CSC Equity Securities Valuation 3 — Questions and Answers
Question 1: An analyst uses a two-stage dividend discount model. What is the main advantage of this approach over the constant-growth model?
- It eliminates the need to estimate a discount rate
- It can accommodate an initial high-growth phase followed by stable growth (Correct answer)
- It only works for non-dividend-paying stocks
- It relies entirely on book value rather than dividends
Correct 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.
Question 2: 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?
- 4.8%
- 7.2% (Correct answer)
- 12.0%
- 40.0%
Correct answer: 7.2%
Sustainable growth rate = Retention ratio × ROE = (1 − 0.40) × 12% = 0.60 × 12% = 7.2%.
Question 3: Which valuation ratio is most useful when comparing companies with negative earnings?
- Price-to-earnings (P/E)
- Price-to-book (P/B)
- Price-to-sales (P/S) (Correct answer)
- Dividend yield
Correct 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.
Question 4: How does a higher required rate of return affect the intrinsic value calculated by the Gordon Growth Model?
- It increases intrinsic value
- It has no effect on intrinsic value
- It decreases intrinsic value (Correct answer)
- It only affects intrinsic value if dividends change
Correct 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.
Question 5: What is 'earnings yield,' and how is it related to the P/E ratio?
- Earnings yield = EPS ÷ Dividends; it is the inverse of the payout ratio
- Earnings yield = EPS ÷ Price; it is the reciprocal of the P/E ratio (Correct answer)
- Earnings yield = Dividends ÷ Price; it equals dividend yield
- Earnings yield = Price ÷ EPS; it equals the P/E ratio
Correct 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.
Question 6: 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?
- To artificially inflate the P/E ratio to attract investors
- To avoid valuation distortion caused by temporarily elevated peak earnings (Correct answer)
- Because GAAP earnings are not permitted in securities analysis
- To use the lowest possible earnings figure in the model
Correct 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.
Question 7: Enterprise Value (EV) is defined as market capitalization plus net debt. Which multiple is commonly computed using EV?
- EV/Net Income
- EV/Dividends
- EV/EBITDA (Correct answer)
- EV/EPS
Correct answer: EV/EBITDA
EV/EBITDA is widely used because it is capital-structure neutral and compares firms with different debt levels.
CSC Equity Securities Valuation 3
An analyst uses a two-stage dividend discount model.
What is the main advantage of this approach over the constant-growth model?