constant rate of 7% per year. The stock sells at a price of $25. What is Bae's expected capital gains yield? a. 6.0% b. 7.0% c. 8.0% d. 5.0% e. 4.0%

e

Investors expect Bae Corporation to pay a dividend of D1 = $1.50 and to grow at a constant rate of 7% per year. The stock sells at a price of $25. What is Bae's expected dividend yield? a. 4.0% b. 7.0% c. 5.0% d. 8.0% e. 6.0%

discounted dividend model

The value of a share of common stock depends on the cash flows it is expected to provide, and those flows consist of two elements: (1) the dividends the investor receives each year while he or she holds the stock and (2) the price received when the stock is sold. The final price includes the original price paid plus an expected capital gain.

true

The value of a share of common stock depends on the cash flows it is expected to provide, and those flows consist of two elements: (1) the dividends the investor receives each year while he or she holds the stock and (2) the price received when the stock is sold. The final price includes the original price paid plus an expected capital gain. True or false?

a

Which of the following statements is NOT CORRECT? a. For the discounted dividend model, you need to know the firm's dividend payments, the dividend growth rate, and the discount rate, or required rate of return. In addition, the model assumes that the firm will only be around for a finite period. The model cannot handle the assumption that there are an infinite number of dividend payments. b. The discounted dividend model deals with a fundamental question in finance—the value or worth of a stock. c. The discount rate, or required rate of return, used in the discounted dividend model reduces the values of future dividend payments to calculate their present values—which are used in arriving at the value of the stock price today. d. To arrive at an estimate of the growth rate used in the discounted dividend model that determines how much dividends are expected to change each year, one looks at the company's history and likely future performance. e. The discounted dividend model calculates what the value of the stock price today should be, so we can then compare that value to the stock's current market price to determine whether to purchase, sell, or hold the stock.

c

Which of the following statements is NOT CORRECT? a. The total return is equal to the dividend yield plus the capital gains yield. b. The capital gains yield is the annual percentage of a stock's change in price. c. The capital gains yield is calculated as the dollar amount of the year's dividend payments divided by the current stock price. d. The dividend yield, the capital gains yield, and the total return are three key components of the Discounted Dividend Model. e. The dividend yield is the percentage of how much of the stock's return is received as dividends

a

Which of the following statements is true about the constant growth model? When using a constant growth model to analyze a stock, if an increase in the growth rate occurs while the required return remains the same, this will lead to a decreased value of the stock. When using a constant growth model to analyze a stock, if an increase in the growth rate occurs while the required return remains the same, this will lead to an increased value of the stock.

b

Which of the following statements is true about the constant growth model? When using a constant growth model to analyze a stock, if an increase in the required rate of return occurs while the growth rate remains the same, this will lead to an increased value of the stock. When using a constant growth model to analyze a stock, if an increase in the required rate of return occurs while the growth rate remains the same, this will lead to a decreased value of the stock.

c

Which of the following statements is true? Increasing dividends will always increase the stock price. Increasing dividends will always decrease the stock price, because the firm is depleting internal funding resources. Increasing dividends may not always increase the stock price, because less earnings may be invested back into the firm and that impedes growth.

c

Which of the following statements will always hold true? The constant growth valuation formula is not appropriate to use for zero growth stocks. It will never be appropriate for a rapidly growing start-up company that pays no dividends at present, but is expected to pay dividends at some point in the future, to use the constant growth valuation formula. The constant growth valuation formula is not appropriate to use unless the company's growth rate is expected to remain constant in the future.

a

You can estimate the value of a company's stock using models such as the corporate valuation model and the dividend discount model. Which of the following companies would you choose to evaluate if you were using the corporate valuation model to estimate the value of the company's stock? A company that is not expected to distribute any earnings to its stockholders for the next few years. A company that has a stable distribution policy.

a

You can estimate the value of a company's stock using models such as the corporate valuation model and the dividend discount model. Which of the following companies would you choose to evaluate if you were using the discounted dividend model to estimate the value of the company's stock? A company that has been distributing a portion of their earnings every quarter for the past six years. A company that is in a high-growth stage and plans to retain all its earnings for the next few years to support its growth.

preferred stock

a hybrid security that has characteristics of both long-term debt and common stock Receives a fixed dividend that must be paid before dividends are paid to common stockholders Companies can omit preferred dividend payments without fear of pushing the firm into bankruptcy Valued like a no-growth perpetuity

growing perpetuity

a stream of cash flows that occurs at regular intervals and grows at a constant rate forever

constant growth model

a valuation method based on constantly growing dividends

proxy fight

an attempt by a person or group to gain control of a firm by getting its stockholders to grant that person or group the authority to vote its shares to replace the current management

D0

just paid, post dividend, past year's dividend

required rate of return

minimum rate of return necessary to attract an investor to purchase or hold a security

preemptive right

right of current stockholders to buy new shares in an amount that will maintain their proportionate ownership in the firm.