M3 Financial Valuation Methods Questions and Answers

M3 Financial Valuation Methods Questions and Answers Coldwell is using a constant growth dividend discount model to forecast the value of a share of common stock. Inherent in Coldwell's assumptions is the idea that: A. Stock price will grow at the same amount as the dividend. B. Dividends will grow at a rate faster than the presumed discount rate. C. Compounding growth is linear. D. Stock price will grow at the same rate as the dividend. D An underlying assumption of the constant growth model is the idea that the stock price will grow at the same rate as the dividend, thereby producing a constant growth rate. Fernwell wants to buy shares of Gurst Company in two years. Fernwell uses a constant growth dividend discount model with a presumed dividend growth rate of 5 percent. If Fernwell's discount rate is 10 percent and Gurst's current year dividend is $20, what is the approximate price Fernwell will pay? A. $463 B. $420 C. $400 D. $441 A Pt = (D x (1 + G)^(t+1)/(R - G) Pt = ($20 x (1.05^3))/(0.05) = 463 Investors are likely to view a high price earnings (P/E) ratio as an indication that: A. There is no logical conclusion to reach about the relationship between price and earnings. B. Earnings have peaked and will remain flat. C. Earnings have growth potential. D. Earnings have peaked and will likely fall. C The P/E ratio measures the amount that investors are willing to pay for each dollar of earnings per share. Higher P/E ratios generally indicate that investors are anticipating more growth and are bidding up the price of the shares in advance of performance. Free Cash Flow (given net income, noncash expenses, change in working capital, capital expenditures) = net income + noncash expenses - increase in working capital - capital expenditures Zero Growth Model, P = Dividend/rate of return P/E ratio (normal) = P₀/EPS₁ Price today/EPS expected in one year Trailing P/E Ratio = P₀/EPS₀ stock price today/EPS for previous year A company's common stock has a market value of $45. The company's most recent annual earnings per share is $3.60 and the company pays an annual dividend of $1.50 per share. What is the company's price-earnings ratio? A. 21.43 B. 12.08 C. 8.82 D. 12.50 D For this stock, with a market price of $45 and earnings equal to $3.60, the P/E ratio is equal to $45/$3.60, or 12.50x. The P/E ratio can be calculated as either a forward P/E (using earnings expected in one year) or a trailing P/E (using most recent earnings). In this question, the trailing P/E ratio is used, because there is no way with the information given to discern the expected earnings in one year. Company A has a higher P/E than Company B. This implies investors expect Company A to have __ (higher/lower) earnings in the future than Company B. Company A will have higher earnings if they have higher P/E PEG = (P₀/EPS₁)/(G x 100) effect of earning growth on a company's P/E lower PEG = undervalued = more attractive for investors Price-to-cash-flow ratio = P₀/CF₁ CF1 = Operating cash flow PER SHARE If coupon rate market interest rate, the bond was issued at a (premium/discount) Discount PV of bond price given face value (FV), annual coupon rate (C), maturity (t), and market interest rate (R) PV = (FV x C)/(1 + R)¹ + (FV x C)/(1 + R)² + ... (FV + (FV x C)/(1 + R)PV = (FV x C)/(1 + R)¹ + (FV x C)/(1 + R)² + ... (FV + (FV x C)/(1 + R)^t^t A client owns a $1,000 10-year bond. The coupon rate is 6 percent. The client acquired the bond three years ago at a discount. What is known about the interest rates three years ago? A. The market rate was more than 6 percent. B. The stated rate was more than 6 percent. C. The stated rate was less than 6 percent. D. The market rate was less than 6 percent. A According to the Black-Scholes option pricing model, what effect does increased volatility of a stock have on the value of a call option of the stock? A. The value of the call option will increase because increased volatility improves the likelihood that the call option will be in-the-money. B. The value of the call option will decrease because increased volatility implies a higher discount rate and a lower present value of future cash flows. C. The value of the call option will decrease, assuming cash flows remain constant, because increased volatility implies an increase in the risk. D. The value of the call option will not be affected by increased volatility because the model assumes that investors are risk-neutral. A Conglomerate Inc. is in the process of valuing its limited life intangible assets. Based on its due diligence, the company has obtained limited market data on recent comparable intangible transactions, and cash flows pertaining to these intangibles are difficult to estimate given the changing landscape of its industries. Under the above circumstances, what is the best approach to use to value the company's intangible assets? A. Combination approach B. Income approach C. Cost approach D. Market approach C In a scenario in which limited intangible asset transactions exist and there are no reliable estimates of income/cash flows, the cost approach should be used. Under this method, the company determines intangible assets value using a replacement costs or a reproduction cost methodology. Price-to-Sales Ratio (2 Formulas) P0/S1 Price Per Share/ Expected Sales Per Share Market Cap / Expected Sales S1 = (S0 (1 + g)) / SHARES