1 . One advantage ofusing price-to-book value (PBV) multiples for stock valuation is that:
A most of the time itis close to the market value.
B)it is a stable andsimple benchmark for comparison to the market price.
C)book value of a firmcan never be negative.
The correct answer wasB
Book value provides arelatively stable measure of value that can be compared to the market price.For investors who mistrust the discounted cash flow estimates of value, itprovides a much simpler benchmark for comparison. Book value may or may not becloser to the market value. A firm may have negative book value if it showsaccounting losses consistently.
2 . The threat ofsubstitute products is most likely to be low for a firm that:
A)produces a commodityproduct in an industry with significant unused capacity.
B)operates in afragmented market with little unused capacity.
C)produces adifferentiated product with high switching costs.
The correct answer wasC
The threat ofcompetition from substitute products is likely to be low for a firm thatproduces a differentiated product with high switching costs. Unused capacityand low industry concentration (a fragmented market) tend to intensify rivalryamong industry competitors but are not directly related to the threat ofsubstitute products.
3 . Given thefollowing estimated financial results, value the stock of FishnChips, Inc.,using the infinite period dividend discount model (DDM).
§ Sales of $1,000,000.
§ Earnings of $150,000.
§ Total assets of $800,000.
§ Equity of $400,000.
§ Dividend payout ratio of 60.0%.
§ Average shares outstanding of 75,000.
§ Real risk free interest rate of 4.0%.
§ Expected inflation rate of 3.0%.
§ Expected market return of 13.0%.
§ Stock Beta at 2.1.
The per share value ofFishnChips stock is approximately: (Note: Carry calculations out to at least 3decimal places.)
A)$26.86.
B)Unable to calculatestock value because ke < g.
C)$17.91.
The correct answer was:A
Here, we are given allthe inputs we need. Use the following steps to calculate the value of thestock:
First, expand theinfinite period DDM:
DDM formula: P0 = D1 /(ke – g)
D1 = (Earnings × Payout ratio) / average number ofshares outstanding
= ($150,000 × 0.60) / 75,000 = $1.20
ke = nominal risk free rate + [beta × (expectedmarket return – nominal risk free rate)]
Note: Nominal risk-free rate = (1 + real risk free rate) × (1 +expected inflation) – 1
= (1.04)×(1.03) – 1 =0.0712, or 7.12%.
ke = 7.12% + [2.1 × (13.0% ? 7.12%)] = 0.19468
g = (retention rate × ROE)
Retention = (1 – Payout) = 1 – 0.60 = 0.40.
ROE =(net income / sales)(sales / total assets)(total assets / equity)
= (150,000 / 1,000,000)(1,000,000/ 800,000)(800,000 / 400,000)
= 0.375
g = 0.375 × 0.40 = 0.15
Then, calculate: P0 =D1 / (ke – g) = $1.20 / (0.19468 ? 0.15) = 26.86.
4 . The free cash flowto equity model is best described as a(n):
A)single-factor model.
B)present value model.
C)enterprise valuemodel.
The correct answer wasB
The free cash flow toequity model is one type of present value model or discounted cash flow model.It estimates a stock’s value as the present value of cash available to commonshareholders. The enterprise value model is an example of a multiplier model.
5 . For relativevaluation, a peer group is best described as companies:
A)in a similar sectoror industry classification.
B)at a similar stageof the industry life cycle.
C)with similarbusiness activities and competitive factors.
The correct answer wasC
An analyst should formpeer groups of companies that have similar business activities, drivers ofdemand and costs, and access to capital. Companies in the same industry orsector and companies at the same stage of the industry life cycle are notnecessarily comparable for equity valuation purposes.
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