The Iowa Electronic Markets
Stock Valuation
Curriculum using the IEM
Prepared for the Spring 2001 IEM*IDEA/NSF Conference
By:
Dr. Roger Ignatius
Associate Professor of Finance
Husson College
Dr. Thomas A. Rietz
Associate Professor of Finance
University of Iowa
April 2001
Student Evaluation
Multiple Choice Questions
General on the IEM in general and trading on the IEM
1. On what do the payoffs to the contracts traded on the IEM Computer Industry Returns market depend?
a. Stock prices relative to “cutoff” levels
b. Relative returns on stocks
c. True underlying valuations of stocks, independent of market valuations
d. All of the above
e. None of the above
2. The contracts you trade on the IEM for this class are based on:
a. the returns for entertainment industry stocks.
b. the returns for computer industry stocks.
c. the outcomes of elections.
d. the level of prices in the economy.
3. Predicting stock values can help in IEM trading because they:
a. can help explain past returns for stocks.
b. can help predict future returns for stocks.
c. determine completely the current price of a stock.
d. are based on past accounting numbers.
4. Contracts are created on the IEM through the following procedure:
a. Each trader gets contracts when he or she opens an account.
b. Contracts are created each time you make a purchase.
c. Contracts are created when traders buy bundles.
d. The number of contracts in the market is fixed and, therefore, no contracts are ever created.
5. If you think that AAPL is the most undervalued and will have the highest return over the next month among
AAPL, IBM, MSFT and the S&P500, you should:
a. Try to buy AAPLm by placing an ask.
b. Try to buy AAPLm by placing a bid.
c. Try to sell AAPLm by placing an ask.
d. Try to sell AAPLm by placing a bid.
Questions on Principles of Valuation
6. Which valuation concept is defined as the depreciated value of assets minus the book value of outstanding
liabilities?
a. Book Value
b. Liquidation Value
c. Market Value (P)
d. Intrinsic Value (V)
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7. Which valuation concept is defined as the amount that would be raised if all assets were sold
independently?
a. Book Value
b. Liquidation Value
c. Market Value (P)
d. Intrinsic Value (V)
8. Which valuation concept is defined as the value according to market price of outstanding stock?
a. Book Value
b. Liquidation Value
c. Market Value (P)
d. Intrinsic Value (V)
9. Which valuation concept is defined as the net present value of future cash flows (discounted at investors’
required rate of return)?
a. Book Value
b. Liquidation Value
c. Market Value (P)
d. Intrinsic Value (V)
10. What is book value?
a. The depreciated value of assets minus the value of outstanding liabilities
b. The amount that would be raised if all assets were sold independently
c. The value according to market price of outstanding stock
d. The net present value of future cash flows (discounted at investors’ required rate of return)
11. What is liquidation value?
a. The depreciated value of assets minus the value of outstanding liabilities
b. The amount that would be raised if all assets were sold independently
c. The value according to market price of outstanding stock
d. The net present value of future cash flows (discounted at investors’ required rate of return)
12. What is market value?
a. The depreciated value of assets minus the value of outstanding liabilities
b. The amount that would be raised if all assets were sold independently
c. The value according to market price of outstanding stock
d. The net present value of future cash flows (discounted at investors’ required rate of return)
13. What is intrinsic value?
a. The depreciated value of assets minus the value of outstanding liabilities
b. The amount that would be raised if all assets were sold independently
c. The value according to market price of outstanding stock
d. The net present value of future cash flows (discounted at investors’ required rate of return)
14. In an efficient market, which two valuation concepts should be the same?
a. Book value and liquidation value
b. Book value and market value
c. Liquidation value and intrinsic value
d. Market value and intrinsic value
15. You need to determine the discount rate to value stock of Walt’s Waffle Warehouse (WWW). You look it up
on the Internet and find WWW = 1.5. You determine that the risk free rate is 3% and the appropriate risk
premium is 8%. What should the required return on WWW stock be?
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Questions on the Constant Dividend Model
16. Steady Disbursements Incorporated (SDI) pays an annual dividend of $5.00, which is expected to remain
constant. If the required return on SDI stock is 8%, what should the price of SDI stock be?
a. $40.00
b. $62.50
c. $160.00
d. Cannot be determined from the information given.
17. Steady Disbursements Incorporated (SDI) pays an annual dividend of $5.00, which is expected to remain
constant. If the risk free rate is 3.5%, the market risk premium is 6% and the beta of SDI stock is 0.75, what
should the price of SDI stock be?
a. $40.00
b. $62.50
c. $160.00
d. Cannot be determined from the information given.
18. Steady Disbursements Incorporated (SDI) pays an annual dividend of $5.00, which is expected to remain
constant. If the price of SDI stock is $62.50, what return are investors demanding on SDI stock?
a. 8.00%
b. 12.50%
c. 31.25%
d. Cannot be determined from the information given.
19. Steady Disbursements Incorporated (SDI) pays an annual dividend, which is expected to remain constant.
If the price of SDI stock is $62.50 and investors demand an 8% return, what is the dividend on SDI stock?
a. $0.1280
b. $5.0000
c. $7.8125
d. Cannot be determined from the information given.
20. Steady Disbursements Incorporated (SDI) pays an annual dividend, which is expected to remain constant.
If the price of SDI stock is $62.50, the risk free rate is 3.5%, the market risk premium is 6% and the beta of
SDI stock is 0.75, what is the dividend on SDI stock?
a. $0.1280
b. $5.0000
c. $7.8125
d. Cannot be determined from the information given.
21. If a stock is valued according to the constant dividend model, which of the following factors increases the
value of the stock?
a. The stock’s dividend
b. The stock’s required return
c. The stock’s beta
d. All of the above
e. None of the above
22. Determine the price of a share of common stock of Intercontinental Ballistics Missiles (IBM) given that the
company pays fixed constant dividends of $2.50 per share (annually) and has a required rate of return on
equity of 15 percent.
23. What is the required rate of return on a share of common stock of Maxisoft if the fixed annual dividend is
$2.00 and the price per share is $60?
24. Calculate the annual dividend on a share of common stock of Steaks R Us if the price per share is $50 and
the required rate of return on equity is 10 percent.
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25. A share of common stock of Pineapple Computers is valued at $40, the fixed annual dividend is $2.00 and
the required rate of return on equity is 15 percent.
a. If the dividend stays fixed and the required rate of return changes as follows, what is the new value per
share in each case?
Required Rate of Return
5%
8%
10%
12%
17%
20%
b. What do the calculations reveal about the relationship between the required rate of return and value per
share, other factors remaining the same? What are some reasons for changes in the required rate of
return for the company’s stock?
c.
If the required rate of return stays constant while the annual dividend changes as follows, what is the
effect on stock value?
Annual Dividend
$0.50
$1.00
$1.50
$2.50
$3.00
$5.00
d. What can you discern about the relationship between dividends and stock value, other things remaining
constant? What are some reasons that companies might change their dividend payments?
Questions on the Constant Growth Model
26. Steady Escalation Systems (SES) paid an annual dividend of $5.00 last year, which is expected to grow at
3% per year forever. If the required return on SES stock is 8%, what should the price of SES stock be?
a. $64.38
b. $100.00
c. $103.00
d. Cannot be determined from the information given.
27. Steady Escalation Systems (SES) paid an annual dividend of $5.00 last year and is expected to pay $5.15
next year. If this growth rate continues forever and the required return on SES stock is 8%, what should the
price of SES stock be?
a. $64.38
b. $100.00
c. $103.00
d. Cannot be determined from the information given.
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28. Steady Escalation Systems (SES) paid an annual dividend of $5.00 last year, which is expected to grow at
3% per year forever. If the risk free rate is 3.5%, the market risk premium is 6% and the beta of SES stock
is 0.75, what should the price of SDI stock be?
a. $64.38
b. $100.00
c. $103.00
d. Cannot be determined from the information given.
29. Steady Escalation Systems (SES) is expected to pay an annual dividend of $5.15 next year, which is
expected to grow at 3% per year forever. If the price of SDI stock is $103.00, what return are investors
demanding on SDI stock?
a. 4.85%
b. 5.00%
c. 8.00%
d. Cannot be determined from the information given.
30. Steady Escalation Systems (SES) paid an annual dividend of $5.00 last year, which is expected to grow at
3% per year forever. If the price of SDI stock is $103.00, what return are investors demanding on SDI
stock?
a. 4.85%
b. 5.00%
c. 8.00%
d. Cannot be determined from the information given.
31. Steady Escalation Systems (SES) is expected to pay an annual dividend of $5.15 next year, which is
expected to grow at a constant forever. If the price of SDI stock is $103.00 and investors are demanding an
8% return, what growth rate must investors be expecting on SDI stock?
a. 3.00%
b. 4.85%
c. 5.00%
d. Cannot be determined from the information given.
32. Steady Escalation Systems (SES) paid an annual dividend of $5.00 last year, which is expected to grow at
a constant rate forever. If the price of SDI stock is $103.00 and investors are demanding an 8% return,
what growth rate must investors be expecting on SDI stock?
a. 3.00%
b. 4.85%
c. 5.00%
d. Cannot be determined from the information given.
33. Steady Escalation Systems (SES) pays an annual dividend which is expected to grow at a constant rate of
3% forever. If the price of SES stock is $103.00 and investors demand an 8% return, what is the next
dividend on SDI stock expected to be?
a. $3.09
b. $5.15
c. $8.24
d. Cannot be determined from the information given.
34. Steady Escalation Systems (SES) pays an annual dividend which is expected to grow at a constant rate of
3% forever. If the price of SES stock is $103.00 and investors demand an 8% return, what was the last
dividend paid on SDI stock?
a. $3.00
b. $5.00
c. $8.00
d. Cannot be determined from the information given.
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35. If a stock is valued according to the constant growth model, which of the following factors increases the
value of the stock?
a. The stock’s dividend growth rate
b. The stock’s required return
c. The stock’s beta
d. All of the above
e. None of the above
36. Steady Escalation Systems (SES) had earnings last year of $7.50 per share and paid out $5.00 in
dividends. If they have an ROE of 9%, what is their sustainable growth rate?
a. 2.50%
b. 3.00%
c. 33.33%
d. Cannot be determined from the information given.
37. All of the following are means of estimating a company’s growth rate except:
a. Historical average growth
b. Beta relative to the market risk premium
c. Average analysts’ estimated growth
d. Sustainable growth
e. Required return versus dividend yield.
38. Internet retailer, Mississippi.com, has earnings per share (EPS) of $2.00 and pays out $0.20 in annual
dividends per share. Its return on equity, ROE, is 30%. What is the sustainable growth rate? If the
required rate of return is 20%, what problems arise when using the Discounted Dividend Model (DDM)?
39. Retailer J.C. Dollar pays an annual dividend of $1.50 per share with an expected growth in dividends of 10
% each year. The required rate of return on equity is 20%. What is the value per share?
40. Moon Microsystems will pay a dividend of $1.00 per share and the growth rate in dividends is expected to
be 8% each year. If the price per share is $25, what is the required rate of return on equity?
41. TLCFY paid a dividend of $1.20 per share.
a. The expected growth rate in dividends is 6% and the required rate of return is 20%. What is the value
per share?
b. If the growth rate in dividends changes as follows while the other factors except price remain constant,
calculate the new value per share in each case.
Growth Rate in Dividends
0%
2%
4%
7%
10%
15%
18%
c.
What is the relationship between growth in dividends and value?
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d. Repeat the exercise for changes in the required rate of return, other factors except price being held
constant.
Required Rate of Return
7%
10%
15%
25%
30%
e. What is the relationship between the required rate of return and value?
Questions on the Discounted Cash Flow Model
42. If one defines cash flows as those available to all investors, then the correct discount rate to use in the
discounted cash flow model is:
a. The CAPM k to the stockholders
b. The WACC k to all investors
c. Either one because they should be the same for all companies
d. Neither one because they do not reflect the risks to cash flows
43. If one defines cash flows as those available to stockholders, then the correct discount rate to use in the
discounted cash flow model is:
a. The CAPM k to the stockholders
b. The WACC k to all investors
c. Either one because they should be the same for all companies
d. Neither one because they do not reflect the risks to cash flows
44. Coin Mover Sales company (CMS) has a stock beta of 2 and is 50% financed with risk free debt. If the risk
free rate is 3.5% and the risk premium is 6%, the discount rate that should be used for cash flows to stock
holders is:
a. 8.5%
b. 9.5%
c. 15.5%
d. Cannot be determined from the information given
45. Coin Mover Sales company (CMS) has a stock beta of 2 and is 50% financed with risk free debt. If the risk
free rate is 3.5% and the risk premium is 6%, the discount rate that should be used for cash flows to an
investors is:
a. 8.5%
b. 9.5%
c. 15.5%
d. Cannot be determined from the information given
46. According to generally accepted accounting principles (GAAP), cash flows to shareholders are defined as:
a. NI
b. NI + depreciation
c. NI + depreciation – preferred stock dividends
d. NI + depreciation –preferred stock dividends – taxes
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47. Recent financial information for Coin Mover Sales company (CMS) follows:
Sales
Costs
Depreciation
Taxes
$1,000,000
$500,000
$250,000
$100,000
If CMS has no preferred stock, the cash flows available to common stock holders are:
a.
b.
c.
d.
-$100,000
$400,000
$500,000
Cannot be determined from the information given
48. Recent financial information for Coin Mover Sales company (CMS) follows:
Sales
Costs
Depreciation
Taxes
$1,000,000
$500,000
$250,000
$100,000
CMS has no preferred stock, 400,000 shares of common stock and a required return of 15.5% for
common stock holders. If cash flows are expected to grow at 12% per year, what should the price of
CMS stock be according to the discounted cash flow model?
a.
b.
c.
d.
$6.45
$28.57
$32.00
Cannot be determined from the information given
49. If a stock is valued according to the discounted cash flow model, which of the following factors increases the
value of the stock?
a. The company’s cash flow growth rate
b. The stock’s required return
c. The stock’s beta
d. All of the above
e. None of the above
General Questions on Market Multiple Models
50. Which of the following are usual means of applying market multiple models:
a. Computing a forecast for a company and applying the company’s historical valuation ratio.
b. Calculating a current number for a company and applying the industry average valuation ratio.
c. Both of the above.
d. None of the above.
Questions on P/E Model
51. P/E ratios reflect:
a. The current discount rate.
b. The value of growth opportunities
c. Both of the above.
d. None of the above.
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52. According to recent financial information for Value Check Enterprises (VCE), VCE stock typically trades at
12 times earnings and the industry average P/E ratio is 8 times earnings. If earnings are forecast to be $3
per share next year, what should the value of VCE stock be if it is valued according to historical ratios?
a. $12.00
b. $24.00
c. $36.00
d. Cannot be determined from the information given.
53. According to recent financial information for Value Check Enterprises (VCE), VCE stock typically trades at
12 times earnings and the industry average P/E ratio is 8 times earnings. If earnings are forecast to be $3
per share next year, what should the value of VCE stock be if it is valued according to industry ratios?
a. $12.00
b. $24.00
c. $36.00
d. Cannot be determined from the information given.
54. According to recent financial information for Value Check Enterprises (VCE), VCE stock typically trades at
12 times earnings and the industry average P/E ratio is 8 times earnings. How is VCE stock typically
valued relative to the industry?
a. Higher than the industry based on earnings.
b. At the same level as the industry based on earnings.
c. Lower than the industry based on earnings.
d. Cannot be determined from the information given.
55. According to recent financial information for Value Check Enterprises (VCE), VCE stock typically trades at
12 times earnings and the industry average P/E ratio is 8 times earnings. Relative to the industry:
a. VCE has less valuable growth opportunities.
b. VCE has the same growth opportunities.
c. VCE has more valuable growth opportunities.
d. Cannot be determined from the information given.
Questions on P/S Model
56. According to recent financial information for Worth Auction Systems (WAS), WAS stock typically trades at 7
times sales and the industry average P/S ratio is 10 times sales. If sales are forecast to be $8 per share
next year, what should the value of VCE stock be if it is valued according to historical ratios?
a. $56.00
b. $70.00
c. $80.00
d. Cannot be determined from the information given.
57. According to recent financial information for Worth Auction Systems (WAS), WAS stock typically trades at 7
times sales and the industry average P/S ratio is 10 times sales. If sales are forecast to be $8 per share
next year, what should the value of VCE stock be if it is valued according to industry ratios?
a. $56.00
b. $70.00
c. $80.00
Cannot be determined from the information given.
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58. According to recent financial information for Worth Auction Systems (WAS), WAS stock typically trades at 7
times earnings and the industry average P/S ratio is 10 times sales. If sales are forecast to be $8 per share
next year, what should the value of VCE stock be if it is valued according to industry ratios?
a. Higher than the industry based on sales.
b. At the same level as the industry based on sales.
c. Lower than the industry based on sales.
d. Cannot be determined from the information given.
Questions on P/CF Model
59. According to recent financial information for Merit Change Company (MCC), MCC stock typically trades at 9
times cash flow and the industry average P/CF ratio is 6 times cash flow. If cash flows are forecast to be
$12 per share next year, what should the value of MCC stock be if it is valued according to historical ratios?
a. $54.00
b. $72.00
c. $108.00
d. Cannot be determined from the information given.
60. According to recent financial information for Merit Change Company (MCC), MCC stock typically trades at 9
times cash flow and the industry average P/CF ratio is 6 times cash flow. If cash flows are forecast to be
$12 per share next year, what should the value of MCC stock be if it is valued according to historical ratios?
a. $54.00
b. $72.00
c. $108.00
d. Cannot be determined from the information given.
61. According to recent financial information for Merit Change Company (MCC), MCC stock typically trades at 9
times earnings and the industry average P/CF ratio is 6 times cash flow. If cash flows are forecast to be
$12 per share next year, what should the value of MCC stock be if it is valued according to historical ratios?
a. Higher than the industry based on cash flow.
b. At the same level as the industry based on cash flow.
c. Lower than the industry based on cash flow.
d. Cannot be determined from the information given.
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