RIA Valuation & Analysis 2 — Questions and Answers

Question 1: The Dividend Discount Model (DDM) values a stock based on:

Total assets minus total liabilities
The present value of expected future dividends (Correct answer)
Price-to-earnings relative to competitors
Book value plus growth premium

Correct answer: The present value of expected future dividends

The DDM calculates stock intrinsic value as the present value of all expected future dividends, discounted at the required rate of return.

The Gordon Growth Model (constant growth DDM): Value = D1 / (r - g), where D1 is next year's dividend, r is required rate of return, and g is the constant dividend growth rate. DDM is most useful for stable, dividend-paying companies. It's less applicable to growth companies that don't pay dividends. Sensitivity to growth rate assumptions is significant—small changes in g can dramatically change the calculated value.

Question 2: Beta of 1.5 for a stock means:

The stock returns 1.5% annually
The stock is 50% more volatile than the market (1.5x market sensitivity) (Correct answer)
The stock has a 1.5% dividend yield
The stock's P/E is 1.5x the market average

Correct answer: The stock is 50% more volatile than the market (1.5x market sensitivity)

Beta measures systematic risk—a beta of 1.5 means the stock tends to move 1.5% for every 1% market move (more volatile than market).

Beta measures a security's sensitivity to market movements. A beta of 1.5 means: when the market rises 10%, the stock tends to rise 15%; when the market falls 10%, the stock tends to fall 15%. High beta stocks amplify market moves (more risk, potentially more return). Low beta stocks (beta < 1) are less sensitive to market movements. Beta is used in CAPM to calculate expected returns and assess systematic risk.

Question 3: Credit rating agencies (Moody's, S&P) evaluate bonds based on:

Only the bond's current market price
The issuer's ability to repay principal and interest (credit risk) (Correct answer)
Historical price volatility of the bond
The bond's duration and interest rate sensitivity

Correct answer: The issuer's ability to repay principal and interest (credit risk)

Credit ratings assess the issuer's financial strength and ability to meet debt obligations—measuring default risk.

Credit rating agencies analyze issuers' financial condition, business profile, cash flow adequacy, debt levels, and economic environment to assign ratings. Investment grade: AAA to BBB- (S&P)/Baa3 (Moody's). High yield (junk): BB+ and below. Higher credit ratings = lower yields (less risk premium required). Rating downgrades can cause significant price drops, especially when bonds cross the investment-grade/high-yield threshold. Advisers use ratings to assess credit risk in fixed income portfolios.

Question 4: Working capital is calculated as:

Total assets minus total liabilities
Current assets minus current liabilities (Correct answer)
Long-term assets minus long-term debt
Revenue minus operating expenses

Correct answer: Current assets minus current liabilities

Working capital = Current Assets - Current Liabilities, measuring a company's short-term liquidity and operational efficiency.

Working capital measures liquidity by comparing short-term assets (cash, accounts receivable, inventory) against short-term obligations (accounts payable, short-term debt). Positive working capital means the company can cover near-term obligations. The current ratio (Current Assets/Current Liabilities) and quick ratio (liquid assets/current liabilities) provide related metrics. Declining working capital can signal liquidity problems even if the company appears profitable.

Question 5: Relative valuation (comparable company analysis) determines value by:

Discounting future cash flows at the WACC
Comparing valuation multiples (P/E, EV/EBITDA) to similar companies or transactions (Correct answer)
Using book value plus intangibles
Calculating replacement cost of assets

Correct answer: Comparing valuation multiples (P/E, EV/EBITDA) to similar companies or transactions

Comparable analysis ('comps') values a company by applying peer group valuation multiples (P/E, EV/EBITDA) to the target company's metrics.

Comparable company analysis (trading comps) selects peer companies and calculates their valuation multiples (P/E, EV/Revenue, EV/EBITDA, P/B). These multiples are then applied to the target company's financial metrics to derive a valuation range. The method assumes markets correctly price similar companies. Strengths: market-based, current. Weaknesses: no two companies are identical; market mispricing of comps affects the target's value. Investment bankers use comps extensively in M&A advisory.

Question 6: The debt-to-equity (D/E) ratio measures:

Annual debt payments relative to equity dividends
The proportion of financing from debt versus equity (Correct answer)
Total revenue relative to total assets
Cash flow adequacy for debt service

Correct answer: The proportion of financing from debt versus equity

D/E ratio = Total Debt / Total Equity, measuring the extent to which a company finances operations with debt versus shareholder equity.

The D/E ratio indicates financial leverage. A high D/E ratio means more debt financing, amplifying both potential returns and bankruptcy risk. Different industries have different acceptable D/E ratios—capital-intensive industries (utilities, real estate) typically carry more debt than technology companies. Advisers analyze D/E alongside interest coverage ratios and free cash flow to assess a company's ability to service debt and its financial stability.

RIA Valuation & Analysis 2

The Dividend Discount Model (DDM) values a stock based on: