6. Equity Valuation Models Flashcards
Fundamental analysts
- Use information concerning current and prospective profitability of company to assess its fair market value
- Purpose: find stocks that are mispriced relative to measures of “true” value
To determine true value of stock, compare with:
- Book value/valuation by comparable
- Liquidation value
- Replacement costs
Book value/valuation by comparables (accounting) examples
- Price/Earnings, Price/Book (market-to-book), Price/Sales, Price/CF, PEG
- PEG normalizes P/E ratio by growth rate. If ratios are below industry average, they might indicate that stock is underpriced. However, more mature companies have lower expected future growth rate
Book value/valuation of comparables
Limitations of book value
Values of assets and liabilities in financial statements are based on historical values (original cost)
Book value/valuation of comparables
Market value of shareholders’ equity
Current value of assets – current value of liabilities. Current values generally don’t match historical values
Liquidation value
- Amount of money that could be realized by breaking up firm, selling assets, repaying debt, distributing remainder to shareholders
- Firm becomes attractive takeover target if market price < liquidation value
Replacement costs
- Cost of replicating firm (important in innovative industries)
- Market value will drive down to replacement cost, because competitors are entering market
Replacement costs
Tobins Q
- Market price / replacement value of firm’s assets should be 1, but evidence is that it can differ significantly from 1 for long periods
- 0 < Q < 1 : market value < replacement cost (undervalued)
- Q > 1 : market value > replacement cost (overvalued)
Quantitative models to value common stock (one year holding period):
- Investor stock expects return consisting of cash dividends and capital gains/losses: expected dividend yield + expected capital gain yield
- Intrinsic value
Quantitative models to value common stock (one year holding period):
Intrinsic value
PV all cash payments to investor in stock discounted at appropriate risk-adjusted interest rate: dividend, proceeds from sale of stock
a. Compare intrinsic value with market value to see whether stock is under- or overvalued. Undervalued stock -> positive-alpha stock.
b. Market capitalisation rate
Quantitative models to value common stock (one year holding period):
Intrinsic value
Market capitalisation rate
Three main methods to value a stock (main problem: get reliable predictions):
- Dividend discount model
- P/E ratios and growth opportunities
- Discounting free cash flow of equity
Trading rules
Dividend discount model
a. Determine investment horizon
b. Predict future dividend payments (and future stock price)
c. Estimate discount rate
d. Set IV equal to discounted expected future dividends
DDM implications