What is the firm’s current ratio?
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A stock has an intrinsic value of $15 and an actual stock price of $13.50. You know that this stock _______
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will generate a positive alpha
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bill, Jim, and Shelly are all interested in buying the same stock that pays dividends. Bill plans on holding the stock for 1 year. Jim plans on holding the stock for 3 years. Shelly plans on holding the stock until she retires in 10 years. Which one of the following statements is correct?
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All three should be willing to pay the same amount for the stock regardless of their holding period.
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A firm cuts its dividend payout ratio. As a result, you know that the firm's _______.
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earnings retention ratio will increase
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__________ is the amount of money per common share that could be realized by breaking up the firm, selling its assets, repaying its debt, and distributing the remainder to shareholders.
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liquidation value per share
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An underpriced stock provides an expected return that is ____________ the required return based on the capital asset pricing model (CAPM).
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greater than
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Stockholders of Dogs R Us Pet Supply expect a 12% rate of return on their stock. Management has consistently been generating an ROE of 15% over the last 5 years but now believes that ROE will be 12% for the next 5 years. Given this, the firm's optimal dividend payout ratio is now ______.
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100%
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The constant-growth dividend discount model (DDM) can be used only when the ___________.
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growth rate is less than the required return
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You want to earn a return of 10% on each of two stocks, A and B. Each of the stocks is expected to pay a dividend of $4 in the upcoming year. The expected growth rate of dividends is 6% for stock A and 5% for stock B. Using the constant-growth DDM, the intrinsic value of stock A _________.
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will be higher than the intrinsic value of stock B
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You are considering acquiring a common share of Sahali Shopping Center Corporation that you would like to hold for 1 year. You expect to receive both $1.25 in dividends and $35 from the sale of the share at the end of the year. The maximum price you would pay for a share today is __________ if you wanted to earn a 12% return.
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$32.37 v0 = (1.25+35.00)/(1+.12) = 32.37
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The market capitalization rate on the stock of Aberdeen Wholesale Company is 10%. Its expected ROE is 12%, and its expected EPS is $5. If the firm's plowback ratio is 60%, its P/E ratio will be _________.
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14.29 Dividend payout ratio = 1 - .46 = .4 Expected dividend = .4 × $5 = $2 Growth rate = .6 × 12% = 7.2% Value = $2/(.1 - .072) = $71.43 P/E = $71.43/$5 = 14.29
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Gagliardi Way Corporation has an expected ROE of 15%. If it pays out 30% of its earnings as dividends, its dividend growth rate will be _____.
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10.5% b = 1 - .3 = .7 g = b × ROE = .7 × 15% = 10.5%
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Fundamental analysis
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use information concerning the current and prospective profitability of a company to assess its fair market value.
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Market value
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how much are investors willing to pay as of now?
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Market value formula
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= per share stock price * number of shares outstanding.
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Investors try to estimate the fair market value to
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identify mispricing (trading opportunities) in the stock market
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The most important tool: financial statement analysis
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• The Balance Sheet • The Income Statement • Statement of Cash Flows
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Book value
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the net worth of common equity reported on the balance sheet.
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Book value of equity =
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Book value of assets - book value of liabilities
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Book value of assets =
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Original costs for purchasing the assets - accumulated depreciation
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• Book value of assets is normally stale, so it is
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not a good measure for true current value (market value)
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Investors calculate the book to market ratio (B/M) as a
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a key characteristic for a stock.
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• Very rarely, some firms can have
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negative book value of equity, but still traded at positive prices
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• Liquidation value:
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net amount that can be realized by selling the assets of a firm and paying off the debt. • Normally considered as a floor (lower bound) of the market value for stocks
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Replacement cost:
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cost to replace a firm's assets (setting up an identical firm) • Market value should not deviate too far above the replacement cost of assets minus liabilities
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The ratio of market value of a firm (equity plus liabilities) to replacement costs for assets is called
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Tobin's q
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In the long run, Tobin's q should tend toward
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1
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tobin q =
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MV liabilities + MV equity / replacement cost assets
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Intrinsic value:
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the present value of future cash flows generated by owning the stock, discounted at the appropriate discount rate ݇k.
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Intrinsic value is
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forward‐looking, and is the per share fair market value.
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Dividends and firm profit (earnings):
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dividend is part of earnings
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divident payout ratio
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div/earnings
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plowback ratio
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1-dividend payout ratio
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The discount rate ݇"k" should
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match the risk level of the stock:
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the CAPM expected return is the
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investor's required rate of return (market capitalization rate):
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k =
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rf + beta * [e(rm)-r(f)]
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• Denote the intrinsic value as V0 the expected value for next period's dividend as E(D1) and price as E(P1)
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v0=E(d1) +E(P1) / 1+k
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dividend discount model (DDM)
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vo =[ d1/(1+k)] +[d2/(1+K)^2] and so on
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The Constant‐Growth DDM
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assuming all future dividends are growing at a constant rate ݃g over time
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The Constant‐Growth DDM v0 =
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= d1/(1+k) + [d1(1+g)]/[(1+k)^2] + [d1(1+g)^2] / [(1+k)^3] ETC
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The Constant‐Growth DDM: special case when g=0, v0 = d1/k
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it's a perpetuity (fixed amount of money every year)
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The Constant‐Growth DDM: special case when g>k, v=infinity
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The dividend is growing so fast that the stock is worth infinity. can't use this
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In order to have good growth, there has to be two things:
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enough plowback (denoted as b ܾ), and good investment opportunities (normally measured by return on equity (ROE)).
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g (growth rate of dividends) =
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b*roe if b is neg then g will decrease must have positive b and high roe to have growth
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present value of growth opportunity (PVGO) =
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value per share with growth - value per share without growth • Only increasing retained earnings is not enough to have positive PVGO (higher share value).
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Price‐earnings ratio
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price per share/earnings per share a measure to gauge whether a stock is "expensive" or "cheap".
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High P/E indicates
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good growth opportunity when the stock is fairly valued
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The higher PVGO is
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the higher the P/E
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The higher ROE is
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the higher the P/E
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Stocks with high risk have
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lower P/E, all else equal
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However, high plowback (B) ܾ will result in higher P/E only if
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ROE>k When the investment opportunity is bad (roe <k) high plow back decreases p/e
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Price‐to‐book
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High ratio indicates a large premium over book value, and a 'floor' value that is often far below market price
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Price‐to‐cash flow
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P/Cash Flow instead of P/E; less subject to accounting manipulation
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Price‐to‐sales
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Useful for firms with low or negative earnings in early growth stage
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An alternative way to evaluate stocks: market value of equity=
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total market value of the firm (enterprise value) - value of debrt
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An alternative way to evaluate stocks: enterprise value=
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PV (all future CF generated by the firm, discounted by an appropriate discount rate) • Cash flows generated by the firm is called free cash flows. • The appropriate discount factor is WACC (weighted average cost of capital). • The details of estimating free cash flows and WACC are covered in the course Corporate Finance.
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