978-0134083308 Chapter 8 Part 1

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Fundamentals of Investing, 13e (Smart)

Chapter 8 Stock Valuation

8.1 Learning Goal 1

1) The most important factors influencing a stock’s current price are its past earnings and

dividends.

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2) The key to the future financial success of a company lies in the sales growth and the net

profit margin.

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3) Companies with high P/E ratios tend to also have high dividend payout ratios.

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4) A stock’s value depends on future cash flows.

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5) A company’s estimated future earnings and its P/E ratio can be used to estimate the stock’s

future price.

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6) The estimated price of a stock in the future is important because it includes the projected

capital gain on the stock.

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7) The single most important issue in the stock valuation process is a company’s

A) past earnings record.

B) historic dividend growth rate.

C) expected future returns.

D) capital structure.

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8) Most analysts would not feel comfortable forecasting a firm’s future earnings for more than

A) the next quarter.

B) 1 to 3 years.

C) 4 or 5 years.

D) the next business cycle.

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9) The value of a stock is a function of

A) future returns.

B) historic dividend growth rate.

C) most recent earnings per share.

D) past returns.

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10) Which of the following variables affect the P/E ratio?

I. capital structure of a firm

II. amount of dividends to be paid

III. inflation rate

IV. earnings rate of growth

A) I, II and III only

B) I, II and IV only

C) I, III and IV only

D) I, II, III and IV

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11) Which of the following will affect the firm’s future cash flows?

I. state of the economy

II. state of the industry

III. the firm’s recent and current earnings

IV. new products in the firm’s pipeline

A) I, II and III only

B) I, II and IV only

C) I, III and IV only

D) I, II, III and IV

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12) Which of the following contributes to high P/E ratios?

A) high dividend payout ratios

B) high rate of earnings growth

C) periods of high inflation

D) high debt ratios

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13) High P/E ratios can be expected when investors expect

A) a high rate of growth in earnings.

B) low earnings. relative to market prices.

C) high interest rates.

D) a bear market.

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14) Which of the following will most directly influence a company’s market value?

A) the state of the economy

B) the book value of its assets

C) the use of financial leverage

D) its future cash flows

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15) List the key variables that affect the P/E ratio and explain the relationship between each

variable and the P/E ratio.

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8.2 Learning Goal 2

1) The first step in predicting a stock’s future price is to forecast profits.

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2) If net income rises, but the number of shares outstanding remains the same, EPS will rise.

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3) The common-size income statement expresses every item on the income statement as a

percentage of sales.

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4) A temporary decline in earnings per share usually results in a temporary reduction of

dividends.

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5) A decline in earnings that investors expect to be temporary may actually increase a firm’s

P/E ratio.

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6) The sales forecast depends on factors both internal and external to the firm.

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7) The Merry Co. has current annual sales of $350,000 and a net profit margin of 6%. Sales are

expected to increase by 5% annually while the profit margin is expected to remain constant.

What is the projected after-tax earnings for two years from now?

A) $19,294

B) $22,050

C) $23,100

D) $23,153

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8) P/E ratios could rise even as earnings fall if

A) earnings fall at a faster rate than stock prices.

B) earnings fall at a slower rate than stock prices.

C) investors expect lower stock prices to be permanent.

D) investors expect lower earnings to be permanent.

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9) Even if a company does not officially follow a fixed-dividend policy, dividend payments are

A) extremely difficult to predict.

B) very volatile and subject to economic conditions.

C) fairly stable from one time period to another.

D) directly tied to a company‘s P/E ratio.

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10) Columbus Co.’s sales revenue for the most recent quarter was $2.5 million and cost of

goods sold was $1.5 million. If sales grow by 15% in the next quarter and all ratios remain the

same, gross profit will be

A) $2.25 million.

B) $1.725 million.

C) $1.15 million.

D) $1.375 million.

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11) If the market multiple is 20.24 and the P/E ratio of a company is 24.5, then the stock’s

relative P/E is

A) 0.83.

B) 1.19.

C) 1.21.

D) 4.26.

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12) The current annual sales of Flower Bud, Inc. are $178,000. Sales are expected to increase

by 4% next year. The company has a net profit margin of 5% which is expected to remain

constant for the next couple of years. There are 10,000 shares of common stock outstanding.

The market multiple is 16.4 and the relative P/E of the firm is 1.21. What is the expected

market price per share of common stock for next year?

A) $15.18

B) $17.66

C) $18.37

D) $19.29

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13) The major forces behind earnings per share are

A) return on assets and total asset value.

B) gross revenue and the stock price.

C) growth and the number of shares outstanding.

D) net income and the number of shares outstanding.

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14) GLOO stock’s P/E ratio is 45 at a time when the market’s P/E ratio is 15. GLOO’s relative

P/E ratio is

A) 30.

B) -30.

C) 3.

D) .33.

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15) Which one of the following is a correct equation to calculate earnings per share?

A) (ROA)(book value per share)

B) (profit margin)(total asset turnover)(equity multiplier)(book value per share)

C) (profit margin)(equity multiplier)(book value per share)

D) (profit margin)(book value per share)

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16) Which one of the following is is most likely to increase the price of a stock?

A) rapid growth in sales

B) rapid decrease in the company’s debt levels

C) rapid growth in earnings

D) rapid increases in bond interest rates

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17) Global Warning’s EPS for the current year is $2.75 and its current P/E ratio is 50. You

have forecasted that EPS will grow by 10% but the P/E ratio will fall to 40. What do you

expect the price of a share of GW’s stock to be at the end of next year?

A) $110

B) $121

C) $137.50

D) $151.25

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18) Over the last year, a firm’s earnings per share increased from $1.20 to $1.40, its dividends

per share increased from $0.50 to $0.60, and its share price increased from $21 to $24. The firm

maintained a relative P/E of 1.10 over the entire time period. Given this information, it follows

that the

A) stock experienced an increase in its P/E ratio.

B) company had a decrease in its dividend payout ratio.

C) current P/E of the overall market is 26.4.

D) overall market P/E is declining.

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19) Which of the following will lead to an increase in earnings per share?

A) an increase in the P/E ratio.

B) an increase in the dividend payout ratio.

C) an increase in return on equity if book value per share stays the same.

D) a decrease in the number of shares if return on equity stays the same.

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20) Markhem Enterprises is expected to earn $1.34 per share this year. The company has a

dividend payout ratio of 40% and a P/E ratio of 18. What should one share of common stock in

Markhem Enterprises be selling for in the market?

A) $9.65

B) $14.47

C) $24.12

D) $33.77

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21) The common stock of Rob’s Discount Furniture is currently selling at $65.20 a share. The

company adheres to a 60% dividend payout ratio and has a P/E ratio of 19. There are 42,000

shares of stock outstanding. What is the amount of the annual net income for the firm?

A) $42,338

B) $36,032

C) $144,126

D) $72,064

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8.3 Learning Goal 3

1) The efficient market hypothesis holds that a stock’s intrinsic value and market value are

essentially the same.

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2) A stock will be an attractive investment if the required rate of return exceeds the expected

rate of return.

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3) There is no assurance that the actual rate of return on an asset will be similar to the projected

rate of return.

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4) The greater the perceived risk of an asset, the lower the expected rate of return.

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