B2 - M6: Financial Valuation Methods I

Question 1

PV of an Annuity

Answer 1

= C * ((1 - PV factor) ÷ r)

= C * (1-(1/(1+r)^t)/r)

C = amount of annuity (future cash flows)
r = rate of return
t = time

Question 2

Perpetuity / Perpetual Annuity / Zero Growth Annuity

Answer 2

• periodic cash flows paid by an annuity that last forever

PV of annuity = P = D ÷ R

P = stock price
D = dividend
R = required rate of return

Question 3

Dividend Growth Model

Answer 3

• assumes dividend payments are CF of a security
• assume intrinsic value of a stock is the PV of the expected future dividends

= Pt = Dt (1+G) ÷ (R-G)

Pt = Current price (price at period t)
D(t+1) = Dividend one year after period t
R = Required return
G = (Sustainable) growth rate

Question 4

How to compute required return for dividend growth model

Answer 4

R = Rfr + B [E(Rm)-Rfr]

R = required rate of return
Rfr = Risk free rake of borrowing
B = Beta
E(Rm) = Expected market return

Question 5

2 types of security valuation models

Answer 5

1) Absolute value models - based on PV of future CFs

2) Relative value models - value based on comparable stocks’ value

Question 6

P/E Ratio (forward)

Answer 6

= Price Today ÷ EPS expected in 1 year

• can be used to calculate the expected value (price) of a share
• measures how much investors are willing to pay for each dollar of earnings
• rising PE means investors anticipate growth

Question 7

P/E Ratio (Trailing)

Answer 7

= Price Today ÷ EPS for past year

• use when forecasted earnings are unavailable

Question 8

P/E + Growth (PEG) Ratio

Answer 8

PEF = PE ratio ÷ G

• effect of earnings growth on a company’s PE
• lower PEG is better

Question 9

Price to Sales Ratio

Answer 9

= Price ÷ Expected sales in 1 year

• not as volatile as PE
• can be used when EPS is low or < 0
• good for startups

Question 10

Price to CF ratio

Answer 10

= Price ÷ Expected CF in 1 year

• CF harder to manipulate

Question 11

Price to Book ratio

Answer 11

= Price ÷ BV of common equity = A - L

• preferred when EPS is extremely high or low or if EPS < 0

Question 12

How does relative valuation models use ratios?

Answer 12

They compute one or many of them for different companies and compare

Question 13

Free Cash Flow

Answer 13

• Amount of cash a business generation after accounting for account re-investments in non-current assets
• NI + noncash expenses - increase in WC - cap ex
  or
• NI + noncash expenses + decrease in WC - cap ex