Benjamin Graham, the father of value investing, once said, \"In the short run, t

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? The intrinsic value of a stock is based only on the perceived risk in the company. A stock's intrinsic value is based on the fundamental cash flows and the company's risk. 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 corporate valuation model to estimate the value of the company's stock? A company that is not expected to distribute any earnings to its stockholders for the next few years A company that has a stable distribution policy

Explanation / Answer

Part A)

A stock's intrinsic value is based on the fundamental cash flows and the company's risk.

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Explanation

The intrinsic value of a company is based on its ability to generate cash flows. It is also known as the fundamental value of the company. It is calculated by discounting the cash flows expected from the project/investment/stock to today's value.

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Part B)

A company that is not expected to distribute any earnings to its stockholders for the next few years.

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Explanation

As the name suggests, dividend discount model of stock valuation is based on the distributions (in the form of dividends) to shareholders. Therefore, for a company which is not going to distribute any dividends in the near future, we cannot use dividend discount model for estimating the stock price. In such a case, we will have to use the corporate valulation model which is not based on the dividend distribution.

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