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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 Teaching Objectives Stock Valuation Motivation What is the goal of business, of management and of financial management in particular? Answers will vary, but typically have a common theme: the creation and management of value. Stock valuation is the attempt to measure the value of a business and that business’ equity in particular. Understanding valuation helps investors and managers alike in meeting their goals. Understand several common stock and business valuation models. Students will learn about several common methods of valuation. These include the dividend discount model, market multiples and the discounted cash flow model. Students should understand how to value companies according to each method and understand the factors driving value for each. Be able to look up data for these models on the internet. Students should be able to look up basic information required for each valuation method on the internet. For the dividend discount model, this information includes current dividend and re-investment rates, return on equity and CAPM inputs. For the market multiples method, this information included P/E, P/S and market-to-book ratios for the firm and industry. For the discounted cash flow method, this includes free cash flows and inputs necessary to compute the weighted average cost of capital. Apply these models to a corporation to value it and understand the major factors influencing value. In an assignment, students will apply these valuation models to several companies: IBM, MSFT and AAPL. At each state, students are asked to ponder differences in the valuations of the models from each other and the actual stock price. They will consider the impact of changes in inputs to these models as well. Trade in IEM based on earnings and valuation predictions. Students will use current information to form expectations on the firm’s value. They will combine this with current prices to trade in the IEM Computer Industry Returns market. As the markets progress, they will monitor prices and returns to determine whether their own assessments prove correct. 2 Lecture Outline Stock Valuation 1. Introduction a. Principles of Valuation 2. Discounted Dividend Models a. Constant Dividend Model b. Constant Growth Model 3. Discounted Cash Flow Model 4. Market Multiple Models a. P/E Model b. P/S Model c. P/CF Model 5. Summary 3 Valuation Assignment Introduction to the IEM The Iowa Electronic Market (IEM for short) is a computerized market on which financial contracts can be traded (bought or sold). For this assignment, you will be using a series of contracts based on three popular companies, Apple Computers (AAPL), IBM (IBM) and Microsoft (MSFT), and an important index called the S&P500 index. Shares of the firms trade over the counter (NASDAQ) and on the New York Stock Exchange (NYSE). Similarly, a daily index value is determined for the S&P500 based upon the stock prices of the 500 companies that compose of it. The contracts you will be using are based on the shares of Apple computers, IBM and Microsoft, and on the value of the S&P500. These contracts are listed on the IEM under the market label “Computer Industry Returns Market” or “Comp_Ret” for short. These contracts are described briefly later in this note and in more depth in the IEM prospectus for the market. The prospectus and other information for these markets are available at the IEM website: http://www.biz.uiowa.edu/iem/markets/computer.html Objectives The objectives of the IEM assignments are to help you apply class concepts in a "real world," unstructured way to learn how to: 1. Apply valuation models to “real world” companies. 2. Understand what factors influence value. 3. Combine predictions and information to develop a trading strategy. Opening an IEM Account All students need to open an account with the Iowa Electronic Market. This involves a minimum deposit of ____ dollars. Funds remaining in your account are refundable at the end of the semester. You can open an IEM account over the internet. To do so, go to the sign-up webpage: http://iemweb.biz.uiowa.edu/signup/ and follow the instructions given to you by your instructor. (DO NOT use forms other than those given to you by your instructor. Using other forms may result in fees or decreased deposits in your account.) After filling out your signup forms, you may need to deposit cash with the IEM office (W283 PBAB, phone 335-0881). Your instructor will give you details about any deposits you need to make. 4 Accessing the IEM You can access the IEM through its website address: http://www.biz.uiowa.edu/iem/ The IEM market has several contracts trading under it. The contracts of interest for our course are the Computer Industry Returns Market (Comp_Ret, for short). You access your trading account from the market pages or directly at: http://iemweb.biz.uiowa.edu/ Computer Industry Returns Contracts The Computer Industry Returns Contracts consist of a series of contracts. Every month, existing contracts in the series are liquidated and payments are made as described below. Then, new contracts are created as described below. These events occur on the Monday after the exchangetraded options for the underlying stocks expire (the Monday after the third Friday of each month). The liquidation values for the contracts in this market are determined solely by the rates of return of Apple Computers Common Stock (AAPL), IBM Common Stock (IBM), Microsoft Common Stock (MSFT) and the S&P500 index (SP500). Whichever of these has the highest rate of return as specified below will payoff $1.00 per share. The remaining contracts will payoff zero. Thus, to do well in this market, you will need to understand what determines real stock market returns. Contracts are designated by a ticker symbol and a letter denoting the month of contract liquidation. Thus, the contracts traded in this market for liquidation in month “m” are: Code AAPLm IBMm MSFTm SP500m Underlying Asset Apple Computers IBM Microsoft S&P 500 Market Index Liquidation Value $1.00 if AAPL Return Highest $1.00 if IBM Return Highest $1.00 if MSFT Return Highest $1.00 if SP500 Return Highest In these contract codes, “m” refers to the month of expiration as given by the following table: Month January February March April Designation a b c d Month May June July August Designation e f g h Month September October November December Designation i j k l For AAPLm, IBMm and MSFTm, the dividend-adjusted rate of return is computed based on closing stock prices of the underlying listed firm between the third Friday in the liquidation month and the third Friday in the previous month. For these purposes, closing prices as reported in the Midwest edition of the Wall Street Journal are used. In particular, this return is calculated as follows. First, the raw return on the underlying stock is computed (as the closing price on the third Friday of the liquidation month, 5 minus the closing price from the third Friday of the previous month, plus any dividends on ex-dividend dates). Then, we divide the raw return by the closing stock price from the previous month to arrive at the dividend-adjusted rate of return. This is represented by the equation: k Pm Pm 1 Dm , Pm 1 where k is the dividend adjusted return, Pm is the price on the third Friday of month m, Pm-1 is the price on the third Friday of the previous month and Dm represents any dividends paid between these dates. For the SP500 contract, the return is computed as the capital gains rate of return. To do this, subtract the closing index value on the third Friday of the previous month from the closing index value on the third Friday of the liquidation month. Then, divide by the previous month’s closing index value. This is represented by the equation: k Pm Pm1 , Pm1 where k is the capital gains index return, Pm is the index value on the third Friday of month m, and Pm-1 is the value on the third Friday of the previous month. Trading on the IEM You can trade on the IEM in several ways. First, you can buy or sell unit portfolios (called “bundles”). A unit portfolio is a set of all contracts in the market such as AAPLm, IBMm, MSFTm and SP500m for the Computer Industry Returns market. You can always buy or sell such portfolios for $1.00 each. Thus, when you start to trade and do not own any contracts, you can buy a unit portfolio and then start to trade. (To do this, select the appropriate contract under “Buy Bundles” or “Sell Bundles” in the “Market Order” drop down menu. Enter a quantity and press the “Market Order” button.) Second, you can buy or sell using a "market order." On the market screen, you will see that some individuals have posted an order to buy or to sell a contract (e.g., MSFTi, the contract for September liquidation in the Computer Industry Returns Market) at a specific price. If you believe that a posted order represents a good deal, you can buy or sell at the posted price. (To do this, select the appropriate contract under “Buy at Best Ask” or “Sell at Best Bid” in the “Market Order” drop down menu. Enter a quantity and press the “Market Order” button.) Third, you can buy or sell using a "limit order." To do so, you state the price at which you are willing to buy or sell a contract and post a limit order on the screen. In doing so, you are waiting for someone who is willing to buy or sell at your stated price. In this manner, when your order executes, it will execute at your stated price, not at somebody else’s. The disadvantage is that the order may never execute because nobody likes your price because it is too high or low. (To place a limit order, select the appropriate contract under “Post a Bid” or “Post an Ask” in the “Limit Order” drop down menu. Enter a price, quantity and expiration date and press the “Limit Order” button.) Completing Your Assignments and Submitting Them As you can see below, the IEM assignments are extensive, multi-part assignments that draw together many concepts from the class. It would be wise to work on the various parts of the assignments as we 6 go over the relevant topics in class. To prepare the assignments for submission, please use the following guidelines: 1. Each assignment must be typed. Label clearly each assignment with a cover page giving your name, student number, and section number. 2. Complete each part in a separate section clearly labeling them Part 1, Part 2, etc. 3. Within each section, give the requested information, including sources of information gathered and equations used to calculate results. 4. Turn in your completed assignment to your instructor on the date it is due. 7 Stock Valuation Assignment Part 1: Discounted Dividend Models DUE: ___________ GOAL In this part of the assignment, you will learn where to find information necessary to apply the discounted dividend models discussed in class. You will use this information to see what discounted dividend models imply for IBM. Background Information To complete this exercise, you will need to collect some basic information on IBM: the annual dividend, an estimate for the risk free rate, the beta for IBM’s stock and some information to help estimate the likely dividend growth rate. Most of what you need is available on the internet. You can collect this information from a variety of sources. What follows are instructions for collecting it from Microsoft’s MoneyCentral webpages. To get information on IBM, go to the Microsoft MoneyCentral webpages at the address: http://moneycentral.msn.com/ In the upper left corner, enter “IBM” as the ticker symbol and press the “go” button. Obtain the required information as follows: 1. Recent IBM Price: The recent price per share is given on the default screen or the “Quotes— Quote Detail” screen. 2. Dividend and Dividend Yield: The annual dividend per share and dividend yield are given on the default screen or the “Quotes—Quote Detail” screen. 3. Beta: Beta is listed on the “Company Report” screen at the bottom of the right hand column. 4. Return on Equity (ROE): ROE is listed on the “Financial Results—Highlights” page. 5. Payout Ratio: The payout ratio is also listed on the “Financial Results—Highlights” page. 6. Historical Dividend Growth Rate: The 5 year historical dividend rate is given on the “Financial Results—Key Ratios—Growth Rates” page. 7. Average Forecast Growth Rate from Analysts: The average forecast growth rates for the next five years is given on the “Analyst Info—Estimates—Earnings Growth Rates” page. 8. Current 3-Month Treasury Rate: Enter the ticker symbol TB3M to obtain the current rate on 3 Month Treasury bills. 8 Question 1: Estimating the Required Return Use the Capital Asset Pricing Model (CAPM) to estimate the required (annual) return for IBM stock. Use the 3-month Treasury rate obtained above for the risk free rate, the beta obtained above for the beta and a risk premium of 8.74% (which is the historical average from 1926-1996). Recall that the CAPM equation is: k rf RP Question 2: Constant Dividend Model Suppose that IBM’s dividends will remain constant at their current level. Use the constant dividend model to value IBM’s stock. Does this number seem too high or too low when comparing it to IBM’s current stock price? Can you explain why that might be? Recall that the Constant Dividend pricing relationship is: P0 D k Question 3: Estimating Dividend Growth There are a variety of means of estimating IBM’s likely future dividend growth. Determine what the estimated growth rate would be using each of the following methods: a. If the past can be used as an indicator of the future, then the historical average is a good estimate. What is the historical average dividend growth rate? b. Analysts forecast growth and their average forecast is often used. What is the average estimated 5-year growth rate according to analysts? c. Another commonly used estimate is the “sustainable growth” rate computed by the (1-Payout Ratio) x ROE. What is the growth rate estimated by these means? d. Finally, since capital gains are driven by growth they should be approximately the same as growth. The total return in a stock (from Question 1) should equal the dividend yield plus the capital gain yield. Thus, you can estimate the growth rate by subtracting the dividend yield from the required return calculated in Question 1 above. What does this give for a growth rate? Given all this information, what do you think is a reasonable long run growth rate for IBM’s dividend? (Remember that, in the long run, growth cannot exceed the required return, which is calculated in Question 1 above.) Question 4: Constant Growth Model Given the dividend, the required return calculated in Question1 and the growth rate calculated in Question 2, what should the price of IBM stock be given the constant growth model? Does this number seem too high or too low when comparing it to IBM’s current stock price? Can you explain why that might be? Recall that the Constant Growth pricing relationship is: P0 9 D (1 g ) D1 0 k g k g Question 5: Implied Growth There is one final way of forecasting the growth rate. Equate the price of the stock today to the value that should exist according to the constant growth model. If you assume that next year’s dividend will grow at the same rate as the projected growth rate and use the required return calculated in Question 1, you can solve for the growth rate. This is called the implied growth rate. What is it? How does it compare to your estimate from Question 3 above? Recall that the Constant Growth pricing relationship implies: 10 Stock Valuation Assignment Part 2: Discounted Cash Flow Models DUE: ___________ GOAL In this part of the assignment, you will learn where to find information necessary to apply the discounted cash flow models discussed in class. You will use this information to see what discounted dividend models imply for IBM, Apple and Microsoft. Background Information To complete this exercise, you will need to collect some basic information on all three companies to help estimate cash flows the likely cash flow growth rate. Most of what you need is available on the internet. You can collect this information from a variety of sources. What follows are instructions for collecting it from Microsoft’s MoneyCentral webpages. To get information, go to the Microsoft MoneyCentral webpages at the address: http://moneycentral.msn.com/ For each of the companies, you will undertake the following steps to gather information. In the upper left corner, enter the ticker symbol for the company (e.g., “IBM”) and press the “go” button. Obtain the required information as follows: 1. Recent Price: The recent price per share is given on the default screen or the “Quotes—Quote Detail” screen. 2. Beta: Beta is listed on the “Company Report” screen at the bottom of the right hand column. 3. Historical Income Statement Information: A five-year history of income statements is available from “Financial Results—Statements.” If it does not come up as the default, select “Income Statement” and “Annual” from the pull-down menus. Make a table like the one that appears below and fill in (1), (2) and (3) below from the income statement and calculate the cash flow as (1) total net income plus (2) depreciation and amortization minus (3) preferred dividends. Year (1) Total Net Income (2) Depreciation & Amortization (3) Preferred Dividends Calculate Cash Flow (1)+(2)-(3) Calculate the growth in cash flow for each year, t, as (CFt-CFt-1)/CFt-1 and calculate the average growth rate for the available years. 4. Historical Growth Rate: The 5 year historical sales growth rate is given on the “Financial Results—Key Ratios—Growth Rates” page. (We will use this as a proxy for cash flow growth.) 11 5. Average Forecast Growth Rate from Analysts: The average forecast growth rates for the next five years is given on the “Analyst Info—Estimates—Earnings Growth Rates” page. 6. Current 3-Month Treasury Rate: Enter the ticker symbol TB3M to obtain the current rate on 3 Month Treasury bills. Question 1: Estimating the Required Return Use the Capital Asset Pricing Model (CAPM) to estimate the required (annual) return for each company’s stock. Use the 3-month Treasury rate obtained above for the risk free rate, the beta obtained above for the beta and a risk premium of 8.74% (which is the historical average from 19261996). Recall that the CAPM equation is: k rf RP Question 2: Estimating Cash Flow Growth There are a variety of means of estimating likely future cash flow growth. Determine what the estimated growth rate would be for each company using each of the following methods: a. If the past can be used as an indicator of the future, then the historical average is a good estimate. What is the historical average cash flow growth rate? b. If the past can be used as an indicator of the future and cash flows vary directly with sales, then the historical average sales growth rate is a good estimate. What is the historical average sales growth rate? c. Analysts forecast earnings growth and their average forecast is often used. Under the assumption that cash flows vary directly with earnings. What is the average estimated 5-year growth rate according to analysts? Given all this information, what do you think is a reasonable long run growth rate for IBM’s cash flow? (Remember that, in the long run, growth cannot exceed the required return, which is calculated in Question 1 above.) Question 3: Discounted Cash Flow Model Given the most recent cash flow (calculated in the table used to collect income statement information above), the required return calculated in Question 1 and the growth rate calculated in Question 2, what should the price of each company’s stock be given current cash flows and the estimate growth rate? Does this number seem too high or too low when comparing it to the company’s current stock price? Can you explain why that might be? Recall that the discounted cash flow pricing relationship is: P0 12 CF0 (1 g ) CF1 k g k g Stock Valuation Assignment Part 3: Market Multiples Models DUE: ___________ GOAL In this part of the assignment, you will learn where to find information necessary to apply the market multiples valuation models discussed in class. You will use this information to see what these models imply for IBM, Apple and Microsoft. Background Information To complete this exercise, you will need to collect some basic information on all three companies to apply each model. Most of what you need is available on the internet. You can collect this information from a variety of sources. What follows are instructions for collecting it from Microsoft’s MoneyCentral webpages. To get information, go to the Microsoft MoneyCentral webpages at the address: http://moneycentral.msn.com/ For each of the companies, you will undertake the following steps to gather information. In the upper left corner, enter the ticker symbol for the company (e.g., “IBM”) and press the “go” button. Obtain the required information as follows: 1. Recent Price: The recent price per share is given on the default screen or the “Quotes—Quote Detail” screen. 2. Company and Industry Ratios: For each company, collect the company and industry P/E, P/S and P/CF ratios. These can be found under “Financial Results—Key Ratios—Price Ratios.” (Use the current P/E ratio.) Also, note the industry for each company listed at the bottom of the page. 3. Average Earnings Forecast from Analysts for Next Year: The average forecast can be found at “Analyst Info—Earnings Estimates.” Use the next fiscal year listed in the “FY” columns. Question 1: Determining Current Earnings, Sales and Cash Flows Since reported ratios are computed on the last 12 months of data and the most recent income statement typically is not, we cannot use the income statements to figure out the earnings, sales and cash flows used in the ratios. Instead, we need to figure out what the earnings per share, sales per share and cash flows per share were from the ratios themselves. This is easy enough to do using the reported ratios and the current price. For each company, undertake the following steps to do this: (a) Determine the earnings for each company by dividing the current price by the P/E ratio. (This works because you know that P = Earnings x P/E, so P/(P/E) = Earnings.) (b) Determine the sales for each company by dividing the current price by the P/S ratio. (This works because you know that P = Sales x P/S, so P/(P/S) = Sales.) 13 (c) Determine the cash flows for each company by dividing the current price by the P/CF ratio. (This works because you know that P = Cash Flow x P/CF, so P/(P/CF) = Cash Flow.) Question 2: P/E Valuation Use earnings and P/E ratios to calculate three estimates for each company’s stock. These three estimates are: (1) Current earnings (from Question 1) times the industry P/E ratio. This gives the company’s value at current earnings levels if it were valued as its industry peers are relative to current earnings. (2) Forecast earnings (from analysts) for next year times the company’s P/E ratio. This gives the company’s future value at current P/E levels if the forecasts are accurate. (3) Forecast earnings (from analysts) for next year times the industry P/E ratio. This gives the company’s future value if the forecasts are accurate and the company is valued as its industry peers are relative to earnings in the future. Question 3: P/S Valuation Use sales and P/S ratios to calculate another estimate for each company’s stock. Take current sales (from Question 1) times the industry P/S ratio. This gives the company’s value at current sales levels if it were valued as its industry peers are relative to current sales. Question 4: P/CF Valuation Use cash flows and P/CF ratios to calculate another estimate for each company’s stock. Take current cash flows (from Question 1) times the industry P/CF ratio. This gives the company’s value at current cash flow levels if it were valued as its industry peers are relative to current cash flows. Question 5: Interpretation For each company, you have the current market price and a range of valuations depending on current and forecast earnings, current sales and current cash flows. Of course, these numbers will not all be the same. Do these differences appear random? Or, can you think of good reasons that these valuations differ? Elaborate on any reasons that the company might be priced differently from the valuations suggested by the industry ratios. Can you come up with specific reasons for the differences of each company? 14 Stock Valuation Assignment Part 4: Implications and Actions DUE: ___________ GOAL In this part of the assignment, you will use financial ratios and information to forecast returns for stocks and turn those forecasts into actions on the IEM. Prediction Given all of your analysis in parts 1 to 5, predict what each stock's return and the SP&500 return will be for the next month. Justify these predictions using the analysis techniques developed in class and in this assignment. Which of the securities do you predict will have the highest return? How confident are you of your prediction? Implication Given your predictions above, which IEM contract (AAPLm, IBMm, MSFTm or SP500m) should be priced the highest at the beginning of trading during the current trading month. Justify your prediction. (Recall that the contract with the highest actual monthly return will liquidate at $1. The others will expire worthless. Thus, you need to predict which stock will have the highest monthly return in order to determine which IEM contract will have the greatest likelihood of payoff. This contract should be priced the highest.) Action Make at least one additional trade in the IEM Computer Industry Returns market between ________ and ________. Log your trades. For each trade, report the date of the trade, the contract traded and the prices. Attach a printout showing your trading activity. (You can either submit a “Processed Orders” report or an ‘Order History” report. To get the first report, make sure that the “confirm” box is checked on the trading screen. You will be asked to “execute” the order. Upon execution, the “Processed Orders” report will appear. To get the second report, go to “My Account” information select “view order history” and print the resulting report.) Justify each trade you make using: 1. 2. 3. 4. Your forecast returns The actual returns to date IEM prices at that time Any other information and analysis you wish to include. 15 Valuation Assignment The Lessons of the Assignment The main lesson from the assignment is that stock valuation is complex, very difficult and quite tricky. A variety of methods can be used to get a handle on what valuations should be, but, in the end, a great deal of judgment is involved. In this exercise, you learned and applied some of the tools that professionals use. One could make substantial profits if one could regularly forecast stock prices better than the market. However, efficient markets theory suggests that this is difficult, if not impossible to do. So, if your predictions didn’t come true, don’t feel bad. If they did, ask yourself: “Was I really good at this, or just lucky?” 16 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) 17 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? 18 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. 19 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. 20 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. 21 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? 22 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 23 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. 24 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. 25 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. 26