Q1. Investors receive dividends as payoffs for investing in equity shares.

Thus, the value of a

share should be calculated by discounting expected dividends. True or false?

A1. This is false. The dividend that are paid out over the period of time like in the foreseeable
future does not mean much. They should be considered only when they are to be paid as a fixed
ratio of the earning. Hence, we can say that they will tie to the value of the share only if they
are paid out as a fixed proportion otherwise not. Hence, the second statement is false as the
dividends are usually distributions of wealth, makes the price of stock go down.

Q2. Some analysts trumpet the saying “Cash is King.” They mean that cash is the primary
fundamental that the equity analyst should focus on. Is cash king? Should a firm that has higher
free cash flows have a higher value?

A2. Cash is not king appositively it should be Free cash flow. Hence FCF is what an analyst
should focus upon because it the amount that is available to the shareholders once you have
paid all the debt and the interest payments. Whereas cash is biased too much by interest
payments, amortization, depreciation as it does not take into account any of these. Hence, we
can say an analyst should primarily focus upon the FCFF/FCFE not the cash.

Q3. Information indicates that a firm will earn a return on common equity above its cost of
equity capital in all years in the future, but its shares trade below book value. Those shares
must be mispriced. True or false?

A3. True. V(E) = B0 + RE1/ re + RE2/r²e+…

Residual earnings = (ROCE - required return on equity) * beginning of period book value of
common equity. This shows us that with residual earnings the value has to be higher than the
book value and therefore the shares are mispriced.

Q4. Jet form Corporation traded at a price-to-book ratio of 1.01 in May 1999. Its most recently
reported ROCE was 10.1 percent, and it is deemed to have a required equity return of 10
percent. What is your best guess as to the ROCE expected for the next fiscal year?

1 
 
 

 
A4. To trade at book value as:- Jet form does, it’s approximately ROCE in future should be
equal to its cost of equity i.e. 10%. Thus market will also expect an ROCE of 10% in future.

Q5. Telesoft Corp. traded at a price-to-book ratio of 0.98 in May 1999 after reporting an ROCE
of 52.2 percent. Does the market regard this ROCE as normal, unusually high, or unusually
low?

A5. The market views this ROCE as normal. The reason behind this is that the P/B is .98 which
is very much close to 1 and hence indicates correct valuation of the firm.

Q6. A share trades at a price-to-book ratio of 0.7. An analyst who forecasts an ROCE of 12
percent each year in the future, and sets the required equity return at 10 percent, recommends
a hold position. Does his recommendation agree with his forecast?

A6. P/B ratio is 0.7 which is much lower than 1. It means that the market judges asset value is
overstated, or the company is faring very badly in terms of returns on its assets. This can only
be the case if the firm’s operations destroy value. But in the question the expected ROCE is
12% which means that firm would create value and it’s the asset value will rise as the required
return is only 10%. Hence this would be considered by the investors and hence the value of the
share will rise and therefore, the recommendation given by the analyst is correct i.e. to hold the
stock.

Q7. Explain why analysts’ forecasts of earnings-per-share growth typically underestimate the
growth that an investor values if a firm pays dividends.

A7. Analysts typically forecast eps and eps growth without consideration for how earnings are
affected by pay-out. That is, they forecast ex-dividend growth, not cum-dividend growth.
Investors’ value ex-dividend earnings growth, but they also value additional earnings to be
earned from their investment of dividends.

2 
 
 

 
Q8. The historical earnings growth rate for the S&P 500 companies has been about 8.5 percent.
Yet the required growth rate for equity investors is considered to be about 12 percent. Can you
explain the inconsistency?

A8. The historical 8.5% growth rate that is often quoted is the ex-dividend growth rate. It
ignores the fact that earnings were also earned by investors from reinvesting dividends (in the
S&P 500 stocks, for example) that were typically 40% of earnings. The cum-dividend rate is
about 12%.

Q9. The following formula is often used to value shares, where Earn1 is forward earnings, r is
the cost of capital, and g is the expected earnings growth rate. Explain why this formula can
lead to errors.

A9. Formula Value of Equity = Earn1/(r-g)

This formula is wrong because it takes into account the growth rate of ex-dividend rather than
the growth rate of cum-dividends. The difference is that the Ex-dividend growth rates does not
takes into account the growth by reinvesting the dividends you are getting in that duration.
Apart from this, the formula does not work if g>k.

Q10. A firm’s earnings are expected to grow at a rate equal to the required rate of return for its
equity, 12 percent. What is the trailing P/E ratio? What is the forward P/E ratio?

A10. Assuming share price of company to be “x‟

Growth rate = 12%

Required rate of return=12%

Trailing P/E ratio = 1*(1+.12)/0.12 = 9.33

Forward P/E ratio = 1/0.12 =8.33

3