Equity Investments【Reading 52】Sample about, company, following, 2012

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An analyst gathered the following information about a company:

• The stock is currently trading at $31.00 per share.
• Estimated growth rate for the next three years is 25%.
• Beginning in the year 4, the growth rate is expected to decline and stabilize at 8%.
• The required return for this type of company is estimated at 15%.
• The dividend in year 1 is estimated at $2.00.

The stock is undervalued by approximately:

A) $15.70.

B) $0.00.

C) $6.40.

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The high “supernormal” growth in the first three years and the decrease in growth thereafter signals that we should use a combination of the multi-period and finite dividend growth models (DDM) to value the stock.
Step 1: Determine the dividend stream through year 4

• D1 = $2.00 (given)
• D2 = D1 × (1 + g) = 2.00 × (1.25) = $2.50
• D3 = D2 × (1 + g) = $2.50 × (1.25) = $3.13
• D4 = D3 × (1 + g) = $3.13 × (1.08) = $3.38

Step 2: Calculate the value of the stock at the end of year 3 (using D4)

• P3 = D4 / (ke – g) = $3.38 / (0.15 – 0.08) = $48.29

Step 3: Calculate the PV of each cash flow stream at ke = 15%, and sum the cash flows. Note: We suggest you clear the financial calculator memory registers before calculating the value. The present value of:

• D1 = 1.74 = 2.00 / (1.15)1, or FV = -2.00, N = 1, I/Y = 15, PV = 1.74
• D2 = 1.89 = 2.50 / (1.15)2, or FV = -2.50, N = 2, I/Y = 15, PV = 1.89
• D3 = 2.06 = 3.13 / (1.15)3, or FV = -3.13, N = 3, I/Y = 15, PV = 2.06
• P3 = 31.75 = 48.29 / (1.15)3, or FV = -48.29, N = 3, I/Y = 15, PV = 31.75
• Sum of cash flows = 37.44.
• Thus, the stock is undervalued by 37.44 – 31.00 = approximately 6.40.

Note: Future values are entered in a financial calculator as negatives to ensure that the PV result is positive. It does not mean that the cash flows are negative. Also, your calculations may differ slightly due to rounding. Remember that the question asks you to select the closest answer.

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If an analyst estimates the intrinsic value for a security that is different from its market value, the analyst should most likely take an investment position based on this difference if:

A) many analysts independently evaluate the security.

B) the security lacks a liquid market and trades infrequently.

C) the model used is not highly sensitive to its input values.

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In general, an analyst can be more confident about an estimate of intrinsic value if the model used is not highly sensitive to changes in its inputs. If a large number of analysts follow a security, its market value is more likely to be a reliable estimate of its intrinsic value. A security that does not trade frequently or in a liquid market may remain mispriced for an extended time, and thus may not result in a profit within the investment horizon even if the analyst’s estimate of intrinsic value is correct.

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An equity valuation model that values a firm based on the market value of its outstanding debt and equity securities, relative to a firm fundamental, is a(n):

A) enterprise value model.

B) asset-based model.

C) market multiple model.

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An enterprise value model relates a firm’s enterprise value (the market value of its outstanding equity and debt securities minus its cash and marketable securities holdings) to its EBITDA, operating earnings, or revenue.

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Witronix is a rapidly growing U.S. company that has increased free cash flow to equity and dividends at an average rate of 25% per year for the last four years. The present value model that is most appropriate for estimating the value of this company is a:

A) multistage dividend discount model.

B) Gordon growth model.

C) single stage free cash flow to equity model.

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A multistage model is the most appropriate model because the company is growing dividends at a higher rate than can be sustained in the long run. Though the company may be able to grow dividends at a higher-than-sustainable 25% annual rate for a finite period, at some point dividend growth will have to slow to a lower, more sustainable rate. The Gordon growth model is appropriate to use for mature companies that have a history of increasing their dividend at a steady and sustainable rate. A single stage free cash flow to equity model is similar to the Gordon growth model, but values future free cash flow to equity rather than dividends.

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A valuation model based on the cash flows that a firm will have available to pay dividends in the future is best characterized as a(n):

A) free cash flow to equity model.

B) free cash flow to the firm model.

C) infinite period dividend discount model.

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Free cash flow to equity represents a firm’s capacity to pay future dividends. A free cash flow to equity model estimates the firm’s FCFE for future periods and values the stock as the present value of the firm’s future FCFE per share.

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The yield on a company’s 7.5%, $50 par preferred stock is 6%. The value of the preferred stock is closest to:

A) $12.50.

B) $50.00.

C) $62.50.

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The preferred dividend is 0.075($50) = $3.75. The value of the preferred = $3.75 / 0.06 = $62.50.

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A preferred stock’s dividend is $5 and the firm’s bonds currently yield 6.25%. The preferred shares are priced to yield 75 basis points below the bond yield. The price of the preferred is closest to:

A) $5.00.

B) $80.00.

C) $90.91.

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Preferred stock yield (Kp) = bond yield – 0.75% = 6.25% − 0.75% = 5.5%
Value = dividend / Kp = $5 / 0.055 = $90.91.

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Assuming a discount rate of 15%, a preferred stock with a perpetual dividend of $10 is valued at approximately:

A) $1.50.

B) $66.67.

C) $8.70.

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The formula for the value of preferred stock with a perpetual dividend is: D / kp, or 10.0 / 0.15 = $66.67.

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Calculate the value of a preferred stock that pays an annual dividend of $5.50 if the current market yield on AAA rated preferred stock is 75 basis points above the current T-Bond rate of 7%.

A) $42.63.

B) $70.97.

C) $78.57.

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kpreferred = base yield + risk premium = 0.07 + 0.0075 = 0.00775
ValuePreferred = Dividend / kpreferred
Value = 5.50 / 0.0775 = $70.97

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A company has 8 percent preferred stock outstanding with a par value of $100. The required return on the preferred is 5 percent. What is the value of the preferred stock?

A) $152.81.

B) $160.00.

C) $100.00.

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The annual dividend on the preferred is $100(.08) = $8.00. The value of the preferred is $8.00/0.05 = $160.00.