Problem set

1. An analyst estimates the intrinsic value of a

stock to be in the range of €17.85 to €21.45. The
current market price of the stock is €24.35. This
stock is most likely:
• A overvalued.
• B undervalued.
• C fairly valued.
 A is correct. The current market price of the
stock exceeds the upper bound of the analyst’s
estimate of the intrinsic value of the stock.
2. An analyst determines the intrinsic value of an
equity security to be equal to $55. If the current
price is $47, the equity is most likely:
• A undervalued.
• B fairly valued.
• C overvalued.
A is correct. The market price is less than the
estimated intrinsic, or fundamental, value.
8. An investor expects to purchase shares of
common stock today and sell them after two years.
The investor has estimated dividends for the next
two years, D1 and D2, and the selling price of the
stock two years from now, P2. According to the
dividend discount model, the intrinsic value of the
stock today is the present value of:
• A next year’s dividend, D1.
• B future expected dividends, D1 and D2.
• C future expected dividends and price—D1, D2
and P2.
C is correct. According to the dividend discount
model, the intrinsic value of a stock today is the
present value of all future dividends. In this
case, the intrinsic value is the present value of
D1, D2, and P2. Note that P2 is the present value
at Period 2 of all future dividends from Period 3
to infinity.
13. The Beasley Corporation has just paid a
dividend of $1.75 per share. If the required rate of
return is 12.3 percent per year and dividends are
expected to grow indefinitely at a constant rate of
9.2 percent per year, the intrinsic value of Beasley
Corporation stock is closest to:
• A $15.54.
• B $56.45.
• C $61.65.
C is correct.
P0 = D1/(r – g) = 1.75(1.092)/(0.123 – 0.092) =
$61.65.
14. An investor is considering the purchase of a
common stock with a $2.00 annual dividend. The
dividend is expected to grow at a rate of 4 percent
annually. If the investor’s required rate of return is
7 percent, the intrinsic value of the stock is closest
to:
• A $50.00.
• B $66.67.
• C $69.33.
C is correct. According to the Gordon growth
model, V0 = D1/(r – g).
In this case, D1 = $2.00 × 1.04 = $2.08,
So, V0 = $2.08/(0.07 – 0.04) = $69.3333 =
$69.33.
15. An analyst gathers / estimates the following
information about a stock:

Based on a dividend discount model, the stock is most

likely:
• A undervalued.
• B fairly valued.
• C overvalued.
16. An analyst is attempting to value shares of the
Dominion Company. The company has just paid a
dividend of $0.58 per share. Dividends are expected
to grow by 20 percent next year and 15 percent the
year after that. From the third year onward,
dividends are expected to grow at 5.6 percent per
year indefinitely. If the required rate of return is
8.3 percent, the intrinsic value of the stock is closest
to:
• A $26.00.
• B $27.00.
• C $28.00.
17. Hideki Corporation has just paid a dividend of ¥450
per share. Annual dividends are expected to grow at the
rate of 4 percent per year over the next four years. At
the end of four years, shares of Hideki Corporation are
expected to sell for ¥9000. If the required rate of return
is 12 percent, the intrinsic value of a share of Hideki
Corporation is closest to:
• A ¥5,850.
• B ¥7,220.
• C ¥7,670.
18. The Gordon growth model can be used to
value dividend- paying companies that are:
• A expected to grow very fast.
• B in a mature phase of growth.
• C very sensitive to the business cycle.
B is correct. The Gordon growth model (also
known as the constant growth model) can be
used to value dividend- paying companies in a
mature phase of growth. A stable dividend
growth rate is often a plausible assumption for
such companies.
19. The best model to use when valuing a young
dividend- paying company that is just entering
the growth phase is most likely the:
• A Gordon growth model.
• B two- stage dividend discount model.
• C three- stage dividend discount model.
C is correct. The Gordon growth model is best
suited to valuing mature companies. The two-
stage model is best for companies that are
transitioning from a growth stage to a mature
stage. The three- stage model is appropriate for
young companies just entering the growth
phase.
Other problems
Problem : An analyst finds that nearly all companies in a
market segment have common shares which are trading at
market prices above the his estimate of the shares’ values.
This market segment is widely followed by analysts. Which of
the following statements describes the analyst’s most
appropriate first action?

• A Issue a sell recommendation for each share issue.

• B Issue a buy recommendation for each share issue.
• C Reexamine the models and inputs used for the valuations.
C is correct.

It seems improbable that all the share issues analyzed are

overvalued, as indicated by market prices in excess of estimated
value—particularly because the market segment is widely followed
by analysts.

Thus, the analyst will not issue a sell recommendation for each issue.
The analyst will most appropriately reexamine the models and
inputs prior to issuing any recommendations. A buy
recommendation is not an appropriate response to an overvalued
security.
Problem : An analyst, using a number of models
and a range of inputs, estimates a security’s
value to be between ¥250 and ¥270. The
security is trading at ¥265. The security appears
to be:
• A overvalued.
• B undervalued.
• C fairly valued.
C is correct. The security’s market price of ¥265
is within the range estimated by the analyst. The
security appears to be fairly valued.
Problem : An investor expects a share to pay dividends of
$3.00 and $3.15 at the end of Years 1 and 2, respectively.
At the end of the second year, the investor expects the
shares to trade at $40.00. The required rate of return on
the shares is 8 percent. If the investor’s forecasts are
accurate and the market price of the shares is currently
$30, the most likely conclusion is that the shares are:
• A overvalued.
• B undervalued.
• C fairly valued.
Problem : Two investors with different holding
periods but the same expectations and required
rate of return for a company are estimating the
intrinsic value of a common share of the company.
The investor with the shorter holding period will
most likely estimate a:
• A lower intrinsic value.
• B higher intrinsic value.
• C similar intrinsic value.
• C is correct. The intrinsic value of a security is
independent of the investor’s holding period.
Problem : An equity valuation model that
focuses on expected dividends rather than the
capacity to pay dividends is the:
• A dividend discount model.
• B free cash flow to equity model.
• C cash flow return on investment model.
• A is correct. Dividend discount models focus
on expected dividends.
 PROBLEM: GORDON GROWTH MODEL
Siemens AG operates in the capital goods and technology
space. It is involved in the engineering, manufacturing,
automation, power, and transportation sectors.

It operates globally and is one of the largest companies in the

sectors in which it operates.

It is a substantial employer in both its original, domestic German

market, as well as dozens of countries around the world.

Selected financial information for Siemens appears in Exhibit 3.

 The analyst estimates the growth rate to be
approximately 5.4 percent based on the
dividend growth rate over the period 2013 to
2017 [3(1 + g)^4 = 3.7, so g = 5.4%].
The analyst estimates a required return of
7.5 percent. The most recent dividend of €3.70 is used
for D0.

Questions:
1 Use the Gordon growth model to estimate
Siemens’s intrinsic value.
2 Comparing to constant dividend model, how much
does the dividend growth assumption add to the
intrinsic value estimate?
3 Based on the estimated intrinsic value, is a share of
Siemens undervalued, overvalued, or fairly valued?

4 What is the intrinsic value if the growth rate estimate is

lowered to 4.4 percent?

5 What is the intrinsic value if the growth rate estimate is

lowered to 4.4 percent and the required rate of return
estimate is increased to 8.5 percent?
• Solution to 3: A. The share of Siemens appears
to be undervalued. The analyst, before making
a recommendation, might consider how
realistic the estimated inputs are and check
the sensitivity of the estimated value to
changes in the inputs.
 The Gordon growth model estimate of intrinsic
value is extremely sensitive to the choice of required
rate of return r and growth rate g. It is possible that
the growth rate assumption and the required return
assumption used initially were too high.
Worldwide economic growth is typically in the
low single digits, which may mean that a large
company such as Siemens may struggle to grow
dividends at 5.4 percent into perpetuity.
NB:The assumptions of the Gordon model are as
follows:
■■ Dividends are the correct metric to use for
valuation purposes.
■■ The dividend growth rate is forever: It is perpetual
and never changes.
■■ The required rate of return is also constant over
time.
■■ The dividend growth rate is strictly less than the
required rate of return.
Problem: Gordon Growth Model in the Case
of No Current Dividend
A company does not currently pay a dividend
but is expected to begin to do so in five years (at
t = 5). The first dividend is expected to be $4.00
and to be received five years from today. That
dividend is expected to grow at 6 percent into
perpetuity. The required return is 10 percent.
What is the estimated current intrinsic value?
• Solution:
The analyst could value the share at t = 4, the
point at which dividends are expected to be paid
in the following year and from which point they
are expected to grow at a constant rate.
Problem : An analyst finds that all the securities
analyzed have estimated values higher than
their market prices. The securities all appear to
be:
• A overvalued.
• B undervalued.
• C fairly valued.
• B is correct. The estimated intrinsic value for
each security is greater than the market price.
The securities all appear to be undervalued in
the market. Note, however, that the analyst
may wish to reexamine the model and inputs
to check that the conclusion is valid.