(41) Equity Valuation - Concepts and Basic Tools

Question 1

LOS 50. a: Evaluate whether a security, given its current market price and a value estimate, is overvalued, fairly valued, or undervalued by the market.

Answer 1

An asset is fairly valued if the market price is equal to its estimated intrinsic value, undervalued if the market price is less than its estimated value, and overvalued if the market price is greater than the estimated value.

For security valuation to be profitable, the security must be mispriced now and price must converge to intrinsic value over the investment horizon.

Securities that are followed by many investors are more likely to be fairly valued than securities that are neglected by analysts.

Question 2

LOS 50. b: Describe major categories of equity valuation models. List the three.

Answer 2

Discounted cash flow models

Multiplier models

Asset-based models

Question 3

LOS 50. b: Describe major categories of equity valuation models. Discounted cash flow models.

Answer 3

Discounted cash flow models estimate the present value of cash distributed to shareholders (dividend discount models) or the present value of cash available to shareholders after meeting capital expenditures and working capital expenses (free cash flow to equity models).

Question 4

LOS 50. b: Describe major categories of equity valuation models. Multiplier models

Answer 4

Multiplier models compare the stock price to earnings, sales, book value, or cash flow. Alternatively, enterprise value is compared to sales or EBITDA.

Question 5

LOS 50. b: Describe major categories of equity valuation models. Asset-based models

Answer 5

Asset-based models define a stock’s value as the firm’s total asset value minus liabilities and preferred stock, on a per-share basis.

Question 6

LOS 50. c: Explain the rationale for using present value models to value equity and describe the dividend discount and free-cash-flow-to-equity models.

Answer 6

The dividend discount model is based on the rationale that a corporation has an indefinite life, and a stock’s value is the present value of its future cash dividends. The most general form of the model is:

Equation

Free cash flow to equity (FCFE) can be used instead of dividends. FCFE is the cash remaining after a firm meets all of its debt obligations and provides for necessary capital expenditures.

FCFE reflects the firm’s capacity for dividends and is useful for firms that currently do not pay a dividend. By using FCFE, an analyst does not need to project the amount and timing of future dividends.

Question 7

LOS 50. d: Calculate the intrinsic value of non-callable, non-convertible preferred stock.

Answer 7

Preferred stock typically pays a fixed dividend and does not mature. It is valued as:

Preferred stock value = D_p/k_p

Question 8

LOS 50. e: Calculate and interpret the intrinsic value of an equity security based on the Gordon (constant) growth dividend discount model or a two-stage dividend discount model, as appropriate.

Answer 8

The Gordon growth model assumes the growth rate in dividends is constant:

V₀ = D₁ / (k_e - g_c)

The sustainable growth rate is the rate at which earnings and dividends can continue to grow indefinitely:

g = b x ROE

where:

b = earnings retention rate = 1 – dividend payout rate

ROE = return on equity.

Question 9

LOS 50. e: Calculate and interpret the intrinsic value of an equity security based on the Gordon (constant) growth dividend discount model or a two-stage dividend discount model, as appropriate. What is key to look out for in question wording?

Answer 9

When doing stock valuation problems on the exam, watch for worlds like “forever,” “infinitely,” “Indefinitely,” “for the foreseeable future,” and so on. This will tell you that the Gordon growth model should be used. Also watch for words like “just paid” or “recently paid.” These will refer to the last dividend, D₀. Words like “will pay” or “is expected to pay” refer to D₁.

Question 10

LOS 50. e: Calculate and interpret the intrinsic value of an equity security based on the Gordon (constant) growth dividend discount model or a two-stage dividend discount model, as appropriate.

Answer 10

A firm with high growth over some number of periods followed by a constant growth rate of dividends forever can be valued using a multistage model:

Where:

P_n = D_n+1 / (k_e – g_c) **ENSURE YOU USE D_n+1**

g_c = constant growth rate of dividends

n = number of periods of supernormal growth

Question 11

LOS 50. f: Identify characteristics of companies for which the constant growth or a multistage dividend discount model is appropriate.

Answer 11

The constant growth model is most appropriate for firms that pay dividends that grow at a constant rate, such as stale and mature firms or noncyclical firms such as utilities and food producers in mature markets.

A 2-stage DDM would be most appropriate for a firm with high current growth that will drop to a stable rate in the future, an older firm that is experiencing a temporary high growth phase, or an older firm with a market share that is decreasing but expected to stabilize.

A 3-stage model would be appropriate for a young firm still in a high growth phase.

Question 12

LOS 50. g: Explain the rationale for using price multiples to value equity, how the price to earnings multiple relates to fundamentals, and the use of multiples based on comparables.

Answer 12

The P/E ratio based on fundamentals is calculated as:

Equation

If the subject firm has a higher dividend payout ratio, higher growth rate, and lower required return than its peers, it may be justified in having a higher P/E ratio.

Price multiples are widely used by analysts, are easily calculated and readily available, and can be used in time series and cross-sectional comparisons.

Question 13

LOS 50. h: Calculate and interpret the following multiples: price to earnings, price to an estimate of operating cash flow, price to sales, and price to book value.

Answer 13

The price-earnings (P/E) ratio is a firm’s stock price divided by earnings per share.

Question 14

LOS 50. h: Calculate and interpret the following multiples: price to earnings, price to an estimate of operating cash flow, price to sales, and price to book value.

Answer 14

The price-sales (P/S) ratio is a firm’s stock price divided by sales per share.

Question 15

LOS 50. h: Calculate and interpret the following multiples: price to earnings, price to an estimate of operating cash flow, price to sales, and price to book value.

Answer 15

The price-book value (P/B) ratio is a firm’s stock price divided by book value per share.

Question 16

LOS 50. h: Calculate and interpret the following multiples: price to earnings, price to an estimate of operating cash flow, price to sales, and price to book value.

Answer 16

The price-cash flow (P/CF) ratio is a firm’s stock price divided by cash flow per share. Cash flow may be defined as operating cash flow or free cash flow.

Question 17

LOS 50. i: Describe enterprise value multiples and their use in estimating equity value.

Answer 17

Enterprise value (EV) measures total company value:

EV = market value of common and preferred stock + market value of debt – cash and short-term investments

EBITDA is frequently used as a denominator in EV multiples because EV represents total company value, and EBITDA represents earnings available to all investors.

Question 18

LOS 50. j: Describe asset-based valuation models and their use in estimating equity value.

Answer 18

Asset-based models value equity as the market or fair value f assets minus liabilities. These models are most appropriate when a firm’s assets are largely tangible and have fair value that can be established easily.

Question 19

LOS 50. k: Explain advantages and disadvantages of each category of valuation model. Advantages of discounted cash flow models:

Answer 19

Advantages of discounted cash flow models:

• Easy to calculate
• Widely accepted in the analyst community
• FCFE model is useful for firms that currently do not pay a dividend
• Gordon growth model is useful for stable, mature, noncyclical firms.
• Multistage models can be used for firms with non-constant growth

Question 20

LOS 50. k: Explain advantages and disadvantages of each category of valuation model. Disadvantages of discounted cash flow models:

Answer 20

Disadvantages of discounted cash flow models:

• Inputs must be forecast
• Estimates are very sensitive to inputs
• For the Gordon growth model specifically”
  
  • Very sensitive to the k – g denominator
  • Required return on equity must be greater than the growth rate
  • Required return on equity and growth rate must remain constant
  • Firm must pay dividends

Question 21

LOS 50. k: Explain advantages and disadvantages of each category of valuation model. Advantages of price multiples:

Answer 21

Advantages of price multiples:

• Often useful for predicting stock returns
• Widely used by analysts
• Easily calculated and readily available
• Can be used in time series and cross-sectional comparisons
• EV/EBITDA multiples are useful when comparing firms values independent of capital structure or when earnings are negative and the P/E ratio cannot be used.

Question 22

LOS 50. k: Explain advantages and disadvantages of each category of valuation model. Disadvantages of price multiples:

Answer 22

Disadvantages of price multiples:

• P/E ratio based on fundamentals will be very sensitive to the inputs
• May not be comparable across firms, especially internationally
• Multiples for cyclical firms may be greatly affected by economic conditions. P/E ratio may be especially inappropriate. (The P/S multiple may be more appropriate for cyclical firms.)
• A stock may appear overvalued by the comparable method but undervalued by the fundamental method or vice versa.
• Negative denominator results in a meaningless ratio; the P/E ratio is especially susceptible to this problem
• A potential problem with EV/EBITDA multiples is that the market value of a firm’s debt is often not available.

Question 23

LOS 50. k: Explain advantages and disadvantages of each category of valuation model. Advantages of asset-based models:

Answer 23

Advantages of asset-based models:

• Can provide floor values
• Most reliable when the firm has mostly tangible short-term assets, assets with a ready market value, or when the firm is being liquidated
• May be increasingly useful for valuing public firms if they report fair values

Question 24

LOS 50. k: Explain advantages and disadvantages of each category of valuation model. Disadvantages of asset-based models:

Answer 24

Disadvantages of asset-based models:

• Market values of assets can be difficult to obtain and are usually different than book values
• Inaccurate when a firm has a large amount of intangible assets or future cash flows not reflected in asset value
• Asset values can be difficult to value during periods of hyperinflation