Equity valuation

Question 1

What is the core idea of fundamental (intrinsic) value in equity valuation?

Answer 1

Intrinsic value is based on estimating the expected cash flows from the stock, estimating the required return, and comparing intrinsic value with the actual market price.

Question 2

What kinds of cash flows can be considered in equity valuation?

Answer 2

Expected cash flows can include earnings, dividends, capital gains, interest, rental income, and other cash flows to investors.

Question 3

How is the required return in equity valuation conceptually built up?

Answer 3

The required return can be viewed as a combination of the real risk-free rate, expected inflation, and a risk premium.

Question 4

What investment decision follows if intrinsic value is greater than market price?

Answer 4

If intrinsic value is greater than the actual market price, the stock appears undervalued and is a buy candidate.

Question 5

What investment decision follows if intrinsic value is less than market price?

Answer 5

If intrinsic value is less than the actual market price, the stock appears overvalued and should not be bought.

Question 6

What are the main types of common stock distributions listed in the reading?

Answer 6

Regular cash dividends, extra or special cash dividends, stock dividends, stock splits, reverse stock splits, and share repurchases.

Question 7

What is the declaration date in dividend chronology?

Answer 7

The declaration date is the date on which the board of directors announces the next dividend.

Question 8

What is the ex-dividend date?

Answer 8

The ex-dividend date is the first date on which purchasers of the stock will not receive the upcoming dividend.

Question 9

What is the record date?

Answer 9

The record date is the date on which shareholders of record are identified as entitled to receive the dividend.

Question 10

What is the payment date?

Answer 10

The payment date is the date on which dividends are actually paid to shareholders of record.

Question 11

What is the value formula for preferred stock in the DDM framework?

Answer 11

Preferred stock is valued as a perpetuity: V0 = D / kp.

Question 12

What is the one-year holding period valuation model for common stock?

Answer 12

The value today is the present value of next period’s dividend plus the expected selling price one period later: V0 = (D1 + P1) / (1 + ke).

Question 13

What is the constant-growth DDM formula?

Answer 13

V0 = D1 / (ke − g).

Question 14

What two key assumptions are required for the constant-growth DDM?

Answer 14

Dividends must grow at a constant rate forever, and the required return on equity must be greater than the growth rate, so ke > g.

Question 15

How is a stock valued under temporary supernormal growth?

Answer 15

Use a multistage or two-stage DDM: project the higher short-term growth period, then estimate the terminal value using normal stable growth and discount everything back to today.

Question 16

What is the justified leading P/E formula?

Answer 16

Justified leading P/E = P0 / E1 = (D1 / E1) / (ke − g) = payout ratio / (ke − g).

Question 17

What is the payout ratio in the justified leading P/E model?

Answer 17

The payout ratio is D1 / E1, which is also equal to 1 minus the retention rate.

Question 18

How is the sustainable growth rate g estimated for a stable expanding company?

Answer 18

g = retention ratio × ROE.

Question 19

How is ROE decomposed in the reading?

Answer 19

ROE = profit margin × total asset turnover × financial leverage.

Question 20

What is the difference between leading P/E and trailing P/E?

Answer 20

Leading P/E uses expected next-period earnings, P0 / E1, whereas trailing P/E uses current or past earnings, P0 / E0.

Question 21

What are the main price multiples listed in the reading?

Answer 21

Price-to-earnings, price-to-book value, price-to-cash flow, and price-to-sales.

Question 22

What is the difference between multiples based on comparables and multiples based on fundamentals?

Answer 22

Comparables-based multiples compare a firm’s valuation multiple with those of similar firms, while fundamentals-based multiples estimate what the multiple should be based on a valuation model.

Question 23

What are the main advantages of valuation multiples?

Answer 23

They are easy to calculate, comparable data are widely available, and low multiples may help predict higher future stock returns.

Question 24

What are the main disadvantages of valuation multiples?

Answer 24

A stock may appear overvalued under comparables but undervalued under fundamentals or vice versa, and multiples can be distorted by differences in accounting methods.

Question 25

When is EV/EBITDA especially useful?

Answer 25

EV/EBITDA is especially useful when firms have different capital structures or when earnings are negative and the P/E ratio cannot be used.

Question 26

What is enterprise value (EV)?

Answer 26

EV = market value of common stock + market value of debt − cash and short-term investments.

Question 27

Why is EV/EBITDA less affected by capital structure than P/E?

Answer 27

EV represents the total market value of the firm, while EBITDA represents earnings available to both debt and equity investors.

Question 28

What is the basic idea of asset-based valuation?

Answer 28

Value of equity = fair value of assets − fair value of liabilities.

Question 29

When are asset-based models most useful?

Answer 29

They are most useful for firms with a large proportion of tangible assets with readily available market values, such as short-term securities or natural resources firms.

Question 30

Why are asset-based models less reliable for some firms?

Answer 30

They are less reliable for firms with significant intangible value, such as service reputation, and may therefore be viewed as a floor value for the firm.