Chapter 08 – Equity Valuation
1. A fair investment is one that gives us a return that is greater than the risk.
a.
True
b.
False
2. An overvalued investment is so expensive that we will not receive a fair return if we bought it.
a.
True
b.
False
3. An undervalued investment is so expensive that we will not receive a fair return if we bought it.
a.
True
b.
False
4. Fundamentalists typically use the “Bottom-Up Approach”, whereas technicians use the “Top-Down Approach” to the
valuation process.
a.
True
Chapter 08 – Equity Valuation
b.
False
5. Those who employ the bottom-up approach start their search immediately at the company level.
a.
True
b.
False
6. Given an optimistic economic and stock-market outlook for a country, the investor should underweight the allocation to
this country in his/her portfolio.
a.
True
b.
False
7. Within a specific market, the top-down analyst then searches for the best industries.
a.
True
b.
False
8. The importance of an industry’s performance on an individual stock’s performance varies across industries.
a.
True
b.
False
9. If the estimated value of an asset is greater than the market price, you would want to buy the investment.
a.
True
b.
False
10. If the intrinsic value of an asset is greater than the market price, you would want to buy the investment.
a.
True
b.
False
11. The three-step valuation process consists of (1) analysis of alternative economies and markets, (2) analysis of
alternative industries, and (3) analysis of industry influences.
a.
True
b.
False
12. The two components that are required in order to carry out asset valuation are (1) the stream of expected cash flows
and (2) the required rate of return.
a.
True
b.
False
13. Growth companies are those firms that consistently earn higher rates of return by assuming greater amounts of risk.
a.
True
b.
False
14. Discounted cash flow techniques for equity valuation may use one of the following: (1) dividends, (2) free cash flow,
or (3) coupons.
a.
True
b.
False
15. The real risk-free rate depends on the real growth in the economy and can be affected for short time periods by
temporary tightness or ease in the capital markets.
a.
True
b.
False
16. The dividend growth models are only meaningful for companies that have a required rate of return that exceeds their
dividend growth rate.
a.
True
b.
False
17. In dividend discount models (DDM) with supernormal growth, supernormal growth may continue indefinitely.
a.
True
b.
False
18. An equity investor’s required rate of return is influenced by the economy’s real risk-free rate, the expected rate of
inflation, and a risk premium.
a.
True
b.
False
19. The required rate of return is determined by (1) the real risk-free rate, (2) the expected rate of inflation, and (3)
liquidity risk.
a.
True
b.
False
20. The growth rate in equity without any external financing is determined by multiplying the payout ratio by the return
on equity (ROE).
a.
True
b.
False
21. The dividend discount model (DDM) can be used to value preferred stock by simply using a growth rate of zero in the
DDM model.
a.
True
b.
False
22. The infinite period dividend discount model (DDM) can be used to value a supernormal growth company.
a.
True
b.
False
23. An example of a relative valuation technique is the Price/Cash Flow ratio.
a.
True
b.
False
24. A relative valuation technique is appropriate to consider when you have a good set of comparable entities.
a.
True
b.
False
25. The growth rate of dividends and profit margin are the main determinants of the P/E ratio.
a.
True
b.
False
26. As an analyst performs ratio analysis, he hopes to determine whether earnings represent cash flows and whether those
cash flows will recur.
Chapter 08 – Equity Valuation
a.
True
b.
False
27. The gross margin is defined as Gross Profit/Sales.
a.
True
b.
False
28. Operating margins are defined as Operating Profit/Sales
a.
True
b.
False
29. Management may “under–reserve” in order to meet earnings expectations, or they may “over–reserve” in order to
smooth future earnings.
a.
True
b.
False
30. Quality financial statements are a good reflection of reality; accounting tricks and one-time changes are not used to
make the firm appear stronger than it really is.
a.
True
b.
False
31. Many analysts recommend that you should read an annual report forwards, that is, you would read the footnotes last.
a.
True
b.
False
32. Which of the following is NOT a consideration in the three-step valuation process?
a.
analysis of alternative economies
b.
analysis of security markets
c.
analysis of alternative industries
d.
analysis of individual companies
e.
All of these are considerations in the three-step valuation process.
33. Which of the following is NOT considered a basic economic force?
a.
fiscal policy
b.
monetary policy
c.
inflation
d.
P/E ratio
e.
All of these are basic economic forces.
34. The process of fundamental valuation requires estimates of all the following factors, EXCEPT for the
a.
time pattern of returns.
b.
economy’s real risk-free rate.
c.
risk premium for the asset.
d.
times series of stock prices.
e.
expected rate of inflation.
35. Which of the following is correct?
a.
if estimated value > Market price, you should buy.
b.
if estimated value > Market price, you should sell.
Chapter 08 – Equity Valuation
c.
if estimated value < Market price, you should do nothing.
d.
if estimated value < Market price, you should buy.
e.
if estimated value > Market price, you should do nothing.
36. Which securities can be valued by dividing the annual dividend by the required rate of return?
a.
low coupon bonds
b.
junk bonds
c.
common stocks
d.
preferred stocks
e.
constant growth common stocks
37. The most appropriate discount rate to use when applying the Operating Free Cash Flows model is the firm’s
a.
required rate of return based on the capital asset pricing model (CAPM).
b.
required rate of return based on the dividend discount model (DDM).
c.
weighted average cost of capital (WACC).
d.
historical cost of debt and equity.
e.
All of these are correct.
38. According to the dividend growth model, if a company were to declare that it would never pay dividends, its value
would be
a.
based on earnings.
b.
based on expectations regarding.
c.
higher than similar firms because it could reinvest a greater amount in new projects.
d.
zero.
e.
based on the capital asset pricing model.
39. Growth rates of the (1) labor force, (2) average number of hours worked, and (3) labor productivity are the main
determinants of a foreign country’s
a.
dividend payout ratio.
b.
beta.
c.
real risk free rate.
d.
nominal risk free rate.
e.
risk premium.
40. The growth rate of equity earnings without external financing is equal to
a.
retention rate plus return on equity.
b.
retention rate minus return on equity.
c.
retention rate divided by return on equity.
Chapter 08 – Equity Valuation
d.
retention rate times return on equity.
e.
return on equity divided by retention rate.
41. In 2018, Montpelier Inc. issued a $100 par value preferred stock that pays a 9 percent annual dividend. Due to changes
in the overall economy and in the company’s financial condition, investors are now requiring a 10 percent return. What
price would you be willing to pay for a share of the preferred if you receive your first dividend one year from now?
a.
$100
b.
$110
c.
$75
d.
$90
e.
$85
42. In 2018, Smiths Corp. issued a $50 par value preferred stock that pays a 6 percent annual dividend. Due to changes in
the overall economy and in the company’s financial condition, investors are now requiring a 7 percent return. What price
would you be willing to pay for a share of the preferred if you receive your first dividend one year from now?
a.
$42.86
b.
$30.00
c.
$31.54
d.
$33.38
e.
$38.37
43. In 2018, Venus Fly Co. issued a $75 par value preferred stock that pays a 7 percent annual dividend. Due to changes
in the overall economy and in the company’s financial condition investors are now requiring a 5 percent return. What price
would you be willing to pay for a share of the preferred if you receive your first dividend one year from now?
a.
$125
b.
$84
c.
$91
d.
$145
e.
$105
44. In 2018, Swisten Inc. issued a $150 par value preferred stock that pays an 8 percent annual dividend. Due to changes
in the overall economy and in the company’s financial condition, investors are now requiring a 15 percent return. What
price would you be willing to pay for a share of the preferred if you receive your first dividend one year from now?
a.
$80
b.
$75
c.
$59
d.
$95
e.
$110
45. Using the constant growth model, a decrease in the required rate of return from 15 to 13 percent combined with an
increase in the growth rate from 5 to 6 percent would cause the price to
Chapter 08 – Equity Valuation
a.
rise more than 50 percent.
b.
rise less than 50 percent.
c.
remain constant.
d.
fall more than 50 percent.
e.
fall less than 50 percent.
46. Using the constant growth model, an increase in the required rate of return from 19 to 17 percent combined with an
increase in the growth rate from 11 to 9 percent would cause the price to
a.
fall more than 2 percent.
b.
fall less than 2 percent.
c.
remain constant.
d.
rise more than 2 percent.
e.
rise less than 3 percent.
47. Using the constant growth model, an increase in the required rate of return from 14 to 15 percent combined with an
increase in the growth rate from 6 to 7 percent would cause the price to
a.
rise more than 1%.
b.
rise less than 1%.
c.
remain constant.
d.
fall more than 1%.
e.
fall less than 1%.