CSC Equity Securities Valuation 4 — Questions and Answers
Question 1: A stock's required rate of return is 9% and it just paid a $2.00 dividend expected to grow at 5% forever. What is its intrinsic value using the Gordon Growth Model?
- $44.44
- $50.00
- $52.50 (Correct answer)
- $55.00
Correct answer: $52.50
V = D1 ÷ (r − g) = ($2.00 × 1.05) ÷ (0.09 − 0.05) = $2.10 ÷ 0.04 = $52.50.
Question 2: Which statement best describes the difference between 'relative valuation' and 'absolute valuation'?
- Relative valuation uses discounted cash flows; absolute valuation uses market multiples
- Absolute valuation estimates intrinsic worth from fundamentals; relative valuation benchmarks a stock against peers using multiples (Correct answer)
- Relative valuation applies only to preferred shares; absolute valuation applies to common shares
- They are identical methods with different names
Correct answer: Absolute valuation estimates intrinsic worth from fundamentals; relative valuation benchmarks a stock against peers using multiples
Absolute valuation (e.g., DDM, DCF) estimates stand-alone intrinsic value, while relative valuation compares multiples such as P/E to industry peers.
Question 3: What does a high return on equity (ROE) indicate when used in equity valuation?
- The company earns very little on shareholders' investment
- The company generates significant profit relative to shareholders' equity, often justifying a premium valuation (Correct answer)
- The company has excessive financial leverage that inflates book value
- ROE is irrelevant to stock valuation
Correct answer: The company generates significant profit relative to shareholders' equity, often justifying a premium valuation
A high ROE indicates efficient use of equity capital and typically supports higher P/B ratios and valuation premiums.
Question 4: An investor applies a P/E multiple of 18× to forecast EPS of $3.50. What is the target share price?
- $51.43
- $54.00
- $63.00 (Correct answer)
- $64.80
Correct answer: $63.00
Target price = P/E × EPS = 18 × $3.50 = $63.00.
Question 5: In equity analysis, what is the 'margin of safety'?
- The ratio of dividends to earnings
- The difference between a company's current ratio and the industry average
- The gap between a stock's intrinsic value and its current market price, providing a buffer against errors (Correct answer)
- The percentage of earnings retained after paying dividends
Correct answer: The gap between a stock's intrinsic value and its current market price, providing a buffer against errors
Margin of safety is the discount at which a stock trades below its estimated intrinsic value, cushioning the investor against misjudgment.
Question 6: Which factor would DECREASE the theoretical P/E ratio a stock should command, all else equal?
- An increase in expected earnings growth
- A decrease in the required rate of return
- An increase in financial risk and uncertainty (Correct answer)
- An improvement in dividend payout consistency
Correct answer: An increase in financial risk and uncertainty
Greater financial risk raises the required rate of return, which compresses the justified P/E multiple.
Question 7: When using comparable company multiples, why must an analyst adjust for differences in growth rates and risk?
- All companies in the same sector have identical multiples by definition
- Differences in growth and risk cause multiples to differ; failing to adjust leads to inaccurate valuation conclusions (Correct answer)
- Growth rate differences only matter for bond valuation, not equity
- Regulatory rules require identical multiples across industry peers
Correct answer: Differences in growth and risk cause multiples to differ; failing to adjust leads to inaccurate valuation conclusions
A high-growth, low-risk peer commands a higher multiple than a low-growth, high-risk company, so raw multiple comparisons without adjustment are misleading.
CSC Equity Securities Valuation 4
A stock's required rate of return is 9% and it just paid a $2.00 dividend expected to grow at 5% forever.
What is its intrinsic value using the Gordon Growth Model?