Questions from "Investment Analysis & Portfolio Management", 10thed. Reilly & Brown

1. Under what conditions would you use a two - or three-stage cash flow model rather than the constant-growth model?

2. What is the rationale for using the price/book value ratio as a measure of relative value?

3. What would you look for to justify a price/book value ratio of 3.0? What would you expect to be the characteristics of a firm with a P/BV ratio of 0.6?

4. Why has the price/cash flow ratio become a popular measure of relative value during the recent past? What factors would help explain a difference in this ratio for two firms?

5. Assume that you uncover two stocks with substantially different price/sales ratios (e.g., 0.5 versus 2.5). Discuss the factors that might explain the difference.

6. A generalized model for the value of any asset is the present value of the expected cash flows:

Value = ^N∑CF_t/t = 1(1+k)^t

Where:

N = life of the asset

CF_t = cash flow in Period t

k = appropriate discount rate

Both stock and bond valuation models use a discounted cash flow approach, which includes the estimation of three factors (N, CF_t, k).

Explain why each of these three factors is generally more difficult to estimate for common stocks than for traditional corporate bonds.

7. Select three companies from any industry except retail drugstores.

a. Compute their forward P/E ratios using last year's average price [(high plus low)/2] and estimated earnings.
b. Compute their growth rate of earnings over the last five years.
c. Look up the most recent beta reported in Value Line.
d. Discuss the relationships among P/E, growth, and risk.

8. Lauren Entertainment, Inc., has an 18 percent annual growth rate compared to the market rate of 8 percent. If the market multiple is 18, determine P/E ratios for Lauren Entertainment, Inc., assuming its beta is 1.0 and you feel it can maintain its superior growth rate for:

a. The next 10 years.
b. The next 5 years.

9. The constant-growth dividend discount model can be used both for the valuation of companies and for the estimation of the long-term total return of a stock.

Assume: $20 = Price of a Stock Today
8% = Expected Growth Rate of Dividends
$0.60 = Annual Dividend One Year Forward

a. Using only the preceding data, compute the expected long-term total return on the stock using the constant-growth dividend discount model.

b. Briefly discuss three disadvantages of the constant-growth dividend discount model in its application to investment analysis.

c. Identify threealternative methods to the dividend discount model for the valuation of companies.