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CHAPTER 15 COMPANY ANALYSIS AND STOCK VALUATION Answers to Questions 1. Examples of growth companies would include technology firms such as Intel and Microsoft. These firms have experienced very high rates of return on total assets and returns on equity when compared to market values. They retain high percentages of earnings to fund superior investment projects. Stock issues of Intel and Microsoft have been considered growth stocks since their P/E ratios are above the industry average. 2. A cyclical stock would be any stock with a high beta value. Examples of high beta stock would include stocks of typical growth companies and some investment firms. As to whether the issuing company is a cyclical company will depend on the specific selection. 3. The biotechnology firm may be considered a growth company because (1) it has a growth rate of 21 percent per year which probably exceeds the growth rate of the overall economy, (2) it has a very high return on equity and (3) it has a relatively high retention rate. However, since a biotechnology firm relies heavily on continuous research and development, the above-average risk will require a high rate of return. Therefore, it is unlikely that the stock would be considered a growth stock due to the extremely high price of the stock relative to its earnings. 4. Student Exercise 5. Student Exercise 6. Student Exercise 7. Student Exercise 8. The DDM assumes that (1) dividends grow at a constant rate, (2) the constant growth rate will continue for an infinite period, and (3) the required rate of return (k) is greater than the infinite growth rate (g). Therefore, the infinite period DDM cannot be applied to the valuation of stock for growth companies because the high growth of earnings for the growth company is inconsistent with the assumptions of the infinite period constant growth DDM model. A company cannot permanently maintain a growth rate higher than its required rate of return, because competition will eventually enter this apparently lucrative business, which will reduce the firm’s profit margins and therefore its ROE and growth rate. Therefore, after a few years of exceptional growth (a period of temporary supernormal growth) a firm’s growth rate is expected to decline. Eventually its growth rate is expected to stabilize at a constant level consistent with the assumptions of the infinite period. 15 - 1
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9. Price/Book Value (P/BV) is used as a measure of relative value because, in theory, market price (P) should reflect book value (BV). In practice, the two can differ dramatically. Some researchers have suggested that firms with low P/BV ratios tend to outperform those with high P/BV ratios. 10. A high P/BV ratio such as 3.0 can result from a large amount of fixed assets being carried at historical cost. A low ratio, such as 0.6, can occur when assets are worth less than book value, for instance, bad real estate loans by banks. 11.
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