Deck 10: Share Valuation: a Second Look

Question 1

Several methods should be used to provide an estimate of a share's value since no single method provides a definitive value.

Answer 1

True

Question 2

Use the table for the question(s)below.
Banco Industries expects sales to grow at a rapid rate over the next three years, but settle to an industry growth rate of 5% in year 4. The spreadsheet above shows a simplified pro forma for Banco Industries. If Banco Industries has a weighted average cost of capital of 12%, $50 million in cash, $60 million in debt, and 18 million shares outstanding, which of the following is the best estimate of Banco's share price at the start of year 1?

A)$20.11
B)$11.12
C)$12.03
D)$6.03

Answer 2

$12.03

Question 3

Bonza Corporation generated free cash flow of $80 million this year. For the next two years, the company's free cash flow is expected to grow at a rate of 7.5%. After that time, the company's free cash flow is expected to level off to the industry long-term growth rate of 3% per year. If the weighted average cost of capital is 15% and Bonza Corporation has cash of $100 million, debt of $300 million, and 100 million shares outstanding, what is Bonza Corporation's expected free cash flow in year 2?

A)$81.80
B)$92.45
C)$79.15
D)$95.04

Answer 3

$92.45

Question 4

What additional adjustments are required to find the share price, in case we are using the discounted cash flow model?

Question 5

Bonza Corporation generated free cash flow of $80 million this year. For the next two years, the company's free cash flow is expected to grow at a rate of 7.5%. After that time, the company's free cash flow is expected to level off to the industry long-term growth rate of 3% per year. If the weighted average cost of capital is 15% and Bonza Corporation has cash of $100 million, debt of $300 million, and 100 million shares outstanding, what is Bonza Corporation's expected current share price?

A)$6.42
B)$5.45
C)$3.85
D)$8.42

Question 6

Which of the following statements is FALSE?

A)If the firm has no debt, then r_wacc equals the risk-free rate of return.
B)Because the firm's free cash flow is equal to the sum of the free cash flows from the firm's current and future investments, we can interpret the firm's enterprise value as the total net present value (NPV)that the firm will earn from continuing its existing projects and initiating new ones.
C)The long-run growth rate g_FCF is typically based on the expected long-run growth rate of the firm's revenues.
D)When using the discounted free cash flow model, we forecast the firm's free cash flow up to some horizon, together with some terminal (continuation)value of the enterprise.

Question 7

The discounted free cash flow model ignores interest income and expense but adjusts for cash and debt directly.

Question 8

The Dividend-Discount Model is the simplest model to use if you want to value a firm that consistently pays out its earnings as dividends.

Question 9

Use the table for the question(s)below.
The table above shows the share prices and multiples for a number of firms in the media industry. Another media firm (not shown)had sales of $620 million, EBITDA of $84 million, excess cash of $66 million, $14 million of debt, and 120 million shares outstanding. If the average enterprise value to sales for comparable businesses is used, which of the following is the best estimate of the firm's share price?

A)$6.89
B)$6.98
C)$7.65
D)$7.41

Question 10

Which of the following is the appropriate way to calculate the price of a share of a given company using the free cash flow valuation model?

A)P₀ = [Div₁/(r_E - g)]/(Shares Outstanding₀)
B)P₀ = (V₀ + Cash₀ - Debt₀)/(Shares Outstanding₀)
C)P₀ = Div₁/(r_E - g)
D)P₀ = PV(Future Free Cash Flow of Firm)/(Shares Outstanding₀)

Question 11

On a particular date, AirCo has a share price of $77.50 and an EPS of $5.00. Its competitor, RoadCo, had an EPS of $0.80. What would be the expected share price of RoadCo on this date, if estimated using the method of comparables?

A)$12.40
B)$13.98
C)$18.39
D)$10.49

Question 12

Use the table for the question(s)below.
Banco Industries expect sales to grow at a rapid rate over the next 3 years, but settle to an industry growth rate of 5% in year 4. The spreadsheet above shows a simplified pro forma for Banco Industries. Banco Industries has a weighted average cost of capital of 12%, $50 million in cash, $60 million in debt, and 18 million shares outstanding. If Banco Industries can reduce their operating expenses so that EBIT becomes 12% of sales, by how much will their share price increase?

A)$4.98
B)$2.81
C)$8.89
D)$3.36

Question 13

Which of the following statements is FALSE?

A)The firm's weighted average cost of capital, denoted r_wacc, is the cost of capital that reflects the risk of the overall business, which is the combined risk of the firm's equity and debt.
B)When using the discounted free cash flow model, we should use the firm's equity cost of capital.
C)We interpret r_wacc as the expected return the firm must pay to investors to compensate them for the risk of holding the firm's debt and equity together.
D)Intuitively, the difference between the discounted free cash flow model and the dividend-discount
Model is that in the divided-discount model the firm's cash and debt are included indirectly through the effect of interest income and expenses on earnings in the dividend-discount model.

Question 14

Valuation multiples take into account differences in the risk and future growth between the firms being compared.

Question 15

Which of the following statements is FALSE?

A)We can interpret the enterprise value as the net cost of acquiring the firm's equity, taking its cash, and paying off all debts.
B)Free cash flow measures the cash generated by the firm after payments to debt or equity holders are considered.
C)We estimate a firm's current enterprise value by computing the present value (PV)of the firm's free cash flow.
D)The more cash the firm uses to repurchase shares, the less it has available to pay dividends.

Question 16

Use the figure for the question(s)below.
An investor estimates the value of a firm which manufactures cookware by examining the cash flows of similar firms. Which of the following is assumed to be the same for these firms?

A)payout rates
B)P/E
C)annual growth rates
D)All of the above

Question 17

If you want to value a firm but do not want to explicitly forecast its dividends, what is the simplest model for you to use?

A)the dividend-discount model
B)the enterprise value model
C)the discounted free cash flow model
D)None of the above models can be used if you do not want to forecast dividends or use of debt.

Question 18

Use the figure for the question(s)below.
On a particular date, the above information was obtained concerning Nick Scali Ltd. Its competitor, Harvey Norman Holdings Limited, had a stock price of $24.72. Which of the following is closest to the EPS of Harvey Norman Holdings Limited if it is estimated using valuation multiples based on price-earnings ratios?

A)$1.65
B)$2.67
C)$14.37
D)$1.83

Question 19

In the method of comparables, the known values of a firm's cash flows are used to estimate the unknown cash flows of a similar firm.

Question 20

Bonza Corporation generated free cash flow of $80 million this year. For the next two years, the company's free cash flow is expected to grow at a rate of 7.5%. After that time, the company's free cash flow is expected to level off to the industry long-term growth rate of 3% per year. If the weighted average cost of capital is 15% and Bonza Corporation has cash of $100 million, debt of $300 million, and 100 million shares outstanding, what is Bonza Corporation's expected terminal enterprise value in year 2?

A)$579.15
B)$441.60
C)$641.60
D)$793.53

Question 21

Aerelon Airways, a commercial airline, suffers a major crash. As a result, passengers are considered to be less likely to choose Aerelon as their carrier and it is expected free cash flows will fall by $20 million per year for five years. If Aerelon has 65 million shares outstanding, an equity cost of capital of 12%, and no debt, by how much would Aerelon's shares be expected to fall in price as a result of this accident?

A)$1.11
B)$1.28
C)$1.45
D)$0.98

Question 22

Which of the following statements is FALSE?

A)Two firms in the same industry selling the same types of products, while similar in many respects, are likely to be of different size or scale.
B)Consider the case of a new firm that is identical to an existing publicly traded company. If these firms will generate identical cash flows, the Law of One Price implies that we can use the value of the existing company to determine the value of the new firm.
C)In the method of comparables, we estimate the value of the firm based on the value of other, comparable firms or investments that we expect will generate very similar cash flows in the future.
D)A valuation multiple is a ratio of some measure of the firm's scale to the value of the firm.

Question 23

Which of the following statements is FALSE?

A)Forward earnings are the expected earnings over the coming 12 months.
B)We can estimate the value of a firm's shares by multiplying its current earnings per share by the average price-earnings ratio of comparable firms.
C)For valuation purposes, the trailing price-earnings ratio is generally preferred, since it is based on actual, not expected, earnings.
D)'Trailing earnings' are the earnings over the previous 12 months.

Question 24

Which of the following statements is FALSE?

A)Because the enterprise value represents the entire value of the firm before the firm pays its debt, to form an appropriate multiple, we divide it by a measure of earnings or cash flows after interest payments are made.
B)We can compute a firm's price-earnings ratio by using either trailing earnings or forward earnings with the resulting ratio called the trailing price-earnings or forward price-earnings.
C)Using a valuation multiple based on comparables is best viewed as a 'shortcut' to the discounted cash flow method of valuation.
D)It is common practice to use valuation multiples based on the firm's enterprise value.

Question 25

Which of the following statements is FALSE?

A)You should be willing to pay proportionally more for a share with lower current earnings.
B)The most common valuation multiple is the price-earnings ratio.
C)A firm's price-earnings ratio is equal to the share price divided by its earnings per share.
D)The intuition behind the use of the price-earnings ratio is that when you buy a share, you are in a sense buying the rights to the firm's future earnings, and differences in the scale of firms' earnings are likely to persist.

Question 26

Advanced Chemical Industries is awaiting the verdict from a court case over whether it is liable for the clean-up of wastes on a disused factory site. If it is liable, this will result in a reduction of its free cash flow by $12 million per year for 10 years. If it is not liable, there will be no effect. On the close of trading the day before the announcement of the verdict, Advanced Chemicals was trading at $20 per share. Most investors calculate that there is a 100% chance that Advanced Chemicals will have a verdict returned against them. One investor, Jo, has performed extensive research into the outcome of the trial and estimates that there is no chance Advanced Chemicals will have a verdict returned against them. Given that Advanced Chemicals has 60 million shares outstanding and an equity cost of capital of 8% with no debt, Jo's estimate of the value of a share of Advanced Chemicals would be how much more than the market price?

A)$20.46
B)$20.68
C)$1.34
D)$20.96

Question 27

On a certain date, Harvey Norman has a share price of $37.50, pays a dividend of $0.64, and has an equity cost of capital of 8%. An investor expects the dividend rate to increase by 6% per year in perpetuity. He then sells all the Harvey Norman shares that he owns. Given Harvey Norman's share price, was this a reasonable action?

A)No, since the difference between his calculated share price and the actual share price most likely indicates that his estimate of dividend growth rate was incorrect.
B)Yes, since the constant dividend growth rate gives a share price estimate greater than $37.50.
C)No, since the constant dividend growth rate gives a share price estimate of $37.50.
D)No, since the constant dividend growth rate gives a share price estimate greater than $37.50.

Question 28

In an efficient market, investors will only find positive-NPV trading opportunities if they have some form of competitive advantage over other investors.

Question 29

On a particular day, a mining company reveals that, due to new extraction technology, the extractable yield from several of its mines has risen by 15%. Which of the following is the LEAST likely consequence of such an announcement?

A)Investors would increase their forecast of future cash flows in that firm.
B)The share price would rise due to the pressure to buy.
C)Investors would revise their estimates of the net present value (NPV)of the firm.
D)Investors would determine that the estimates of the firm's value on the date prior to the announcement were too high.

Question 30

If a manager wishes to raise his firm's share price, he should do which of the following? I. Focus on maximising the present value (PV)of the free cash flow.
II. Focus on accounting earnings.
III. Focus on financial policy.

A)I only
B)II only
C)I and II
D)II and III

Question 31

Valuation models use the relationship between share value, future cash flows, and the cost of capital to estimate these quantities for a given firm. Realistically, for a publicly traded firm, what can we reliably use such models to determine? I. the firm's future cash flows
II. the firm's cost of capital
III. the firm's stock price

A)I only
B)II only
C)III only
D)I and II

Question 32

Use the table for the question(s)below.
The table above shows the share prices and multiples for a number of firms in the media industry. Another media firm (not shown)had sales of $620 million, EBITDA of $84 million, excess cash of $66 million, $14 million of debt, and 120 million shares outstanding. If the firm had an EPS of $0.48, what is the difference between the estimated share price of this firm if the average price-earnings ratio is used and the estimated share price if the average enterprise value/EBITDA ratio is used?

A)$4.94
B)$0.34
C)$0.49
D)$5.43

Question 33

Praetorian Industries will pay a dividend of $2.50 per share this year and has an equity cost of capital of 8%. Praetorian's shares are currently trading at $84 per share. By comparing Praetorian with similar firms, an investor expects that its dividends will grow by up to 5% per year. What is the best next step that the investor should take regarding Praetorian's shares?

A)Short Praetorian's shares.
B)Sell all Praetorian shares that she owns.
C)Revise Praetorian's equity cost of capital.
D)Revise her estimate of Praetorian's dividend growth.

Question 34

Use the table for the question(s)below.
The table above shows the share prices and multiples for a number of firms in the media industry. Another media firm (not shown)had sales of $620 million, EBITDA of $84 million, excess cash of $66 million, $14 million of debt, and 120 million shares outstanding. If the average enterprise value to sales for comparable businesses is used, which of the following is the range of reasonable share price estimates?

A)$1.12 to $1.68
B)$6.00 to $9.04
C)$6.07 to $8.59
D)$5.72 to $8.09

Question 35

Which of the following is the best statement of the 'efficient markets hypothesis'?

A)Investor's decisions are dependent on complete current information of a firm's cash flows and accurate predictions of future cash flows.
B)Investors with information that a share has a positive net present value (NPV)will buy it, while investors with information that a share has a negative net present value (NPV)will sell it.
C)Competition between investors works to make the net present value (NPV)of all trading opportunities zero.
D)A share's price is the aggregate of the information of many investors.

Question 36

If you value a firm using a range of share valuation methods and these valuations indicate a share price that is greater than its actual market price, it is most likely that the stock is undervalued.

Question 37

An advantage of the 'valuation multiple method' as compared to the 'discounted cash flow method' is that it takes into account important differences between different firms.

Question 38

Gooringa Oil announces that an exploratory well that it has sunk in a new area has shown the existence of substantial oil reserves. The exploitation of these reserves is expected to increase Gooringa's free cash flow by $100 million per year for eight years. If investors had not been expecting this news, what is the most likely effect on Gooringa's share price upon the announcement, given that Gooringa has 80 million shares outstanding, no debt, and an equity cost of capital of 10%?

A)rise by $6.67
B)no effect
C)rise by $8.30
D)rise by $5.78

Question 39

Use the table for the question(s)below.
The table above shows the share prices and multiples for a number of firms in the media industry. Which of the following ratios would most likely be the most reliable in determining the share price of a comparable firm?

A)P/E
B)Enterprise Value/Sales
C)Enterprise Value/EBITDA
D)Price/Book

Question 40

Which is the best valuation technique when using comparables?

Question 41

The implications of the efficient markets hypothesis for corporate managers regarding accounting earnings are that managers should not focus on accounting earnings but instead focus on maximising cash flows.

Question 42

A study of trading behaviour of individual investors at a discount brokerage found that individual investors

A)trade very actively, partly because their performance is better than the professionals' due to low trading costs.
B)trade very conservatively, partly because their performance is better than the professionals' due to low trading costs.
C)trade very conservatively, despite the fact that their performance is actually worse because of trading costs.
D)trade very actively, despite the fact that their performance is actually worse because of trading costs.

Question 43

Individual investors who grow up and live during a time of high share returns are more likely to invest in shares.

Question 44

Individual investors' tendency to trade too much based on the mistaken belief that they can pick winners and losers better than investment professionals is known as

A)the 'excessive trading costs hypothesis'.
B)the 'disposition effect'.
C)the investor 'attention hypothesis'.
D)the investor 'overconfidence hypothesis'.

Question 45

Which of the following tendencies of individual investors is called the 'disposition effect'?

A)the tendency to buy stocks that have been in the news, advertised more, have very high trading volume, or recently had extreme (high or low)returns
B)the tendency to put too much weight on their own experience rather than considering historical evidence
C)the tendency to trade too much based on the mistaken belief that they can pick winners and losers better than investment professionals
D)the tendency to hold on to stocks that have lost value and sell stocks that have risen in value since the time of purchase

Question 46

Individual investors trade conservatively, given the difficulty of finding over- and under-valued stocks.