Equity Valuation: Concepts and Tools

Correct Answer: Dividends are the primary source of value for shareholders

The dividend discount model (DDM) assumes that the value of a stock is the present value of all its future dividend payments. This means that dividends are considered the primary source of value for shareholders in the DDM framework. The assumption that a company's future growth rate will remain constant indefinitely is not a key assumption of the DDM. In fact, the DDM can accommodate different growth rate assumptions, such as a two-stage or three-stage model with varying growth rates. While the cost of equity is an important input in the DDM, the assumption stated in the third option is not entirely accurate. The cost of equity is typically estimated using models like the Capital Asset Pricing Model (CAPM) or by adding a risk premium to the risk-free rate, rather than being set equal to the dividend yield plus the expected growth rate of dividends.

Correct Answer: Price-to-earnings (P/E) ratio

The price-to-earnings (P/E) ratio is calculated by dividing a company's stock price by its earnings per share (EPS). This ratio shows how much investors are willing to pay for each dollar of a company's earnings. The enterprise value-to-EBITDA ratio compares a company's total value (including debt) to its earnings before interest, taxes, depreciation, and amortization. While useful, it is not directly calculated using the stock price and EPS. The price-to-book ratio compares a company's market value to its book value of equity. Again, this is a valuable ratio but not the one specifically calculated using stock price divided by EPS.

Correct Answer: Debt-to-equity ratio

The debt-to-equity ratio is the most appropriate measure of a company's financial leverage when conducting equity valuation. This ratio compares a company's total debt to its total equity, providing insight into the extent to which the company relies on borrowed funds to finance its operations and growth. A higher debt-to-equity ratio indicates that a company has a higher level of financial risk, as it is more dependent on debt financing. The price-to-earnings ratio, while a useful valuation metric, does not directly measure financial leverage. It compares a company's stock price to its earnings per share, indicating how much investors are willing to pay for each dollar of the company's earnings. The enterprise value-to-EBITDA ratio is a valuation metric that compares a company's overall value to its earnings before interest, taxes, depreciation, and amortization. While this ratio can be useful in assessing a company's value relative to its earnings, it does not specifically measure financial leverage.