Equity Investments A: Markets and Valuation

• Topic 01

  Market Organisation and Structure

  63 questions
• Topic 02

  Market Efficiency

  54 questions
• Topic 03

  Overview of Equity Valuation

  39 questions
• Topic 04

  Discounted Dividend Models

  34 questions
• Topic 05

  Free Cash Flow Valuation Models

  48 questions
• Topic 06

  Market-Based Valuation

  52 questions
• Topic 07

  Residual Income Valuation

  51 questions
• Topic 08

  Introduction to Private Company Valuation

  51 questions

A few questions from this unit, with the answer and a full explanation. The complete bank is available when you start practising.

1. Representativeness bias, as a behavioural finance concept, leads investors to:

   • A
     Overreact to recent news by judging the probability of future outcomes based on their similarity to recent patterns rather than on base-rate probabilities
     Correct answer
   • B
     Sell all winning positions after any positive return, regardless of the size of the gain
   • C
     Trade too infrequently because they are too conservative in acting on new information
   • D
     Hold positions indefinitely to avoid realising any taxable gain
   Explanation

   Representativeness bias occurs when investors judge the likelihood of a future event based on how similar it is to a known pattern or stereotype, rather than on statistical base rates. In markets, this causes overreaction to recent news: after several quarters of strong earnings growth, investors assume the company 'is a growth company' and bid up the stock too aggressively, ignoring mean reversion in earnings. This contributes to value/growth cycles and to price overshooting around major announcements.

2. Why is the DDM considered theoretically inapplicable to a company that repurchases all shares rather than paying dividends, and what adjustment makes it theoretically valid?

   • A
     If no dividends are ever paid, the DDM yields a present value of zero for a perpetual zero cash flow stream. The theoretical fix is to substitute total equity distributions — dividends plus buybacks — for dividends, recognising that buybacks return the same economic value through price appreciation rather than cash payments.
     Correct answer
   • B
     The DDM is inapplicable because the growth rate formula g = ROE × b breaks down when the payout ratio equals 100%; the adjustment is to set g equal to the rate of GDP growth.
   • C
     The DDM is inapplicable because the discount rate must equal the dividend yield for the GGM to converge; with no dividends, the discount rate is undefined.
   • D
     The DDM is inapplicable because buyback companies typically have negative free cash flow, making any discounting model impossible to apply.
   Explanation

   The DDM derives equity value as the discounted present value of all future dividends received by an investor. If dividends are always zero, the DDM produces an intrinsic value of zero for that investor's claim — which is clearly wrong for a profitable company that repurchases shares. The resolution lies in recognising that equity holders receive value through either: (1) cash dividends, or (2) capital gains from share repurchases, which increase earnings per share and share price. Theoretically, total distributions (dividends + buybacks on a per-share basis) should be substituted into the DDM numerator. The Modigliani-Miller dividend irrelevance theorem supports this: under certain assumptions, dividends and buybacks are equivalent forms of returning capital. In practice, FCFE models circumvent this problem entirely by focusing on cash generation capacity rather than actual distribution choices.

3. An analyst projects FCFF for years 1–5 and estimates terminal value at year 5 using an EV/EBITDA exit multiple of 8x applied to projected year-5 EBITDA of \$120 million. WACC is 10%. What is the terminal value at year 5, and what is its present value at time 0?

   • A
     Terminal value at year 5 = 8 × \$120 million = \$960 million. Present value = \$960 million / (1.10)^5 = \$960 million / 1.6105 = approximately \$596 million.
     Correct answer
   • B
     Terminal value at year 5 = 8 × \$120 million = \$960 million; present value = \$960 million × (1.10)^5 = \$1,546 million (future value, not present value).
   • C
     Terminal value at year 5 = 8 × \$120 million = \$960 million; present value = \$960 million / 1.10 = \$872.7 million (discounting for only one year rather than five).
   • D
     Terminal value at year 5 = \$120 million / 8 = \$15 million; present value = \$15 million / 1.6105 = \$9.3 million.
   Explanation

   Exit multiple terminal value: TV₅ = EV/EBITDA multiple × EBITDA₅ = 8 × \$120M = \$960 million. This terminal value is expressed in year-5 dollars (it is the enterprise value of the business at that future point). To find its present value at time 0, discount at WACC for 5 years: PV = \$960M / (1.10)⁵. (1.10)⁵ = 1.6105. PV = \$960M / 1.6105 ≈ \$596M. The total firm value equals PV of Stage 1 FCFFs (years 1–5) plus \$596M. A common error is to confuse discounting (dividing) with compounding (multiplying), or to discount for only one year instead of five.