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Reading 41: Discounted Dividend Valuation- LOS a~ Q1-8

 

LOS a: Compare and contrast dividends, free cash flow, and residual income as measures of cash flow in discounted cash flow valuation, and identify the investment situations for which each measure is suitable.

Q1. Which of the following is least likely a limitation of the two-stage dividend discount model (DDM)?

A)   most of the value is due to the terminal value, which is very sensitive to the estimates of stable growth.

B)   use of one required rate of return for both stages might overstate the value.

C)   the length of the high-growth stage is difficult to measure.

 

Q2. Historical information used to determine the long-term average returns from equity markets may suffer from survivorship bias, resulting in:

A)   deflating the mean return.

B)   inflating the mean return.

C)   unpredictable results.

 

Q3. Multi-stage growth models can become computationally intensive. For this reason they are often referred to as:

A)   spreadsheet models.

B)   quadratic models.

C)   R-squared models.

 

 

Q4. Julie Davidson, CFA, has recently been hired by a well-respected hedge fund manager in New York as an investment analyst. Davidson’s responsibilities in her new position include presenting investment recommendations to her supervisor, who is a principal in the firm. Davidson’s previous position was as a junior analyst at a regional money management firm. In order to prepare for her new position, her supervisor has asked Davidson to spend the next week evaluating the fund’s investment policy and current portfolio holdings. At the end of the week, she is to make at least one new investment recommendation based upon her evaluation of the fund’s current portfolio. Upon examination of the fund’s holdings, Davidson determines that the domestic growth stock sector is currently underrepresented in the portfolio. The fund has stated to its investors that it will aggressively pursue opportunities in this sector, but due to recent profit-taking, the portfolio needs some rebalancing to increase its exposure to this sector. She decides to search for a suitable stock in the pharmaceuticals industry, which, she believes, may be able to provide an above average return for the hedge fund while maintaining the fund’s stated risk tolerance parameters.

Davidson has narrowed her search down to two companies, and is comparing them to determine which is the more appropriate recommendation. One of the prospects is Samson Corporation, a mid-sized pharmaceuticals corporation that, through a series of acquisitions over the past five years, has captured a large segment of the flu vaccine market. Samson financed the acquisitions largely through the issuance of corporate debt. The company’s stock had performed steadily for many years until the acquisitions, at which point both earnings and dividends accelerated rapidly. Davidson wants to determine what impact any additional acquisitions will have on Samson’s future earnings potential and stock performance.

The other prospect is Wellborn Products, a manufacturer of a variety of over-the-counter pediatric products. Wellborn is a relatively new player in this segment of the market, but industry insiders have confidence in the proven track record of the company’s upper management who came from another firm that is a major participant in the industry. The market cap of Wellborn is much smaller than Samson’s, and the company differs from Samson because it has grown internally rather than through the acquisition of its competitors. Wellborn currently has no long-term debt outstanding. While the firm does not pay a dividend, it has recently declared that it intends to begin paying one at the end of the current calendar year.

Select financial information (year-end 2005) for Samson and Wellborn is outlined below:

Samson:

Current Price:

$36.00

Sales:

$75,000,000

Net Income:

$5,700,000

Assets:

$135,000,000

Liabilities:

$95,000,000

Equity:

$60,000,000

Wellborn:

Current Price:

$21.25

Dividends expected to be received at the end of 2006:

$1.25

Dividends expected to be received at the end of 2007:

$1.45

Price expected at year-end 2007:

$27.50

Required return on equity:

9.50%

Risk-free rate:

3.75%

Other financial information:

One-year forecasted dividend yield on market index:

1.75%

Consensus long-term earnings growth rate:

5.25%

Short-term government bill rate:

3.75%

Medium-term government note rate:

4.00%

Long-term government bond rate:

4.25%

It is the beginning of 2006, and Davidson wants use the above data to identify which will have the greatest expected returns. She must determine which valuation model(s) is most appropriate for these two securities. Also, Davidson must forecast sustainable growth rates for each of the companies to assess whether or not they would fit within the fund’s investment parameters.

Using the Gordon growth model (GGM), what is the equity risk premium?

A)   5.50%.

B)   3.25%.

C)   2.75%.

 

Q5. Davidson is familiar with the use of the capital asset pricing model (CAPM) and arbitrage pricing theory (APT) to estimate the required rate of return for an equity investment. However, there are some limitations associated with both models that should be considered in her analysis. Which of the following is least likely a limitation of the CAPM and/or APT?

A)   Model uncertainty, because it is unknown if the use of either model is theoretically correct and appropriate.

B)   Risk premium exposure, because it fails to consider the implications of an asset’s sensitivity to the various risk factors in the market.

C)   Input uncertainty, because it is difficult to estimate the appropriate risk premiums accurately.

 

Q6. Which of the following valuation models would be most appropriate in the valuation analysis of Wellborn Products?

A)   The dividend discount model (DDM), because the hedge fund’s investment would represent a minority interest in the company.

B)   The free cash flow model, because the firm does not have a steady dividend payment history.

C)   The residual income approach, because the firm is likely to have negative free cash flow for the foreseeable future.

 

Q7. Davidson needs to determine if the shares of Wellborn are currently undervalued or overvalued in the market relative to the shares’ fundamental value. The estimated fair value of Wellborn shares, using a two-period dividend discount model (DDM), is:

A)   $21.25.

B)   $25.29.

C)   $27.58.

 

Q8. As a part of her analysis, Davidson needs to calculate return on equity for both potential investments. What is last year’s return on equity (ROE) for Samson shares?

A)   9.50%.

B)   17.10%.

C)   5.28%.

 

[2009] Session 11 - Reading 41: Discounted Dividend Valuation- LOS a~ Q1-8

 

 

LOS a: Compare and contrast dividends, free cash flow, and residual income as measures of cash flow in discounted cash flow valuation, and identify the investment situations for which each measure is suitable. fficeffice" />

Q1. Which of the following is least likely a limitation of the two-stage dividend discount model (DDM)?

A)   most of the value is due to the terminal value, which is very sensitive to the estimates of stable growth.

B)   use of one required rate of return for both stages might overstate the value.

C)   the length of the high-growth stage is difficult to measure.

Correct answer is B)

The two-stage DDM uses a different required rate of return (cost of equity) for high-growth period (r) and steady state (rn). Most of the time r > rn, since during the stable period the firm is less risky and shareholders require a lower rate of return.

 

Q2. Historical information used to determine the long-term average returns from equity markets may suffer from survivorship bias, resulting in:

A)   deflating the mean return.

B)   inflating the mean return.

C)   unpredictable results.

Correct answer is B)

Survivorship bias refers to the weeding out of underperforming firms, resulting in an inflated value for the mean return.

 

Q3. Multi-stage growth models can become computationally intensive. For this reason they are often referred to as:

A)   spreadsheet models.

B)   quadratic models.

C)   R-squared models.

Correct answer is A)

The computationally intensive nature of these models make them a perfect application for a spreadsheet program, hence the name spreadsheet models.

 

Q4. Julie Davidson, CFA, has recently been hired by a well-respected hedge fund manager in ffice:smarttags" />New York as an investment analyst. Davidson’s responsibilities in her new position include presenting investment recommendations to her supervisor, who is a principal in the firm. Davidson’s previous position was as a junior analyst at a regional money management firm. In order to prepare for her new position, her supervisor has asked Davidson to spend the next week evaluating the fund’s investment policy and current portfolio holdings. At the end of the week, she is to make at least one new investment recommendation based upon her evaluation of the fund’s current portfolio. Upon examination of the fund’s holdings, Davidson determines that the domestic growth stock sector is currently underrepresented in the portfolio. The fund has stated to its investors that it will aggressively pursue opportunities in this sector, but due to recent profit-taking, the portfolio needs some rebalancing to increase its exposure to this sector. She decides to search for a suitable stock in the pharmaceuticals industry, which, she believes, may be able to provide an above average return for the hedge fund while maintaining the fund’s stated risk tolerance parameters.

Davidson has narrowed her search down to two companies, and is comparing them to determine which is the more appropriate recommendation. One of the prospects is Samson Corporation, a mid-sized pharmaceuticals corporation that, through a series of acquisitions over the past five years, has captured a large segment of the flu vaccine market. Samson financed the acquisitions largely through the issuance of corporate debt. The company’s stock had performed steadily for many years until the acquisitions, at which point both earnings and dividends accelerated rapidly. Davidson wants to determine what impact any additional acquisitions will have on Samson’s future earnings potential and stock performance.

The other prospect is Wellborn Products, a manufacturer of a variety of over-the-counter pediatric products. Wellborn is a relatively new player in this segment of the market, but industry insiders have confidence in the proven track record of the company’s upper management who came from another firm that is a major participant in the industry. The market cap of Wellborn is much smaller than Samson’s, and the company differs from Samson because it has grown internally rather than through the acquisition of its competitors. Wellborn currently has no long-term debt outstanding. While the firm does not pay a dividend, it has recently declared that it intends to begin paying one at the end of the current calendar year.

Select financial information (year-end 2005) for Samson and Wellborn is outlined below:

Samson:

Current Price:

$36.00

Sales:

$75,000,000

Net Income:

$5,700,000

Assets:

$135,000,000

Liabilities:

$95,000,000

Equity:

$60,000,000

Wellborn:

Current Price:

$21.25

Dividends expected to be received at the end of 2006:

$1.25

Dividends expected to be received at the end of 2007:

$1.45

Price expected at year-end 2007:

$27.50

Required return on equity:

9.50%

Risk-free rate:

3.75%

Other financial information:

One-year forecasted dividend yield on market index:

1.75%

Consensus long-term earnings growth rate:

5.25%

Short-term government bill rate:

3.75%

Medium-term government note rate:

4.00%

Long-term government bond rate:

4.25%

It is the beginning of 2006, and Davidson wants use the above data to identify which will have the greatest expected returns. She must determine which valuation model(s) is most appropriate for these two securities. Also, Davidson must forecast sustainable growth rates for each of the companies to assess whether or not they would fit within the fund’s investment parameters.

Using the Gordon growth model (GGM), what is the equity risk premium?

A)   5.50%.

B)   3.25%.

C)   2.75%.

Correct answer is C)

The GGM calculates the risk premium using forward-looking or expectational data. The equity risk premium is estimated as the one-year forecasted dividend yield on market index, plus the consensus long-term earnings growth rate, minus the long-term government bond yield. Note that because equities are assumed to have a long duration, the long-term government bond yield serves as the proxy for the risk-free rate.

Equity risk premium = 1.75% + 5.25% ? 4.25% = 2.75%

 

Q5. Davidson is familiar with the use of the capital asset pricing model (CAPM) and arbitrage pricing theory (APT) to estimate the required rate of return for an equity investment. However, there are some limitations associated with both models that should be considered in her analysis. Which of the following is least likely a limitation of the CAPM and/or APT?

A)   Model uncertainty, because it is unknown if the use of either model is theoretically correct and appropriate.

B)   Risk premium exposure, because it fails to consider the implications of an asset’s sensitivity to the various risk factors in the market.

C)   Input uncertainty, because it is difficult to estimate the appropriate risk premiums accurately.

Correct answer is B)

Both CAPM and APT consider the sensitivity of an asset’s return to various risk factors. CAPM measures an asset’s sensitivity relative to the market portfolio with beta, while APT measures an asset’s sensitivity to a variety of risk factors, such as investor confidence, time horizon, inflation, business-cycle and market-timing.

 

Q6. Which of the following valuation models would be most appropriate in the valuation analysis of Wellborn Products?

A)   The dividend discount model (DDM), because the hedge fund’s investment would represent a minority interest in the company.

B)   The free cash flow model, because the firm does not have a steady dividend payment history.

C)   The residual income approach, because the firm is likely to have negative free cash flow for the foreseeable future.

Correct answer is B)

Free cash flow models are appropriate for firms such as Wellborn that do not have a dividend payout history.

 

Q7. Davidson needs to determine if the shares of Wellborn are currently undervalued or overvalued in the market relative to the shares’ fundamental value. The estimated fair value of Wellborn shares, using a two-period dividend discount model (DDM), is:

A)   $21.25.

B)   $25.29.

C)   $27.58.

Correct answer is B)

The value of Wellborn using a two-period DDM is:

($1.25 / 1.095) + (($1.45 + $27.50) / 1.0952) = $25.29

 

Q8. As a part of her analysis, Davidson needs to calculate return on equity for both potential investments. What is last year’s return on equity (ROE) for Samson shares?

A)   9.50%.

B)   17.10%.

C)   5.28%.

Correct answer is A)

ROE can be calculated using the DuPont formula, which is:

ROE = Net Income / Stockholder’s Equity

ROE = (net income / sales) × (sales / total assets) × (total assets / stockholders’ equity)

Therefore: ROE = (5,700,000 / 75,000,000) × (75,000,000 / 135,000,000) × (135,000,000 / 60,000,000) = (0.076) × (0.556) × (2.25) = 0.095 = 9.50%.

 

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