Fundamentals of Investing, 11e (Gitman/Joehnk/Smart)
Chapter 8 Stock Valuation
1) The primary reason an investor should look at the past performance of a company is to gain
insight into the future direction and profitability of the firm.
2) The key to the future behavior of a company lies in the sales growth and the net profit margin.
3) Companies with high P/E ratios tend to also have high dividend payout ratios.
4) Higher rates of growth and lower debt levels contribute to higher P/E ratios.
5) The price of a stock with a low relative P/E will tend to be more volatile than the price of a
stock with a high relative P/E.
6) The estimated price of a stock in the future is important because it includes the projected
capital gain on the stock.
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.
8) 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.
9) Which of the following variables affect the P/E ratio?
I. capital structure of a firm
II. amount of dividends 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
10) 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
11) 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.
12) 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.
13) List the key variables that affect the P/E ratio and explain the relationship between each
variable and the P/E ratio.
1) A relative P/E ratio greater than 1 indicates that a company may be undervalued.
2) If net income rises, but the number of shares outstanding remains the same, EPS will rise.
3) The common-size income statement expresses every item on the income statement as a
percentage of sales.
4) A temporary decline in earnings per share usually results in a temporary reduction of
dividends.
5) 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
6) 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.
7) 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.
8) Whisper numbers are
A) officially published forecast numbers provided by company management.
B) the official released estimates prepared by financial analysts.
C) generally less accurate than the released estimates by analysts.
D) generally higher than the released analysts‘ forecasts.
9) If the market multiple is 23.0 and the P/E ratio of a company is 27.4, then the stock’s relative
P/E is
A) 0.84.
B) 1.19.
C) 3.21.
D) 4.40.
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10) 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
11) The major forces behind earnings per share are
A) return on assets and book value.
B) return on assets and total asset turnover.
C) return on equity and the equity multiplier.
D) return on equity and book value.
12) GLOO stock’s P/E ratio is 45 at a time when the market’s P/E ratio is 15. GLOO’s realtive
P/E ratio is
A) 30.
B) -30.
C) 3.
D) .33.
13) 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)
14) Which one of the following is is most likely to increase the price of a stock?
A) rapid growth in sales.
B) rapid growth in dividends.
C) rapid growth in earnings.
D) rapid increases in bond interest rates.
15) 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.
16) 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
17) The common stock of Jennifer’s Furniture Outlet is currently selling at $32.60 a share. The
company adheres to a 60% dividend payout ratio and has a P/E ratio of 19. There are 21,000
shares of stock outstanding. What is the amount of the annual net income for the firm?
A) $21,619
B) $36,032
C) $48,327
D) $60,053
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8.3 Learning Goal 3
1) Risk is brought into the stock valuation process through the required rate of return.
2) As a company’s beta rises, the required return on the stock should fall, all other things being
equal.
3) There is no assurance that the actual rate of return on an asset will be similar to the projected
rate of return.
4) The greater the perceived risk of an asset, the lower the expected rate of return.
5) The required rate of return denotes the minimum rate of return an investor should expect.
6) The intrinsic value of an asset equals the present value of all future cash flows at a given
discount rate.
7) The intrinsic value of a stock provides a purchase price for the stock
A) that is reasonable given the associated level of risk.
B) which will assuredly yield the anticipated capital gain.
C) which will guarantee the expected rate of return.
D) that is always below the market value but yet yields the expected rate of return.
8) The risk-free rate of return is 4.2 percent, the expected market return is 9 percent, and the beta
for Lea, Inc. is 1.12. What is Lea’s required rate of return?
A) 9.58%
B) 10.08%
C) 13.70%
D) 14.28%
9) The risk free rate is 2%. The expected rate of return on the market is 12%. Beta and the
expected rate of return for four stocks are as follows.: ABC .8 , 10%; DEF 1, 12%; GHI 1.2 ,
13%, and JKL 2, 22%. Which of these stocks should not be purchased?
A) ABC
B) DEF
C) GHI
D) JKL
10) Which of the following are key inputs to determining the value of an asset?
I. the required rate of return
II. future cash flows
III. current stock price
IV. timing of future cash flows
A) I and II only
B) I and III only
C) I, II and IV only
D) II, III and IV only
11) Which of the following characteristics appeal to so-called value investors?
I. high P/E ratios.
II. low debt to equity ratios
III. high cash flow relative to price
IV. high book value relative to market price.
A) I and II only
B) I and III only
C) I, II and IV only
D) II, III and IV only
12) An investor should purchase a stock when
A) the market price exceeds the intrinsic value.
B) the expected rate of return equals or exceeds the required return.
C) the capital gains rate is less than the required return and no dividends are paid.
D) the market price is greater than the justified price.
13) William is the type of stock market investor who focuses on factors such as a company’s
book value, debt load, return on equity, and cash flow. In searching for stock investments, he
looks at a company’s historical performance and attempts to find undervalued stocks. This
information indicates that Sam is the type of investor known as
A) a growth investor.
B) a premium investor.
C) an earnings investor.
D) a value investor.
14) Stephanie is an investor who believes that the real key to a company’s future stock price lies
in its future earnings. When investing in a company, she carefully studies its future earnings
potential, and sells a company’s stock at the first sign of any trouble. This information indicates
that Della would correctly be classified as
A) a growth investor.
B) a value investor.
C) a buy-and-hold investor.
D) an index investor.
15) Explain how the time value of money concept is used in stock valuation.
1) Overall, professional analysts have an outstanding record of predicting changes in market
direction before they happen.
2) The approach to stock valuation which holds that the value of a share of stock is a function of
its future dividends is known as the dividend valuation model (DVM).
3) If the annual dividend on a stock never changes, its price will never change.
4) The dividend valuation model (DVM) is very sensitive to the growth rate (g) being used,
because it affects both the model’s numerator and its denominator.
5) The dividend valuation model estimates the value of a share of stock as the future value of all
dividends.
6) One of the easiest aspects of the dividend valuation model (DVM) is specifying the
appropriate growth rate for a firm’s dividends over time.
7) The intrinsic value of a zero-growth stock is simply the capitalized value of its annual
dividends.
8) One method of estimating the dividend growth rate is to calculate the discount rate that
equates today’s dividend with the dividend paid ten years ago.
9) The rate of dividend growth can be estimated by multiplying the return on equity rate by the
dividend payout ratio.
10) The rate of growth can exceed the required return during the variable-growth period without
invalidating the variable growth dividend valuation model.
11) The subjective approach to determining a required rate of return for a stock includes
I. the rate of return on a long-term bond.
II. a risk premium for the perceived business risk of the asset.
III. a risk premium for assuming the risk of the market.
IV. the desired rate of return of the individual investor.
A) I and III only
B) II and IV only
C) I, II and IV only
D) I, II and III only
12) Lindell, Inc. has 8% , $100 par value preferred stock outstanding. To earn 12% on an
investment in this stock, you need to purchase the shares at a per share price of
A) $9.60.
B) $66.67.
C) $96.00.
D) $150.00.
13) James is willing to settle for a 10% rate of return on EG stock at a time when investors, on
average, are requiring an 11% rate of return on the same stock. Which of the following will
happen?
A) James will be have to pay more for the stock than he was willing to pay.
B) Investors with different required rates of return will pay different prices for the stock.
C) James will not be able to buy the stock unless the price changes.
D) James will be happy to buy the stock for less than he was willing to pay.