Book 3_Equity_READING 48_EQUITY VALUATION_CONCEPTS AND BASIC TOOLS

Question 1

Discounted cash flow models

Answer 1

• 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)

Question 2

Multiplier models

Answer 2

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

Question 3

Asset-based models

Answer 3

define a stock’s value as the firm’s total asset value minus liabilities and preferred stock, on a per-share basis

Question 4

Regular cash dividends vs special dividend

Answer 4

• Regular cash dividend are paid at set intervals
• while special dividend is a one-time cash payment to shareholders.

Question 5

Stock dividend and split

Answer 5

• Stock dividends are additional shares of stock.
• Stock splits divide each existing share into multiple shares
• In either case, the value of each share will decrease because the total value of outstanding shares is unchanged

Question 6

reverse stock split

Answer 6

• the number of shares owned by each shareholder is decreased,
• total shares outstanding are decreased
• and the value of a single share is increased.

Question 7

A share repurchase

Answer 7

• A purchase by the company of its outstanding shares.
• Share repurchases are an alternative to cash dividends as a way to distribute cash to shareholders

Question 8

Dividend payment chronology

Answer 8

1. Declaration date: The date the board of directors approves payment of the dividend.
2. Ex-dividend date: The first day a share of stock trades without the dividend, one or two business days before the holder-of-record date. On the ex-dividend date, the value of each share decreases by the amount of the dividend.
3. Holder-of-record date: The date on which share owners who will receive the dividend are identified.
4. Payment date. The date the dividend checks are sent to, or payment is transferred to, shareholders

Question 9

The dividend discount model

Answer 9

• is based on the rationale that a corporation has an indefinite life
• a stock’s value is the present value of its future cash dividends.
• V = D1/(1-ke)

Question 10

Free cash flow to equity (FCFE)

Answer 10

• the cash remaining after a firm meets all of its debt obligations and provides for necessary capital expenditures
• can be used instead of dividends
• reflects the firm’s capacity for dividends and is useful for firms that currently do not pay a dividend
• does not need to project the amount and timing of future dividends.

Question 11

Advantages of discounted cash flow models:

Answer 11

• Easy to calculate.
• Widely accepted in the analyst community.
• FCFE model is useful for firms that currently do not pay a dividend.
• Gordon growth model is useful for stable, mature, noncyclical firms.
• Multistage models can be used for firms with nonconstant growth.

Question 12

Disadvantages of discounted cash flow models:

Answer 12

• Inputs must be forecast.
• Estimates are very sensitive to inputs.
• For the Gordon growth model specifically:
  + Very sensitive to the k
  + g denominator.
  + Required return on equity must be greater than the growth rate.
  + Required return on equity and growth rate must remain constant.
  + Firm must pay dividends.

Question 13

Advantages of price multiples

Answer 13

• Often useful for predicting stock returns.
• Widely used by analysts.
• Easily calculated and readily available.
• Can be used in time series and cross-sectional comparisons.
• EV/EBITDA multiples are useful when comparing firm values independent of capital structure or when earnings are negative and the P/E ratio cannot be used.

Question 14

Disadvantages of price multiples:

Answer 14

• P/E ratio based on fundamentals will be very sensitive to the inputs.
• May not be comparable across firms, especially internationally.
• Multiples for cyclical firms may be greatly affected by economic conditions.
• P/E ratio may be especially inappropriate. The P/S multiple may be more appropriate for cyclical firms.
• A stock may appear overvalued by the comparable method but undervalued by the fundamental method or vice versa.
• Negative denominator results in a meaningless ratio;
• A potential problem with EV/EBITDA multiples is that the market value of a firm’s debt is often not available.

Question 15

Advantages of asset-based models:

Answer 15

• Can provide floor values.
• Most reliable when the firm has mostly tangible short-term assets, assets with a ready market value, or when the firm is being liquidated.
• May be increasingly useful for valuing public firms if they report fair values.

Question 16

Disadvantages of asset-based models:

Answer 16

• Market values of assets can be difficult to obtain and are usually different than book values.
• Inaccurate when a firm has a large amount of intangible assets or future cash flows not reflected in asset value.
• Asset values can be difficult to value during periods of hyperinflation.

Question 17

Preferred stock valuation

Answer 17

= Dp/kp

Question 18

The Gordon growth model

Answer 18

Vo = D1/(ke-gc)
g = b x ROE in which: b is the earning retention rate

Question 19

The constant growth model

Answer 19

is most appropriate for firms that pay dividends that grow at a constant rate, such as stable and mature firms or noncyclical firms such as utilities and food producers in mature markets

Question 20

A 2-stage DDM

Answer 20

• would be most appropriate for a firm with high current growth that will drop to a stable rate in the future,
• an older firm that is experiencing a temporary high growth phase,
• or an older firm with a market share that is decreasing but expected to stabilize

Question 21

A 3-stage model

Answer 21

would be appropriate for a young firm still in a high growth phase.

Question 22

The P/E ratio

Answer 22

P/E = D1/(E1*(k-g))
- widely used by analysts, are easily calculated and readily available, and can be used in time series and cross-sectional comparisons.

Question 23

Valuation multiplier

Answer 23

P/E; P/S; P/B; P/CF

Question 24

Enterprise value (EV)

Answer 24

enterprise value = market value of common and preferred stock + market value of debt − cash and short-term investments

Question 25

EBITDA is frequently used as the denominator in EV multiples

Answer 25

because EV represents total company value, and EBITDA represents earnings available to all investors.

Question 26

Asset-based models value equity as

Answer 26

• The market or fair value of assets minus liabilities
• are most appropriate when a firm’s assets are largely tangible and have fair values that can be established easily.