1.1: Stock Pricing Flashcards
What are the two potential sources of cash flows from owning a stock?
- Cash that the firm pays out to shareholders through dividends.
- Cash generated by selling the shares at some future date
Which discount rate do we use to discount cash flows from a stock and why?
The equity cost of capital (rE). The cash flows are risky, so this is equal to the expected return of other investments available in the market with equivalent risk.
What is the NPV of investment opportunities in a competitive market?
0, every buyer must have a seller.
What two parts are the total return of a stock (rE) divided into?
- Dividend Yield: Div1/P0
- Capital gain rate: (P1-P0)/P0
What is the dividend yield?
The expected percentage return from dividends
If there is no bubble in the market, what will the current stock price equal?
The present value of the expected future cash flows (dividends) it will pay
What is a common approximation for estimating dividends?
Letting it grow at a constant rate, g
What are the conditions of the Constant Dividend Growth Model/Gordon Growth Model?
- Dividends grow at the same constant rate of g
- The growth lasts forever
- g < rE
When trying to maximise share price, what tradeoff do firms face?
They would like to increase both current dividend level and the expected growth rate. But, increased growth may require investment, and money spent on investment cannot be used to pay dividends.
What is the dividend payout rate?
The fraction of earnings that a firm pays in dividends each year.
In what three ways can a firm increase its dividend?
- Increase earnings
- Increase dividend payout rate
- Decrease the number of shares outstanding
What is the retention rate?
The fraction of current earnings that the firm retains.
What is the formula for the earnings growth rate, g, when the number of shares outstanding are fixed, the firm only grows through investment, and the dividend payout rate is constant?
g = Retention rate * Return on new investment
What determines whether the firm should increase dividend or investment to increase the share price?
The NPV of the investment. Cutting the dividend to raise stock price will only work if the new investments have a positive NPV.
- Positive if: return > equity cost of capital
- Negative if: Return < equity cost of capital
What does high growth rates imply on the stock price?
Higher stock price
What does high expected returns imply on the stock price?
Lower stock prices (holding dividends fixed)
What are some limitations of the dividend-discount model?
It values a stock based on a forecast of the future dividends –> high uncertainty (need to forecast earnings, dividend payout rate and future share count).
What are share repurchases?
The firm uses excess cash to buy back its own stock.
What are the two consequences of share repurchases on the dividend-discount model?
- More cash used to repurchase shares means less available to pay dividends.
- Share count decreases, which increases EPS and dividends per share.
What is an alternative method to the dividend-discount model, which is more reliable when a firm repurchases shares?
The total payout model. Values all of the firm’s equity rather than a single share. Total payouts is the amount spent on both dividends and share repurchases
What growth rate do we use when forecasting the growth of a firm’s total payouts?
The growth rate of total earnings (rather than earnings per share).
What is the starting point in the Discounted Free Cash Flow Model?
Determine the total value of the firm to all investors, both equity and debt holders = Enterprise value
What is the formula for the enterprise value?
Enterprise value = Market value of equity + Debt - Cash
What is an advantage of the discounted free cash flow model?
It allows us to value a firm without explicitly forecasting its dividends, share repurchases, or use of debt.
How do we estimate a firm’s enterprise value?
Compute the present value of the free cash flows that the firm has available to all investors (both debt and equity holders).
What does free cash flow measure?
The cash generated before any payments to debt or equity holders.
What are the two steps of the Discounted Free Cash Flow model?
- Value the enterprise (V0)
- Determine the share price based on the enterprise value
What discount rate do we use when discounting the free cash flows in the Discounted Free Cash Flows model?
r(wacc) = weighted average cost of capital.
(since we discount cash flows to be paid to both debt and equity holders)
What is the r(wacc)?
The average cost of capital a firm must pay to all of its investors, hence reflecting the average risk of all its investments
How do we typically estimate the terminal value (V(N)) in the Discounted Free Cash Flow Model?
Assuming a constant long-run growth rate g(FCF) for free cash flows beyond year N, typically based on the expected growth rate of revenues.
What does the present value of dividend payments determine?
Discounted at rE, it determines the stock price
What does the present value of Total payouts determine?
Discounted at rE, it determines the Equity value
What does the present value of FCF determine?
Discounted at r(wacc), it determines the enterprise value
What is the method of comparables?
A valuation method where we estimate the firm’s value based on the value of other comparable firms/investments that we expect will generate very similar cash flows in the future.
What is a valuation multiple?
A ratio of the value to some measure of the firm’s scale or cash flow (for example price per square foot).
What is the most common valuation multiple?
The P/E ratio
What is the P/E ratio?
The share price divided by the earnings per share.
How can we estimate a firm’s share value with a P/E ratio?
Multiply the current EPS by the average P/E ratio of comparable firms
What is the forward P/E?
The P/E multiple computed based on forward earnings (expected earnings over the next 12 months)
What should give companies high P/E multiples?
High growth rates and cash generated in excess of investment needs.
When are enterprise value multiples useful?
If we want to compare firms with different amounts of leverage, since the enterprise value represents the total value of the firm’s underlying business.
Which companies have high enterprise value multiples?
Those with high growth rates and low capital requirements
What are some limitations of the comparables/multiples approach?
- Does not take into account important differences among firms (g, risk, or accounting policies)
- Only provide information on the value relative to other firms in the comparison set, and will hence not help us determine is an entire industry is overvalued.
What method do real world practitioners use for valuation?
Often a combination of methods since no single technique provides a final answer regarding a stock’s true value. If results are consistent across a variety of methods, they gain confidence
What are the parts of the valuation triad?
- Share value
- Future Cash Flows
- Cost of capital
What is the efficient markets hypothesis?
Securities will be fairly priced based on their future cash flows, given all information available to investors (immediately). Securities with equivalent risk should have the same expected return.
How is the efficient market hypothesis affected by public, easily interpretable information?
The hypothesis should hold well. Most investors would find that the stock price already reflects this information.
How is the efficient market hypothesis affected by private or difficult-to-interpret information?
The small number of investors with the information may be able to profit by trading on their information, making the hypothesis not hold in the strict sense. As the informed being to trade, they will tend to move prices, so over time prices will begin to reflect their information as well.
What are possible competitive advantages of investors?
- Expertise or access to information only known to few other people
- Lower trading costs than other market participants –> exploit opportunities others find unprofitable
What is the general formula for calculating dividend amount?
Div = EPS * Dividend payout rate
What is the formula for the stock price in the Total payout model?
P0 = PV(future total dividends and repurchases) / Shares outstanding0
What is the formula for Free Cash Flows?
FCF = Unlevered net income - Net investment - increases in NWC
where:
- Unlevered net income = EBIT * (1-t)
- Net investment = CapEx - Depreciation
What is the formula for the enterprise value?
V0 = PV(future FCF of firm)
- Discounted by r(wacc)
What is the formula for the market value of equity in the FCF model?
V0 + Cash0 - Debt0
What is the formula for estimating the share price in the FCF model?
P0 = (V0 + Cash0 - Debt0) / Shares outstanding0
