B: Describe major categories of equity valuation models

Question 1

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).

Answer 1

Present value models
– Discounted cash flow models
– Dividend discount models
– Free cash flow to equity models

Estimate intrinsic value based on present value of future benefits.
Example approaches
– 1. Cash to be received (dividends expected)
– 2. Cash flows available to be distributed to shareholders (but may
not be paid out
• (Note movement of stock prices immediately before
and after dividend record date)

The free cash flow to equity model is best described as a(n): The free cash flow to equity model is one type of present value model or discounted cash flow model. It estimates a stock’s value as the present value of cash available to common shareholders. The enterprise value model is an example of a multiplier model.

Question 2

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

Answer 2

Multiplier models (market multiple models)
– Stock price – (divided by) earnings P/E, sales P/S, book value P/BV, or
cash flow P/CF
– Enterprise value – (divided by) … frequently uses either EBITDA
EV/EBITDA or revenues EV/ EBITDA in the denominator of the ratio

Multiplier models
• Forward or trailing basis – Examples: Price / Last Twelve Months (LTM)
earnings or Price / Projected Twelve Months Earnings. It’s very
important that there be consistency in use of the same “forward” or
“trailing” earnings data from the subject company and the market
comparables
• Sources of multiples
– Comparable firms
– Intrinsic multiples : One example (k – g)

An equity valuation model that values a firm based on the market value of its outstanding debt and equity securities, relative to a firm fundamental, is a(n): An enterprise value model relates a firm’s enterprise value (the market value of its outstanding equity and debt securities minus its cash and marketable securities holdings) to its EBITDA, operating earnings, or revenue.

Question 3

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.

Answer 3

Asset based models
– (Total assets) minus (liabilities and preferred stock) equals equity
value
– Adjust the book values of assets and liabilities to their fair values
• Adjusts book values of assets and liabilities to reflect their market
values to develop estimate of equity value
• Challenge: Identifying and valuing individual assets and liabilities can
be difficult
• Best for asset intensive companies with readily valued assets or firms
in liquidation