6. Equity Valuation Models Flashcards

1
Q

Fundamental analysts

A
  • 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
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2
Q

To determine true value of stock, compare with:

A
  1. Book value/valuation by comparable
  2. Liquidation value
  3. Replacement costs
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3
Q

Book value/valuation by comparables (accounting) examples

A
  • 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
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4
Q

Book value/valuation of comparables

Limitations of book value

A

Values of assets and liabilities in financial statements are based on historical values (original cost)

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5
Q

Book value/valuation of comparables

Market value of shareholders’ equity

A

Current value of assets – current value of liabilities. Current values generally don’t match historical values

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6
Q

Liquidation value

A
  • 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
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7
Q

Replacement costs

A
  • Cost of replicating firm (important in innovative industries)
  • Market value will drive down to replacement cost, because competitors are entering market
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8
Q

Replacement costs

Tobins Q

A
  • 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)
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9
Q

Quantitative models to value common stock (one year holding period):

A
  1. Investor stock expects return consisting of cash dividends and capital gains/losses: expected dividend yield + expected capital gain yield
  2. Intrinsic value
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10
Q

Quantitative models to value common stock (one year holding period):

Intrinsic value

A

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

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11
Q

Quantitative models to value common stock (one year holding period):

Intrinsic value

Market capitalisation rate

A
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12
Q

Three main methods to value a stock (main problem: get reliable predictions):

A
  1. Dividend discount model
  2. P/E ratios and growth opportunities
  3. Discounting free cash flow of equity
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13
Q

Trading rules

A
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14
Q

Dividend discount model

A

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

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15
Q

DDM implications

A
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16
Q

P/E ratios and growth opportunities

A
a. Common claim
i.
ii.
b. P/E ratios
i.
ii.
iii.