CFA level 1 - EI - equity valuation Questions and Answers

CFA level 1 - EI - equity valuation Questions and Answers An analyst estimating intrinsic value is implicitly questioning what? the market's estimate of value If the market's estimated value exceeds the market price, the analyst infers the security is (undervalued over overvalued)? undervalued If the market's estimated value equals the market price, the analyst infers the security is (fairly valued or unfairly valued)? fairly valued If the market's estimated value is less than the market price, the analyst infers the security is (overvalued or undervalued)? overvalued Because of the uncertainties involved in valuation, an analyst may require that value estimates differ markedly from what before concluding that a misvaluation exists? market price Analysts often use more than one valuation model because of concerns about the applicability of any particular model and the variability in estimates that result from what? changes in inputs What are the 3 major categories of equity valuation models? present value, multiplier, and asset-based valuation models Present value models estimate value as the present value of what? expected future benefits Multiplier models estimate intrinsic value based on a multiple of what? some fundamental variable Asset-based valuation models estimate value based on the estimated value of what? assets and liabilities What will the choice of model depend upon? availability of information to input into the model and the analyst's confidence in both the information and the appropriateness of the model What do companies use to distribute cash to shareholders? dividend payments and share repurchases What are the key dates in dividend chronology? declaration date, ex-dividend date, holder-of-record date, and payment date In the dividend discount model, value is estimated as the present value of what? expected future dividends In the free cash flow to equity model, value is estimated as the present value of what? expected future free cash flow to equity How does the Gordon growth model, a simple DDM, estimate value? D1/(r - g). The two stage dividend discount model estimates value as the sum of the present values of dividends over a short-term period of high growth and the present value of what? the terminal value at the end of the period of high growth What model estimates terminal value? using the Gordon growth model The choice of dividend model is based upon the patterns assumed with respect to future dividends. Multiplier models typically use multiples of the form: P/ measure of fundamental variable or EV/ measure of fundamental variable. Multiples can be based upon fundamentals or comparables. Asset-based valuations models estimate value of equity as the value of the assets less the value of liabilities. An analyst estimates the intrinsic value of a stock to be in the range of €17.85 to €21.45. The current market price of the stock is €24.35. This stock is most likely: overvalued. undervalued. fairly valued. overvalued An analyst determines the intrinsic value of an equity security to be equal to $55. If the current price is $47, the equity is most likely: undervalued. fairly valued. overvalued. undervalued In asset-based valuation models, the intrinsic value of a common share of stock is based on the: estimated market value of the company's assets. estimated market value of the company's assets plus liabilities. estimated market value of the company's assets minus liabilities. estimated market value of the company's assets minus liabilities Which of the following is most likely used in a present value model? Enterprise value. Price to free cash flow. Free cash flow to equity. free cash flow to equity (Explanation: FCFE can be used in a form of present value, or discounted cash flow, model. Both EV and price to free cash flow are forms of multiplier models.) Book value is least likely to be considered when using: a multiplier model. an asset-based valuation model. a present value model. a present value model An analyst is attempting to calculate the intrinsic value of a company and has gathered the following company data: EBITDA, total market value, and market value of cash and short-term investments, liabilities, and preferred shares. The analyst is least likely to use: a multiplier model. a discounted cash flow model. an asset-based valuation model. a discounted cash flow model (Explanation: To use a discounted cash flow model, the analyst will require FCFE or dividend data. In addition, the analyst will need data to calculate an appropriate discount rate.) An analyst who bases the calculation of intrinsic value on dividend-paying capacity rather than expected dividends will most likely use the: dividend discount model. free cash flow to equity model. cash flow from operations model. free cash flow to equity model An investor expects to purchase shares of common stock today and sell them after two years. The investor has estimated dividends for the next two years, D1 and D2, and the selling price of the stock two years from now, P2. According to the dividend discount model, the intrinsic value of the stock today is the present value of: next year's dividend, D1. future expected dividends, D1 and D2. future expected dividends and price—D1, D2 and P2. future expected dividends and price—D1, D2 and P2. In the free cash flow to equity (FCFE) model, the intrinsic value of a share of stock is calculated as: the present value of future expected FCFE. the present value of future expected FCFE plus net borrowing. the present value of future expected FCFE minus fixed capital investment. the present value of future expected FCFE (Explanation: In the FCFE model, the intrinsic value of stock is calculated by discounting expected future FCFE to present value. No further adjustments are required.) With respect to present value models, which of the following statements is most accurate? Present value models can be used only if a stock pays a dividend. Present value models can be used only if a stock pays a dividend or is expected to pay a dividend. Present value models can be used for stocks that currently pay a dividend, are expected to pay a dividend, or are not expected to pay a dividend. present value models can be used for stocks that currently pay a dividend, are expected to pay a dividend, or are not expected to pay a dividend (Explanation: Dividend discount models can be used for a stock that pays a current dividend or a stock that is expected to pay a dividend. FCFE can be used for both of those stocks and for stocks that do not, or are not expected to, pay dividends in the near future. Both of these models are forms of present value models.) A Canadian life insurance company has an issue of 4.80 percent, $25 par value, perpetual, non-convertible, non-callable preferred shares outstanding. The required rate of return on similar issues is 4.49 percent. The intrinsic value of a preferred share is closest to: $25.00. $26.75. $28.50.`` $26.75 (Explanation: The expected annual dividend is 4.80% × $25 = $1.20. The value of a preferred share is $1.20/0.0449 = $26.73.) Two analysts estimating the value of a non-convertible, non-callable, perpetual preferred stock with a constant dividend arrive at different estimated values. The most likely reason for the difference is that the analysts used different: time horizons. required rates of return. estimated dividend growth rates. required rates of return (Explanation: The required rate of return, r, can vary widely depending on the inputs and is not unique. A preferred stock with a constant dividend would not have a growth rate to estimate, and the investor's time horizon would have no effect on the calculation of intrinsic value.) The Gordon growth model can be used to value dividend-paying companies that are: expected to grow very fast. in a mature phase of growth. very sensitive to the business cycle. in a mature phase of growth The best model to use when valuing a young dividend-paying company that is just entering the growth phase is most likely the: Gordon growth model. two-stage dividend discount model. three-stage dividend discount model. three-stage dividend discount model (Explanation: The Gordon growth model is best suited to valuing mature companies. The two-stage model is best for companies that are transitioning from a growth stage to a mature stage. The three-stage model is appropriate for young companies just entering the growth phase.) An equity analyst has been asked to estimate the intrinsic value of the common stock of Omega Corporation, a leading manufacturer of automobile seats. Omega is in a mature industry, and both its earnings and dividends are expected to grow at a rate of 3 percent annually. Which of the following is most likely to be the best model for determining the intrinsic value of an Omega share? Gordon growth model. Free cash flow to equity model. Multistage dividend discount model. Gordon growth model A price earnings ratio that is derived from the Gordon growth model is inversely related to the: growth rate. dividend payout ratio. required rate of return. required rate of return The primary difference between P/E multiples based on comparables and P/E multiples based on fundamentals is that fundamentals-based P/Es take into account: future expectations. the law of one price. historical information. future expectations (Explanation: Multiples based on comparables are grounded in the law of one price and take into account historical multiple values. In contrast, P/E multiples based on fundamentals can be based on the Gordon growth model, which takes into account future expected dividends.) An analyst makes the following statement: "Use of P/E and other multiples for analysis is not effective because the multiples are based on historical data and because not all companies have positive accounting earnings." The analyst's statement is most likely: inaccurate with respect to both historical data and earnings. accurate with respect to historical data and inaccurate with respect to earnings. inaccurate with respect to historical data and accurate with respect to earnings. inaccurate with respect to both historical data and earnings (Explanation: The statement is inaccurate in both respects. Although multiples can be calculated from historical data, forecasted values can be used as well. For companies without accounting earnings, several other multiples can be used. These multiples are often specific to a company's industry or sector and include price-to-sales and price-to-cash flow.) The market value of equity for a company can be calculated as enterprise value: minus market value of debt, preferred stock, and short-term investments. plus market value of debt and preferred stock minus short-term investments. minus market value of debt and preferred stock plus short-term investments. minus market value of debt and preferred stock plus short-term investments (Explanation: Enterprise value is calculated as the market value of equity plus the market value of debt and preferred stock minus short-term investments. Therefore, the market value of equity is enterprise value minus the market value of debt and preferred stock plus short-term investments.) Which of the following statements regarding the calculation of the enterprise value multiple is most likely correct? Operating income may be used instead of EBITDA. EBITDA may not be used if company earnings are negative. Book value of debt may be used instead of market value of debt. operating income may be used instead of EBITDA (Explanation: Operating income may be used in place of EBITDA when calculating the enterprise value multiple. EBITDA may be used when company earnings are negative because EBITDA is usually positive. The book value of debt cannot be used in place of market value of debt.)