CSC Equity Securities Valuation 5 — Questions and Answers
Question 1: A company has a payout ratio of 60%, ROE of 15%, and investors require an 11% return. Using the Gordon Growth Model, what is the implied dividend growth rate?
- 4.0%
- 6.0% (Correct answer)
- 9.0%
- 15.0%
Correct answer: 6.0%
Growth rate g = Retention ratio × ROE = (1 − 0.60) × 15% = 0.40 × 15% = 6.0%.
Question 2: What is the primary weakness of using P/E ratios for cross-border equity comparison?
- P/E ratios cannot be calculated for large-cap stocks
- Differences in accounting standards and tax regimes distort earnings, making cross-border P/E comparisons unreliable (Correct answer)
- P/E ratios are only valid in the Canadian market
- Earnings are always identical across countries under IFRS
Correct answer: Differences in accounting standards and tax regimes distort earnings, making cross-border P/E comparisons unreliable
Different GAAP/IFRS applications, tax laws, and reporting conventions make earnings — and therefore P/E ratios — difficult to compare across countries.
Question 3: Which of the following best defines 'free cash flow to equity' (FCFE) used in equity valuation?
- Net income plus all non-cash charges, before debt repayment
- Cash available to equity holders after operating expenses, capital expenditures, and net debt repayments (Correct answer)
- Operating income divided by total assets
- Dividends declared divided by shares outstanding
Correct answer: Cash available to equity holders after operating expenses, capital expenditures, and net debt repayments
FCFE is the cash remaining for equity shareholders after funding operations, capital spending, and net debt obligations.
Question 4: A preferred share pays a fixed annual dividend of $3.00 and investors require a 6% return. What is its theoretical value?
- $18.00
- $33.33
- $50.00 (Correct answer)
- $66.67
Correct answer: $50.00
Value of perpetual preferred = Dividend ÷ Required return = $3.00 ÷ 0.06 = $50.00.
Question 5: In a discounted cash flow (DCF) model for equities, what does the 'terminal value' represent?
- The book value of assets at the end of the forecast period
- The value of all cash flows beyond the explicit forecast horizon, captured in a single figure (Correct answer)
- The tax liability owed at the end of the company's operating life
- The par value of equity at maturity
Correct answer: The value of all cash flows beyond the explicit forecast horizon, captured in a single figure
Terminal value aggregates the present value of all cash flows after the detailed forecast period, typically using a perpetuity growth formula.
Question 6: Why might two analysts using the same valuation model arrive at different intrinsic values for the same stock?
- Valuation models are legally standardized so different values are impossible
- Different assumptions about growth rates, discount rates, or future earnings lead to divergent estimates (Correct answer)
- Only one set of inputs is mathematically valid for any given model
- Intrinsic value is fixed and equal to current market price by efficient market theory
Correct answer: Different assumptions about growth rates, discount rates, or future earnings lead to divergent estimates
Valuation models are highly sensitive to input assumptions; varying growth or discount rate estimates produces materially different intrinsic value outcomes.
Question 7: Which of the following would cause a stock's calculated intrinsic value to INCREASE under the dividend discount model?
- An increase in the required rate of return
- A decrease in the expected dividend growth rate
- A decrease in the required rate of return (Correct answer)
- An increase in systematic risk (beta)
Correct answer: A decrease in the required rate of return
Lowering the required return shrinks the denominator (r − g) in the DDM formula, increasing the calculated present value.
CSC Equity Securities Valuation 5
A company has a payout ratio of 60%, ROE of 15%, and investors require an 11% return.
Using the Gordon Growth Model, what is the implied dividend growth rate?