Equity Securities Valuation Flashcards

An analyst uses a two-stage dividend discount model. What is the main advantage of this approach over the constant-growth model?

Answer: It can accommodate an initial high-growth phase followed by stable growth

The two-stage DDM allows for a high-growth period before the firm matures into a stable, slower-growth phase.

A company earned $3.00 EPS last year, pays out 40% as dividends, and retains the rest at a 12% return on equity. What is the sustainable dividend growth rate?

Answer: 7.2%

Sustainable growth rate = Retention ratio × ROE = (1 − 0.40) × 12% = 0.60 × 12% = 7.2%.

Which valuation ratio is most useful when comparing companies with negative earnings?

Answer: Price-to-sales (P/S)

When earnings are negative, P/E is meaningless, but price-to-sales remains valid because revenues are rarely negative.

How does a higher required rate of return affect the intrinsic value calculated by the Gordon Growth Model?

Answer: It decreases intrinsic value

In the Gordon Growth Model, intrinsic value = D1 ÷ (r − g); a higher r increases the denominator and lowers the calculated value.

What is 'earnings yield,' and how is it related to the P/E ratio?

Answer: Earnings yield = EPS ÷ Price; it is the reciprocal of the P/E ratio

Earnings yield = EPS ÷ Price, which is the mathematical inverse of the P/E ratio.

A cyclical company reports unusually high earnings at the peak of an economic cycle. Why might an analyst use 'normalized' or 'mid-cycle' earnings for valuation?

Answer: To avoid valuation distortion caused by temporarily elevated peak earnings

Normalized earnings smooth out cyclical peaks and troughs, preventing overvaluation when peak profits are unsustainably high.

Enterprise Value (EV) is defined as market capitalization plus net debt. Which multiple is commonly computed using EV?

Answer: EV/EBITDA

EV/EBITDA is widely used because it is capital-structure neutral and compares firms with different debt levels.