Questions: Stock Valuation Fundamentals

Question 1

Which of the following best describes the intrinsic value of a stock according to discounted cash flow theory?

• A. The current market price of the stock on an exchange
• B. The book value of the company's assets minus its liabilities
• C. The present value of all future cash flows the stock will generate for shareholders
• D. The stock's earnings per share multiplied by the industry-average P/E ratio

Answer: (C)

DCF theory defines intrinsic value as the present value of all future cash flows attributable to shareholders — dividends, buybacks, and terminal value. Market price is what the stock trades for today, which may differ from intrinsic value. Book value is an accounting measure, not a forward-looking cash flow concept. P/E multiples are a relative valuation shortcut, not the theoretical definition of intrinsic value.

Question 2

If two analysts use the same earnings forecasts and the same DCF model but reach very different intrinsic value estimates, they should have made a calculation error.

• T. True
• F. False

Answer: False

Small differences in discount rate or long-term growth rate assumptions produce dramatically different valuations because these inputs affect a perpetuity-like calculation. A 1 percentage point change in the discount rate or terminal growth rate can shift estimated intrinsic value by 30-50%. This is a feature of the math, not an error — it reflects the genuine uncertainty in stock valuation and why 'valuation is an art as much as a science.'

Question 3

Why does stock valuation require estimating future cash flows rather than simply observing them, unlike bond valuation?

Model answer: Stocks have no fixed maturity date, no promised coupon payments, and no guaranteed principal repayment. Future dividends and earnings depend on uncertain business performance. Bond cash flows (coupons and face value) are contractually specified, making them straightforward to discount. For stocks, the analyst must forecast what the business will earn and pay out, which introduces significant uncertainty.

Bonds are contracts: the issuer promises specific cash flows on specific dates, and the only uncertainty is default risk. Stocks are residual claims on a business's future profitability — there are no guaranteed payments. The entire valuation problem for stocks is forecasting uncertain future earnings and growth rates, which is why reasonable analysts using the same framework can reach very different values.