B Flashcards
Goldfarb
Briefly explain how high growth rates affect dividends.
High growth rates and high dividends are not sustainable at the same time, which means high growth rates will be o↵set by lower dividend amounts
Goldfarb
Briefly explain how high growth rates affect the risk-adjusted rate.
Firms with high growth rates tend to be riskier, which drives the risk-adjusted rate up
Goldfarb
Explain the difference between private valuation and equilibrium market valuation.
Private valuation assumes that individual investors have their own views of “risk.” Potential investments are assessed relative to their existing portfolios, resulting in the same investment having different value to different investors. Equilibrium market valuation assumes that all investors hold the same portfolio and assess “risk” in identical fashions. Thus, investments will have the same value for all investors
Goldfarb
Briefly describe two ways of determining beta used in the Capital Asset Pricing Model.
⇧ Use a firm beta – run a linear regression of the company’s returns against the market returns using historical stock price data
⇧ Use an industry beta – use an industry-wide mean or median value
Goldfarb
If an industry beta is used to determine the risk-adjusted discount rates, briefly describe two adjustments that may need to be made to beta.
⇧ Mix of business – only use firms with comparable mixes of business. Unfortunately, this drops the number of firms significantly, which reduces the reliability of the result
⇧ Financial leverage – using debt to raise capital increases the risk to equity holders. This shows up in the beta estimate, making the betas of di↵erent firms di cult to compare. To correct this, beta can be defined to reflect solely business risk and not the e↵ect of debt leverage
Goldfarb
Briefly describe two limitations of the dividend discount model
⇧ Actual dividend payments are discretionary and can be di cult to forecast
⇧ Due to increased use of stock buybacks as a vehicle for returning funds to shareholders, we may need to redefine “dividend”
Goldfarb
a) Describe two approaches for implementing the discounted cash flow model.
b) Identify the preferred approach and explain why it is preferred.
Part a:
⇧ Free Cash Flow to Firm (FCFF)
• Focuses on free cash flow to the entire firm, prior to accounting for debt payments or taxes associated with debt payments
• Discounting the FCFF gives the total firm value. The equity value of the firm is found by subtracting the market value of the debt from the total firm value
⇧ Free Cash Flow to Equity (FCFE)
• Focuses on cash flows to equity holders only
• Subtract the debt payments, net of their associated tax consequences, from the free cash flow to the firm to determine the free cash flow to equity. Discount the resulting free cash flows to determine equity value
Part b:
⇧ The preferred approach is FCFE. The FCFF method requires either a weighted average
cost of capital or an all-equity cost of capital. Since policyholder liabilities make it di cult to precisely define either of these measures, the FCFE method is preferred
Goldfarb
In theory, the dividend discount model and the discounted cash flow model should use different discount rates. Explain why.
The DDM and FCFE models should use different discount rates due to the riskiness of the cash flows paid to shareholders. With DDM, assumed dividends are paid to shareholders, and remaining income is reinvested in marketable securities. In contrast, the FCFE pays out all free cash flow to shareholders. This means that the DDM’s measure of risk is impacted by a larger proportion of the risk coming from marketable securities than from underwriting risk. Thus, the DDM model should theoretically use a larger discount rate than the FCFE model
Goldfarb
Briefly describe three weaknesses of the discounted cash flow method.
⇧ Must forecast financial statements according to a specific set of accounting standards
⇧ Variety of adjustments must be made to the forecasts of net income to estimate free cash
flows
⇧ Resulting free cash flows may not be very similar to those used internally for planning purposes
Goldfarb
Define abnormal earnings in words.
Abnormal earnings represent the portion of earnings ABOVE the required earnings, where required earnings are based on the required rate of return for the firm
Goldfarb
a) Briefly describe how the terminal value is calculated under the abnormal earnings method.
b) Explain why this is an appealing way to calculate the terminal value.
Part a:
⇧ The abnormal earnings method assumes that abnormal earnings do NOT continue into perpetuity. Instead, they should decline to zero as new competition enters the market to capture some of those abnormal earnings
Part b:
⇧ This is an appealing quality of the AE method since it forces analysts to explicitly consider the limits of growth from a value perspective (i.e. growth in earnings does not drive growth in value; we only grow in value if we exceed expected returns)
Goldfarb
Briefly describe two adjustments to book value that may be needed in order to implement the abnormal earnings method.
⇧ Eliminate systematic bias in reported asset and liability values
⇧ Adjust reported book value to reflect tangible book value, which removes the impact of intangible assets such as goodwill (i.e. brand, reputation, etc.)
Goldfarb
Briefly describe two benefits of the abnormal earnings method.
⇧ Uses assumptions that are more directly tied to value creation (abnormal profits) instead of those that are consequences of value creation (dividends and free cash flows)
⇧ De-emphasizes the terminal value, and reflects more of the firm value within the forecast horizon
Goldfarb
Provide two reasons why a relative valuation using multiples might be preferred over the dividend discount model.
⇧ Investor may not have access to data in su cient detail to parameterize the model
⇧ Horizon used may stretch the limits of our forecasting ability
Goldfarb
In addition to valuing firms, P-E ratios have alternative uses. Briefly describe three alternative uses of P-E ratios.
⇧ Validation of assumptions – if differences in P-E ratios between firms with comparable growth rates, dividend payout ratios, etc. cannot be explained by these key variables, we may need to revisit our assumptions
⇧ Shortcut to valuation – when industry average performance is expected, we can select a group of peer companies and use their mean or median P-E ratio
⇧ Terminal value – we may rely on peer P-E ratios to guide the terminal value calculation
