Response: The compounding rate is the rate that increases a present value to a future value. Section: The Dividend Discount Model.
5. Janice is considering buying a stock, which currently pays a dividend of $0.15 per share. She expects this dividend to continue indefinitely, but to neither increase nor decrease. She has also determined that 10% is an appropriate rate to discount these cash flows. What is the highest amount she should pay for this stock?
Response: Using formula (10-3), Value = D0 / k = $0.15 / 10% = $1.50. Note that Janice should be happy to buy at $1.49, not want to buy at $1.51, and be indifferent if she pays $1.50. Section: The Dividend Discount Model.
6. Sam is considering buying a stock, which will pays a dividend of $1.15 per share at the beginning of next year. He expects this dividend to grow by 3% per year. He has also determined that 12% is an appropriate rate to discount these flows. What is the highest amount he should pay for this stock?
Response: Using formula (10-5), Value = D1 / (k –g) = $1.15 / ( 12% - 3%) = $1.15 / .09 = $12.78. Section: The Dividend Discount Model.
7. Sam is considering buying another stock, but on this one he does not know how much the next dividend will be, but he does know that the company just paid a dividend of $1.00 per share. He expects this dividend to grow by 4% per year, and he has also determined that 11% is an appropriate rate to discount these flows. What is the highest amount he should pay for this stock?
Response: Formula (10-5), has D1 in the numerator, so first we must convert D0 to D1. D1 = D0 (1+g) , so D1 = $1.00 (1.104) = $1.04. Using formula (10-5), value = $1.04 / (.11 -.04) = $1.04 / .07 = $14.86 Section: The Dividend Discount Model.
8. Sam is still considering buying the stock from question #8, on which he does not know how much the next dividend will be, but he does know that the company just paid a dividend of $1.00 per share. He expects this dividend to grow by 4% per year, and he has also determined that 11% is an appropriate rate to discount these cash flows. What will the price of this stock be next year?
Response: See Example 10-2 Section: The Dividend Discount Model.
9. Which of the following could increase the price an investor is willing to pay for stock?
a) The investor increases his estimate of the constant growth rate for dividends.
b) The investor decreases his estimate of the constant growth rate for dividends.
c) The investor increases his estimate of the required rate of return.
d) The investor now assumes the dividends will remain constant.
Response: By increasing the assumed growth rate, the denominator of equation 10-5, decreases, so the stock price increases. Section: The Dividend Discount Model.
10. Charlie is investigating a common stock with forecast dividends as shown below. Charlie thinks that 10% is an appropriate discount rate. What is the most he should pay for this stock?
Response: First, we can discount the first 4 flows back to D0. Using the constant growth model (formula 10-4) for the later stage, constant growth portion, we find
Value = (3.17*1.06) / (.10 - .06) = 3.36 / .04 = 84.01. This 84.01 is the value at the end of Year 3, so it also has to be discounted back to Year 0: 84.01 / 1.331 =
Total Year 0 Value =1.82 + 1.98 + 2.07 + 2.17 + 57.38 = 65.42
See example 10-6. Section: The Dividend Discount Model.
11. Mr. & Mrs. Jones are considering buying stock to earn the funds needed for their son, Arthur’s, college education. They will need to sell the stock in 7 years to pay tuition, so what amount should they use as a value in year 7 to help calculate an appropriate price to pay now?
The discounted value of the dividends for years 1 through 6, because that is all the dividends they will receive.
The discounted value of all the dividends from year 7 on, because that is the value a potential buyer will pay when the Joneses sell in year 7.
The discounted value all dividends from year 1 on, because that the value the Joneses will get back is included in the value they will pay.
Whatever price is currently quoted in the stock market.
Response: The discounting the change in price (or capital gains) is the same as discounting as the future flows after the resale. Section: The Dividend Discount Model.
12. Stephen used the discounted dividend model to determine that the price of a stock should be $23.50. Stephen checks on the internet and finds the latest price quoted for this stock is $27.00. What should he do?
Buy the stock at $27.00
Sell the stock at $27.00, even selling short if he does not own it.
Do nothing, as his estimate of the intrinsic value may be off as much as 15%.
Buy the stock at $23.50, because that is all it is worth.
Response: If intrinsic value is less than the current market price of the stock, then the asset is seen as currently overvalued and should be sold or even possibly sold short. Section: Other Discounted Cash Flow Approaches.
13. Some corporations pay no dividends. Which of the following describes an appropriate approach to valuing a stock, which does not pay a dividend?
Set D0 = 0, g = 0, then solve the normal constant growth formula.
Use the price listed in the Wall Street Journal.
Use the constant growth formula, but replace dividends D with Cash Flow CF.
Use the constant growth formula, but replace dividends D with Cash Flow CF, then subtract the market value of outstanding debt and preferred stock, if any.
Response: This is the approach attempts to measure the discounted value of the company’s cash flows, then subtract the portion of this value claimed by those more senior to common equity. Section: Other Discounted Cash Flow Approaches.
14. What is the major difficulty with using the discounted dividend or discounted cash flow methods of estimating a stock’s intrinsic value?
a) Prices in the stock market move from moment to moment.
b) Small changes to the assumptions of k or g result in major changes in the estimated value.
c) It is extremely unlikely that a stream of dividends or a stream of cash flows will grow. at exactly the same rate, year after year.
d) The relative valuation techniques are much easier to calculate.
Response: All valuation techniques require assumptions, which don’t always turn out to be accurate. Section: The Target Price and Relative Valuation Approach.
15. Another approach of valuing stocks is the relative valuation techniques. Which of the following is NOT used in relative valuation comparisons?
a) The specific stock in past periods.
b) The industry under consideration.
c) The entire market for common stocks.
d) The Fed Funds rate.
Response: Interest rates would be picked up in overall market valuations already. Section: The Target Price and Relative Valuation Approach.
16. Which of the following descriptions of the Price / Earnings Ratio is the most accurate?
The PE Ratio is completely different from the Constant Growth Model.
Companies with low PE ratios are better buys – high PE’s are too expensive.
Companies with high growth rates will generally have higher PE’s.
Less risky companies will have lower PE’s.
Response: Investors are generally willing to pay more for companies that are growing a an acclerated rate. Section: The Target Price and Relative Valuation Approach.
17. What is used as “Earnings” in the Price/Earnings ratio?
a) The net income shown in the company’s most recent annual report.
b) The last four published quarterly income statements.
c) The estimated earning for the next 12 months
d) All of these definitions of earnings are be used by different analysts.
Response: Depending on the particular analyst and their preferred methods, any of the above are reasonable estimates for earnings. Section: The Target Price and Relative Valuation Approach.
18. Which factor is NOT likely to explain why one company has a higher P/E ratio than another?
a) The first company has a higher growth rate of earnings.
b) The first company has a higher required rate of return.
c) The first company has a higher dividend payout ratio.
d) The first company has a lower required rate of return.
Response: A higher required rate of return would result in a lower P/E ratio. Section: The Target Price and Relative Valuation Approach.
19. Which of the following is most likely to increase a company’s P/E ratio?
a) The company announces a new product which will increase sales and profits.
b) The company increases its dividend payout ratio.
Response: Using equation (10-13), choice A increases g, choice B reduces g more than it increases D1, choice C increases k, and choice D increases k. Section: The Target Price and Relative Valuation Approach.
20. Sometimes analysts use other ratios such as Price to Book Value or Price to Sales Ratio. Which of the following is a weakness of the use of these ratios?
Some companies are structured very differently, especially across industries.
A price to book value less than one indicates that management is not using the assets efficiently.
A high price to sales ratio shows that the shareholders are getting a large proportion of the money the customers are spending.
The price to sales ratio cannot be used for companies that report a net loss in the accounting period.
Response: There is no perfect relative valuation technique that will capture the idiosyncracies of every company. Section: Which Approach to Use.
Type: True False
1. The only reliable way to calculate the price of a common stock is to discount the future flow of dividends at a discount rate appropriate to the riskiness of the company.
Response: Discounting methods can use dividends (if any), earnings, or cash flow. Section: Which Approach to Use.
2. The required return of return needed to discount the future flows can be determined using the CAPM approach from Chapter 9.
Response: Section: The Dividend Discount Model.
3. No one knows with precision which valuation model should be used for any particular stock.
Response: Section: Some Final Thoughts on Valuation.
4. In March 2000, Yahoo had a P/E ratio of 650, which then declined to 35 exactly one year later.
Response: Section: Bursting the Bubble on New Economy Stocks – A Lesson in Valuation.
5. If a stock’s dividend growth rate or discount rate changes even a small amount, the difference in the price calculated by the constant growth model can be very large.
Response: See Examples 10-3, 10-4, and 10-5. Section: The Dividend Discount Model.
6. All investors will arrive at the same intrinsic valuation of common stocks, as the valuation is an objective fact.
Response: Different investors can have very different opinions as to the appropriate growth rate or discount rate. Section: Some Final Thoughts on Valuation.
7. Using formula (10-9), Phillip calculates the “expected return” as 8% on stock XYZ. He should definitely buy this.
Response: Phillip needs to compare the 8% against a “required return” he calculates based on the CAPM approach. Section: The Dividend Discount Model.
8. Many analysts prefer to use a relative valuation technique, such as comparing P/E ratios, because these techniques are based on better theory.
Response: These relative valuation techniques are widely used, but most analysts agree that the Discounted Dividend Model is theoretically better, although difficult to estimate. Section: Which Approach to Use.
9. The Price / Earnings ratio is one of the most widely used measures of the attractiveness of potential stock investments.
Response: Section: Which Approach to Use.
10. An increase in interest rates generally reduces P/E ratios, and thus stock prices.