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Chapter: Chapter 04: The Alchemy of Stock Market Performance
Multiple Choice
1. Which of the following represents the minimum horizon where the focus of managers on
improving total returns to shareholders (TRS) to win performance bonuses will align their
interests and the interests of their shareholders?
a) 3–5 years.
b) 6–9 years.
c) 10–15 years.
d) 16–20 years.
2. Total returns to shareholders (TRS) equal dividends plus share repurchases.
3. Which of the following are potential reasons why TRS over short periods of time may not
reflect the actual performance of a company and its management?
I. A well-performing company may not deliver a high TRS if the expectations include
knowledge of the performance.
II. When TRS is analyzed in its traditional way, it does not show the degree to which
improvements in operations produced or increased the TRS.
III. Outside factors such as changing interest rates can affect TRS and be unrelated to the
firm’s operations.
IV. TRS is difficult to calculate for short periods of time.
a) II and IV.
b) I and II.
c) II and III.
d) I, II, and III.
4. Which of the following are frequently observed detrimental activities of managers on the
“expectations treadmill”?
I. Increasing leverage.
II. Decreasing the weighted average cost of capital (WACC).
III. Pursuing risky major acquisitions.
IV. Pursuing unrealistic earnings growth.
a) I and II only.
b) I, III, and IV only.
c) II and IV only.
d) II, III, and IV only.
5. The expectations treadmill is the dynamic behind the adage that a good company and a
good investment may not be the same.
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6. The expectations treadmill refers to the fact that recent growth builds expectations of
future growth.
7. The expectations treadmill can be detrimental to total returns to shareholders (TRS) if the
managers grow the company without keeping the ROIC above the cost of capital or if they
make unnecessary acquisitions that do not create value.
8. Which of the following is NOT one of the three components in the traditional approach’s
three-component breakdown of total returns to shareholders?
a) Percent change in cash flow.
b) Percent change in earnings.
c) Percent change in P/E.
d) Percent change in dividend yield.
9. Which of the following are problems with expressing total returns to shareholders (TRS)
in the traditional three-component format?
I. It does not distinguish the source of earnings growth.
II. It excludes return from moves in the overall market.
III. It does not account for the impact of financial leverage.
IV. It does not recognize that dividend yield can affect future earnings.
a) I and II only.
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b) I, III, and IV only.
c) II, III, and IV only.
d) III and IV only.
10. The traditional approach to analyzing TRS treats the key components as if they were
independent of each other, and this does not link TRS to the true underlying sources of
value creation.
11. List and describe the four-part decomposition of TRS that gives a clearer insight into how
much of the measure derives from changes in operational performance.
Ans: [1. The value generated from revenue growth net of the capital required to grow,
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True/False
12. Company Y can outperform Company Z on all key value drivers (e.g., growth and ROIC)
but still deliver lower total returns to shareholders (TRS).
13. Given that TRS is not a clear measure of management performance, which of the
following metrics should be used to gauge a company’s performance?
a) ROIC and growth.
b) ROIC, growth, and TRS performance relative to peers.
c) EPS and TRS.
d) None of the above.
Use the following financials for the next question.
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14. The enhanced TRS from performance is closest to:
a) –4.4 percent.
b) 3.1 percent.
c) 4.4 percent.
d) 8.4 percent.
]
Use the following financials to answer the next question.
15. Total returns to shareholders is closest to:
a) 8.0 percent.
b) 9.5 percent.
c) 11.1 percent.
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d) 15.5 percent.
Use the following financials to answer Questions 16 through 19.
$ million
Base year
1 year later
Invested capital
$200.0
$214.0
Earnings
$25.0
$26.8
P/E
10
10.3
Equity value
$250.0
$275.0
Dividends
$10.0
$11.0
16. What is the TRS from performance?
a) –2.0 percent.
b) 0.0 percent.
c) 1.4 percent.
d) 7.0 percent.
17. What is the dividend yield?
a) 2.0 percent.
b) 4.4 percent.
c) 5.0 percent.
d) 7.0 percent.
18. What is the zero-growth return?
a) 10.0 percent.
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b) 14.4 percent.
c) 3.0 percent.
d) 7.0 percent.
19. What is the TRS?
a) 7.0 percent.
b) 3.0 percent.
c) 4.4 percent.
d) 14.4 percent.
Use this information to answer the following three questions.
Suppose that on January 1, 2014, you bought 100 shares of M.Co for $100 per share with
the expectation of receiving a perpetual dividend of $10 per share. On January 1, 2015,
M.Co announces that it will increase its annual dividend to $20 per share. Upon
announcement, the stock price rises to $200.
20. What was the expected return on the investment as on January 1, 2014?
a) 110 percent.
b) 10 percent.
c) 20 percent.
21. If you sold the shares on January 1, 2015, what would be your return?
a) 110 percent.
b) 10 percent.
c) 20 percent.
22. If an investor bought 100 shares of M. Co on January 1, 2015, what will be the expected
return?
a) 110 percent.
b) 10 percent.
c) 20 percent.
True/False
23. An effective compensation system of a company should focus on period to period
changes in TRS performance rather than TRS relative to peers in the industry.