Question

Benjamin Graham, the father of value investing, once said, "In the short run, the market is a voting machine, but in the long run, the market is a weighing machine." In this quote, Benjamin Graham was referring to the key difference between the "price" and the "value" of a security. In November 2006, Citigroup's stock (NYSE: C) was trading at $49.59. Following the credit crisis of 2007-2008 and by the end of October 2009, Citigroup's stock price had plummeted to $4.27. Several banks went under, and others saw their stock prices lose more than 60% of their value. Based on your understanding of stock prices and intrinsic values, which of the following statements is true? a. A stock's market price is based only on true investor returns. b. A stock's intrinsic value is based on true risk in the company. You can estimate the value of a company's stock using models such as the corporate valuation model and the dividend discount model. Which of the following companies would you choose to evaluate if you were using the discounted dividend model to estimate the value of the company's stock? a. A company that has been distributing a portion of their earnings every quarter for the past six years b. A company that is in a high-growth stage and plans to retain all its earnings for the next few years to support its growth

Answer 1

Answer: 1. b. A stock's intrinsic value is based on true risk in the company.

2. a. A company that has been distributing a portion of their earnings every quarter for the past six years

Explanation:

1. A Stock's intrinsic value is what it is truly a measure of it's true risk. It is not like the market price that follows trading patterns but rather is based on factors inside the company. It is often arrived at through complex calculations that take into account the business aspects of the company and as such is much more thorough. This is why it is the true risk of a stock.

2. The Dividend discount model of stock valuation relies heavily on dividends bein gdistributed to calculate stock price. The formula requires that the dividend of the next period be divided by the rate of return minus the growth rate. A company that is paying no dividends therefore cannot use this model to calculate stock value which is why the first option is correct.  

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