Deck 10: Stock Valuation: a Second Look

Question 1

Use the table for the question(s) below. FCF Forecast ($ million)
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 11%, $40 million in cash, $70 million in debt, and 18 million shares outstanding. If Banco Industries can reduce its operating expenses so that EBIT becomes 12% of sales, by how much will its stock price increase?

A) $3.27
B) $3.92
C) $5.72
D) $9.80

Answer 1

$3.27

Question 2

Which of the following statements is FALSE?

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

Answer 2

When using the discounted free cash flow model, we should use a firm's equity cost of capital.

Question 3

Gonzales Corporation generated free cash flow of $88 million this year. For the next two years, the company's free cash flow is expected to grow at a rate of 10%. After that time, the company's free cash flow is expected to level off to the industry long-term growth rate of 4% per year. If the weighted average cost of capital is 12% and Gonzales Corporation has cash of $100 million, debt of $300 million, and 100 million shares outstanding, what is Gonzales Corporation's expected terminal enterprise value in year 2?

A) $1384.24
B) $1245.82
C) $1107.39
D) $968.97

Answer 3

$1384.24

Question 4

On a particular date, FedEx has a stock price of $89.27 and an EPS of $7.11. Its competitor, UPS, had an EPS of $0.38. What would be the expected price of UPS stock on this date, if estimated using the method of comparables?

A) $4.77
B) $7.16
C) $9.54
D) $10.50

Question 5

Use the figure for the question(s) below:
On a particular date, the above information concerning Office Depot, Incorporated, was given on Google Finance. Its competitor, Staples Incorporated, had a stock price of $24.33. Which of the following is closest to the EPS of Staples Incorporated if it is estimated using valuation multiples based on price-earnings ratios?

A) $1.58
B) $1.84
C) $2.63
D) $14.15

Question 6

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

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

Question 7

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 8

If you want to value a firm that consistently pays out its earnings as dividends, the simplest model for you to use is the ________.

A) enterprise value model
B) method of comparables
C) dividend-discount model
D) discounted free cash flow model

Question 9

Use the table for the question(s) below.

The table above shows the stock prices and multiples for a number of firms in the newspaper publishing industry. Another newspaper publishing firm (not shown) had sales of $600 million, EBITDA of $84 million, excess cash of $68 million, $18 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) $6.45
B) $7.20
C) $7.17
D) $7.53

Question 10

Which of the following statements concerning the valuation of firms using the method of comparables is FALSE?

A) If two different firms generate identical cash flows, the Law of One Price will imply that both firms have the same value.
B) Comparables adjust for scale differences when valuing similar firms.
C) Valuation multiples take into account differences in the risk and future growth between the firms being compared.
D) Two firms that sell very similar products or offer very similar services will have different values if they are of different sizes.

Question 11

Which of the following statements is FALSE?

A) The long-run growth rate g_FCF is typically based on the expected long-run growth rate of a firm's revenues.
B) Since a 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) If a firm has no debt, then r_wacc equals the risk-free rate of return.
D) When using the discounted free cash flow model, we forecast a firm's free cash flow up to some horizon, together with some terminal (continuation) value of the enterprise.

Question 12

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

Question 13

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

Question 14

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

Question 15

Use the table for the question(s) below. FCF Forecast ($ million)
Banco Industries expect 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 11%, $50 million in cash, $80 million in debt, and 18 million shares outstanding, which of the following is the best estimate of Banco's stock price at the start of year 1?

A) $6.52
B) $11.74
C) $13.04
D) $23.48

Question 16

The discounted free cash flow model ignores interest income and expense but adjusts for cash and debt directly, if free cash flow is calculated based on EBIT.

Question 17

Which of the following statements is FALSE?

A) The more cash a firm uses to repurchase shares, the less it has available to pay dividends.
B) Free cash flow measures the cash generated by a 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) We can interpret the enterprise value of a firm as the net cost of acquiring the firm's equity, taking its cash, and paying off all debts.

Question 18

Gonzales Corporation generated free cash flow of $86 million this year. For the next two years, the company's free cash flow is expected to grow at a rate of 10%. After that time, the company's free cash flow is expected to level off to the industry long-term growth rate of 4% per year. If the weighted average cost of capital is 11% and Gonzales Corporation has cash of $100 million, debt of $275 million, and 100 million shares outstanding, what is Gonzales Corporation's expected current share price?

A) $14.37
B) $11.87
C) $12.49
D) $16.24

Question 19

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

Question 20

Gonzales Corporation generated free cash flow of $81 million this year. For the next two years, the company's free cash flow is expected to grow at a rate of 9%. After that time, the company's free cash flow is expected to level off to the industry long-term growth rate of 4% per year. If the weighted average cost of capital is 11% and Gonzales Corporation has cash of $100 million, debt of $300 million, and 100 million shares outstanding, what is Gonzales Corporation's expected free cash flow in year 2?

A) $1429.79 million
B) $86.61 million
C) $1572.77 million
D) $96.24 million

Question 21

On a certain date, Kastbro has a stock price of $42.50, 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 stocks that he owns in Kastbro. Given Kastbro's share price, was this a reasonable action?

A) No, since the constant dividend growth rate gives a stock estimate of $42.50.
B) No, since the constant dividend growth rate gives a stock estimate greater than $42.50.
C) Yes, since the constant dividend growth rate gives a stock estimate greater than $42.50.
D) No, since the difference between his calculated stock price and the actual stock price most likely indicates that his estimate of dividend growth rate was incorrect.

Question 22

Which is the best valuation technique when using comparables?

Question 23

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

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

Question 24

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 $11 million per year for ten 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 40 million shares outstanding and an equity cost of capital of 6% 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) $2.02
B) $20.81
C) $21.01
D) $21.62

Question 25

Use the table for the question(s) below.

The table above shows the stock prices and multiples for a number of firms in the newspaper publishing industry. Another newspaper publishing firm (not shown) had sales of $620 million, EBITDA of $81 million, excess cash of $62 million, $11 million of debt, and 120 million shares outstanding. If the firm had an EPS of $0.41, 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) -$0.08
B) -$0.13
C) -$1.27
D) -$1.39

Question 26

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

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

Question 27

Which of the following should be done by a manager wishing to raise his stock's price? I. Focus on maximizing the present value (PV) of the free cash flow.

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

Question 28

Which of the following statements is FALSE?

A) The most common valuation multiple is the price-earnings ratio.
B) You should be willing to pay proportionally more for a stock with lower current earnings.
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 stock, 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 29

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

A) Investors with information that a stock had a positive net present value (NPV) will buy it, while investors with information that a stock had a negative net present value (NPV) will sell it.
B) Investor's decisions are dependent on complete current information of a firm's cash flows and accurate predictions of future cash flows.
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 30

Praetorian Industries will pay a dividend of $2.50 per share this year and has an equity cost of capital of 8%. Praetorian's stock is 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 stock?

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

Question 31

Which of the following is NOT an advantage of the valuation multiple method as compared to the discounted cash flow method?

A) calculations based upon widely available information
B) based upon actual stock prices of real firms
C) does not rely on estimates of future cash flows
D) takes into account important differences between different firms

Question 32

Carbondale Oil announces that a well that it has sunk in a new oil province has shown the existence of substantial oil reserves. The exploitation of these reserves is expected to increase Carbondale'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 Carbondale's stock price upon the announcement, given that Carbondale has 80 million shares outstanding, no debt, and an equity cost of capital of 11%?

A) no effect
B) rise by $5.15
C) rise by $6.43
D) rise by $7.72

Question 33

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 $15million per year for five years. If Aerelon has 55 million shares outstanding, an equity cost of capital of 10%, and no debt, by how much would Aerelon's shares be expected to fall in price as a result of this accident?

A) $0.93
B) $1.03
C) $1.14
D) $1.34

Question 34

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

Question 35

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

Question 36

Which of the following statements is FALSE?

A) 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.
B) For valuation purposes, the trailing price-earnings ratio is generally preferred, since it is based on actual not expected earnings.
C) Forward earnings are the expected earnings over the coming 12 months.
D) Trailing earnings are the earnings over the previous 12 months.

Question 37

Use the table for the question(s) below.

The table above shows the stock prices and multiples for a number of firms in the newspaper publishing industry. Which of the following ratios would most likely be the most reliable in determining the stock price of a comparable firm?

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

Question 38

Use the table for the question(s) below.

The table above shows the stock prices and multiples for a number of firms in the newspaper publishing industry. Another newspaper publishing firm (not shown) had sales of $640 million, EBITDA of $84 million, excess cash of $67 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) $6.27 to $8.86
B) $4.59 to $12.23
C) $1.15 to $1.53
D) $6.19 to $9.32

Question 39

Which of the following statements is FALSE?

A) As the enterprise value represents the entire value of a 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) It is common practice to use valuation multiples based on a firm's enterprise value.
D) Using a valuation multiple based on comparables is best viewed as a "shortcut" to the discounted cash flow method of valuation.

Question 40

Which of the following statements is FALSE?

A) Even 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) In the method of comparables, we estimate the value of a firm based on the value of other, comparable firms or investments that we expect will generate very similar cash flows in the future.
C) 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.
D) A valuation multiple is a ratio of some measure of a firm's scale to the value of the firm.

Question 41

What are the implications of the efficient markets hypothesis for corporate managers regarding accounting earnings?

Question 42

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

Question 43

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

Question 44

Disposition effect is the tendency of individual investors to ________.

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

Question 45

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

Question 46

A study of trading behavior of individual investors at a discount brokerage found that individual investors ________.

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