Chapter 07 Valuing Stocks

Chapter 006 - Valuing Stocks

True / False Questions

1.The term "irrational exuberance" was coined by Fed Chairman Greenspan to describe the dot.com boom.
TRUE

2.The New York Stock Exchange (NYSE) is an example of an auction market.
TRUE

3.An excess of market value over the book value of equity can be attributed to going concern value.
TRUE

4.Securities with the same expected risk should offer the same expected rate of return.
TRUE

5.If investors believe a company will have the opportunity to make very profitable investments in the future, they will pay more for the company's stock today.
TRUE

6.The dividend discount model should not be used to value stocks in which the dividend does not grow.
FALSE

7.Nasdaq operates a dealer market, in which a dealer acts as the auctioneer.
FALSE

8.Google's stock price tripling after the IPO suggests that valuing growth stocks is an exact science.
FALSE

9.The liquidation value of a firm is equal to the book value of the firm.
FALSE

10.Sustainable growth rates can be estimated by multiplying a firm's ROE by its dividend payout ratio.
FALSE

11.A "round lot" on the stock exchange signifies 100 shares of common stock.
TRUE

12.According to the dividend discount model, a stock's price today depends on the investor's horizon for holding the stock.
FALSE

13.If the market is efficient, stock prices should only be expected to react to new information that is released.
TRUE

14.The intent of technical analysis is to discover patterns in past stock prices.
TRUE

15.Technical analysts have no effect upon the efficiency of the stock market.
FALSE

16.Technical analysts would be more likely than other investors to index their portfolios.
FALSE

17.Market efficiency implies that security prices impound new information quickly.
TRUE

18.One of the quickest ways to profit in the stock market is to own stocks that split.
FALSE

19.If security prices follow a random walk, then on any particular day, the odds are that an increase or decrease in price is equally likely.
TRUE

20.Fundamental analysts attempt to get rich by identifying patterns in stock prices.
FALSE

21.Strong-form market efficiency implies that one could earn above average returns by examining the history of a firm's stock price.
FALSE

22.Market price is not the same as book value or liquidation value.
TRUE

23.Market value, unlike book value and liquidation value, treats the firm as a going concern.
TRUE

24.The dividend yield of a stock is much like the current yield of a bond. Both ignore prospective capital gains or losses.
TRUE

25.At each point in time all securities of the same risk are priced to offer the same expected rate of return.
TRUE

26.The dividend discount model states that today's stock price equals the present value of all expected future dividends.
TRUE

AACSB: Communication Abilities
Bloom's: Knowledge
Difficulty: Easy
Learning Objective: 07-02 Calculate the present value of a stock given forecasts of future dividends and future stock price.
27.The dividend discount model indicate that the value of a stock is the present value of the dividends it will pay over the investor's horizon plus the present value of the expected stock price at the end of that horizon.
TRUE

28.Investors known as fundamental analysts try to achieve superior returns by spotting and exploiting patterns in stock prices.
FALSE

29.If the stock prices follow a random walk, successive stock prices are not related.
FALSE

30.If the stock prices follow a random walk, successive stock price changes are not related.
TRUE

31.If the stock prices follow a random walk, successive stock prices fluctuate above and below a normal long-run price.
FALSE

32.If the stock prices follow a random walk, the history of stock prices cannot be used to predict future returns to investors.
TRUE

Multiple Choice Questions

33.If stock prices follow a random walk, which of the following statement(s) is(are) correct?
A.Successive stock price changes are not related.
B.The history of stock prices cannot be used to predict future returns to investors.
C.Both A and B.
D.Neither A nor B.

34.In the calculation of rates of return on common stock, dividends are ______and capital gains are _____.
A.guaranteed; not guaranteed
B.guaranteed; guaranteed
C.not guaranteed; not guaranteed
D.not guaranteed; guaranteed

35.What dividend yield would be reported in the financial press for a stock that currently pays a $1 dividend per quarter and the most recent stock price was $40?
A.2.5%
B.4.0%
C.10.0%
D.15.0%

$1 dividend per quarter = $4 annually.
$4/$40 = 10% dividend yield.

36.Which of the following values treats the firm as a going concern?
A.market value
B.book value
C.liquidation value
D.none of the above.

37.If a stock's P/E ratio is 13.5 at a time when earnings are $3 per year, what is the stock's current price?
A.$4.50
B.$18.00
C.$22.22
D.$40.50

P/E = 13.5X
Then P = 13.5 x $3
Price = $40.50

38.How many round lots were traded in a specific stock on a day in which 467,800 shares changed hands?
A.467.8 round lots
B.4,678 round lots
C.467,800 round lots
D.Price must be known to determine round lots.

39.The book value of a firm's equity is determined by:
A.multiplying share price by shares outstanding.
B.multiplying share price at issue by shares outstanding.
C.the difference between book values of assets and liabilities.
D.the difference between market values of assets and liabilities.

40.What is the current price of a share of stock for a firm with $5 million in balance-sheet equity, 500,000 shares of stock outstanding, and a price/book value ratio of 4?
A.$2.50
B.$10.00
C.$20.00
D.$40.00

book value per share = $5,000,000/500,000 = $10
If price/book value = 4
then price = $10 x 4 = $40

41.If the liquidation value of a firm is negative, then:
A.the firm's debt exceeds the market value of assets.
B.the firm's debt exceeds the book value of equity.
C.the book value of assets exceeds the firm's debt.
D.the market value of assets exceeds the firm's debt.

42.A firm's liquidation value is the amount:
A.necessary to repurchase all shares of common stock.
B.realized from selling all assets and paying off its creditors.
C.a purchaser would pay for the firm in bankruptcy.
D.equal to the book value of equity.

43.Which of the following is least likely to account for an excess of market value over book value of equity?
A.Inaccurate depreciation methods.
B.High rate of return on assets.
C.The presence of growth opportunities.
D.Valuable off-balance sheet assets.

44.Firms with valuable intangible assets are more likely to show a(n):
A.excess of book value over market value of equity.
B.high going-concern value.
C.low liquidation value.
D.low P/E ratio.

45.Which of the following is inconsistent with a firm that sells for very near book value?
A.Low current earning power
B.No intangible assets
C.High future earning power
D.Low, unstable dividend payment

46.The main purpose of a market-value balance sheet is to:
A.show an inflated value of the firm.
B.avoid the recording of certain liabilities.
C.value assets and liabilities without GAAP restrictions.
D.improve the credit rating of the firm.

47.A stock paying $5 in annual dividends sells now for $80 and has an expected return of 14%. What might investors expect to pay for the stock one year from now?
A.$82.20
B.$86.20
C.$87.20
D.$91.20

Expected return =
14% =
$11.20 = P1 - $75
$86.20 = P1

48.Which of the following statements is correct about a stock currently selling for $50 per share that has a 16% expected return and a 10% expected capital appreciation?
A.Its expected dividend exceeds the actual dividend.
B.Its expected return will exceed the actual return.
C.It is expected to pay $3 in annual dividends.
D.It is expected to pay $8 in annual dividends.

Expected return = expected dividend yield + expected capital appreciation.
16% = expected dividend yield + 10%
6% = expected dividend yield
$50 share price x 6% = $3 expected dividend payment

49.The expected return on a common stock is composed of:
A.dividend yield.
B.capital appreciation.
C.both dividend yield and capital appreciation.
D.capital appreciation minus the dividend yield.

50.Firms having a higher expected return have a higher:
A.level of expected risk.
B.dividend yield.
C.market value of equity.
D.degree of certainty concerning their returns.

51.How much should you pay for a share of stock that offers a constant growth rate of 10%, requires a 16% rate of return, and is expected to sell for $50 one year from now?
A.$42.00
B.$45.00
C.$45.45
D.$47.00

The easiest way to solve this problem is to realize:
Expected return = expected dividend yield
+ expected capital appreciation
Then:
.16 = .06 + expected capital appreciation
.10 = expected capital appreciation
And
P1 = 110% of Po
$50.00 = 1.1Po
$45.45 = Po

52.According to the dividend discount model, the current value of a stock is equal to the:
A.present value of all expected future dividends.
B.sum of all future expected dividends.
C.next expected dividend, discounted to the present.
D.discounted value of all dividends growing at a constant rate.

53.How is it possible to ignore cash dividends that occur far into the future when using a dividend discount model? Those dividends:
A.will be paid to a different investor.
B.will not be paid by the firm.
C.have an insignificant present value.
D.ignore the tax consequences of future dividends.

54.If the dividend yield for year one is expected to be 5% based on the current price of $25, what will the year four dividend be if dividends grow at a constant 6%?
A.$1.33
B.$1.49
C.$1.58
D.$1.67

.05 x 25 = 1.25 = Div1
then, D4 = 1.25 x (1.06)3 = $1.49

7-1