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investments > chapter 13 - equity valuation > Flashcards

chapter 13 - equity valuation Flashcards

1
Q

valuation by comparables

A

The relationship between price and various determinants of value for similar firms and then extrapolating that relationship to the firm in question

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2
Q

when does a company have to file with the SEC

A

when a US public companies has more than $10 million in assets and 500 shareholders

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3
Q

most common valuation metrics

A

Price/Earnings, Price/Book, Price/Sales, PEG(P/E/Growth Rate)

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4
Q

most common profitability ratios

A

ROE, ROA, operating profit margin, net profit margin

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5
Q

book value

A

The net worth of common equity according to a firm’s balance sheet

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6
Q

limitation of book value

A
  • Values of assets and liabilities recognized on financial statements are based on historical values
  • BV = historical costs
  • MV = current values
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7
Q

liquidation value

A
  • Net amount that can be realized by selling the assets of a firm and paying off the debt
  • Better measure of a floor for the stock price
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8
Q

replacement cost

A
  • Cost to replace a firm’s assets
  • (Replacement cost - liabilities) is another measure of value
  • If MV gets too far above replacement cost for long competitors will enter the market
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9
Q

Tobin’s q

A
  • Ratio of market value of the firm to replacement cost
  • According to this theory, in the long run, the ratio of MP/replacement cost will tend toward 1
  • The evidence is that this ratio can differ significantly from 1 for very long periods of time
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10
Q

intrinsic value

A

The present value of a firm’s expected future net cash flows discounted by the required rate of return

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11
Q

what is considered a positive alpha stock

A

If intrinsic value is above MP the stock is considered undervalued

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12
Q

market-capitalization rate

A

The market-consensus estimate of the appropriate discount rate for a firm’s cash flows

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13
Q

dividend discount model (DDM)

A

A formula stating that the intrinsic value of a firm equals the present value of all expected future dividends

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14
Q

Formula for dividend discount model

A

V0 = (D1 / (1+k)) + (D2 / (1+k)^2) + … + (DH+PH / (1+k)H)

K (discount rate): RRoR determined by CAPM

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15
Q

constant growth DDM

A

A form of the dividend discount model that assumes dividends will grow at a constant rate

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16
Q

formula for a constant growth DDM

A

V0 = D0(1+g) / (k-g) = D1 / (k-g)

Only valid when g is less than k

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17
Q

The constant growth rate DDM implies that a stock’s value will be greater:

A
  1. The larger the expected dividend per share
  2. The lower the market capitalization rate, k
  3. The higher expected growth rate of dividends
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18
Q

other implications of the constant growth rate DDM

A

The stock price is expected to grow at the same rate as dividends

For a stock whose market price equals its intrinsic value (V0=P0), the expected HPR = div yield + capital gains yield

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19
Q

Valuation of a perpetuity:

A

P0 = D1/k

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20
Q

div payout ratio

A

Fraction of earnings paid out as dividends

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21
Q

Plowback or earnings retention ratio (b)

A

The proportion of the firm’s earnings that is reinvested in the business (and not paid out as dividends)

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22
Q

div payout and plowback equation

A

Dividend payout ratio + earnings retention ratio = 1

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23
Q

is a high or low reinvestment rate plan better

A

Eventually, a high reinvestment rate plan will provide higher dividends than a low reinvestment rate plan

As long as the dividend growth generated by the reinvested earnings is high enough, the stock will be worth more under the high reinvestment strategy

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24
Q

% increase in capital stock =

A

= ROE x plowback ratio

G = ROE x b

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25
Q

For a given ROE and plowback ratio, the firm can grow at this rate indefinitely so g is called the:

A

Sustainable growth rate

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26
Q

Sustainable growth rate

A

Growth rate of earnings and dividends if the firm reinvests a constant fraction of earnings and maintains both a constant return on equity and constant debt ratio

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27
Q

If MP = V0 and the ROE and payout ratios are consistent the stock should sell at:

A

P0 = D1 / k-g

28
Q

Present value of growth opportunities (PVGO):

A

Net present value of a firm’s future investments

29
Q

when do planned investments have a positive NPV

A

when investments provide an expected RoR greater than the required rate

30
Q

how can we think about the value of the firm as it relates to PVGO

A

the sum of the value of assets already in place (no growth value of the firm) + net PV of the future investment

Price = no growth value per share + PVGO

P0 = (E1 / k) + PVGO

31
Q

why do dividend cuts almost always cause a drop in stock price

A

Because dividend cuts are usually taken as bad new about the future prospects of the firm, this is new info that causes a price decline

32
Q

two-staged DDM

A

Dividend discount model in which dividend growth is assumed to level off to a steady, sustainable rate only at some future date

33
Q

Common three-stage growth model

A

Year-by-year forecasts of dividends for the short term, a transition period, during which dividend growth rates taper off from the initial rate to the ultimate sustainable rate, and a final period of sustainable growth

34
Q

price/earnings multiple

A
  • The ratio of a stock’s price to its earnings per share
  • Reflects the market’s optimism concerning a firm’s growth prospects
  • P/E increases with ROE and high plowback (as long as ROE exceeds k)
  • Growth rate ≈ P/E
35
Q

P/E formula

A

P0/E1 = 1/k x [1 + (PVGO/(E1/k))]

If PVGO = 0, P0 = E1/k (perpetuity)

And P0/E1 = 1/k

36
Q

PVGO to E/k ratio

A

the component of the firm value reflecting growth opportunities to the value of assets already in place

37
Q

more precise P/E formula

A

P0/E1 = 1-b / [k - (ROE x b)]

38
Q

PEG ratio

A

Ratio of P/E multiple to earnings growth rate

39
Q

P/E ratios and stock risk relationship

A

Risker stocks will have lower P/E ratios (holding all else equal)

P/E = 1-b / k-g

Will have higher RoR (k)

40
Q

Pitfalls in P/E analysis

A
  • The denominator in P/E is accounting earnings
  • P/E ratios have generally been inversely related to the inflation rate
  • No way to say a P/E ratio is overly high/low without referring to the firm’s long-run growth prospects and current EPS relative to the long-run trend line
41
Q

earnings management

A

The practice of using flexibility in accounting rules to manipulate the apparent profitability of the firm

Gives a clearer picture of the underlying profitability and comparisons with earlier periods can make more sense

42
Q

pro forma earnings

A

operating earnings

43
Q

why are pro forma earnings (operating earnings) an example of earnings management

A

no precise generally accepted definition

Ignoring certain expenses

E.x. restructuring charges or write-down of assets from continuing operations

44
Q

forward P/E

A

ratio of today’s price to the trend value of future earnings

45
Q

trailing P/E

A

ratio of price to the most recent past accounting earnings

46
Q

Cyclically adjusted P/E ratio (CAPE)

A

Divide the stock price by an estimate of sustainable long-term earnings rather than current earnings

Using average inflation-adjusted earnings over an extended period

47
Q

how can you use P/E and EPS to estimate a future price

A

P/E x EPS = estimated future price

48
Q

what price should you use in the DDM

A

P/E x EPS = estimated future price

49
Q

price/book ratio

A

Price per share / book value per share

An indicator of how aggressively the market values the firm

50
Q

price/cash flow ratio

A

Price per share / cash flow per share

Operating cash flow or free cash flow

51
Q

what is the difference between operating cash flow and free cash flow

A

Operating cash flow measures cash generated by a company’s business operations.

Free cash flow is the cash that a company generates from its business operations after subtracting capital expenditures.

52
Q

price/sales ratio

A
  • Price per share / annual sales per share
  • For firms with no earnings
  • Ratio depends on industry
53
Q

free cash flow

A

cash flow available to the firm or equityholders net of cap ex

54
Q

Free cash flow to firm (FCFF)

A
  • After-tax CF generated by operations, net of investments in fixed and working capital
  • Discounting FCFF at the WACC to find the value of the whole firm
  • Subtracting the value of debt then results in the value of equity
55
Q

Free cash flow to firm (FCFF) formula

A

FCFF = EBIT(1-tc) + depreciation - cap ex - increase in NWC

56
Q

FCFF valuation

A
  • Discounts year-by-year CFs + an estimate of terminal value
  • Using a constant-growth model to estimate terminal value
  • Appropriate discount rate is WACC
57
Q

FCFF valuation model

A

Firm value = ∑Tt=1 [ (FCFFt / (1+WACC)^t) + (VT / (1+WACC)^T) ]

VT = FCFFT+1 / (WACC-g)

58
Q

Free cash flow to equity holders (FCFE)

A

FCFE = FCFF - interest expense(1-tc) + increases in net debt

Discounting those directly at the cost of equity to obtain the market value of equity

59
Q

Intrinsic value of equity formula

A

= ∑ Tt=1 [ (FCFEt / (1+kE)^t) + (ET / (1+kE)^T) ]

VT = FCFET+1 / (kE-g)

60
Q

how is terminal value calculated

A

Terminal value calculated by the PV of a constant growth perpetuity or a multiple of EBIT, BV, earnings, or FCF

61
Q

how is terminal value calculated?

A

Terminal value calculated by the PV of a constant growth perpetuity or a multiple of EBIT, BV, earnings, or FCF

62
Q

FCFF valuation example

A

A. inputs from Value Line
P/E, cap spending/share, LT debt, shares, EPS, working capital, etc.

B. calculate FCF
Sum of after-tax profits + after-tax interest payments
Subtract net working capital
Add back depreciation
Subtract cap-ex
This gives us FCFF

C. find the PV of CFs
Discount at WACC
Weighted average of the after-tax cost of debt and the cost of equity
Must account for the change in leverage forecast
Use CAPM for COE

63
Q

problem with DCF models

A

Most of the action in these models is in the terminal value and that this value can be highly sensitive to even small change in some input values

64
Q

what is the most popular approach to valuing the overall stock market?

A

earnings multiplier

65
Q

steps to valuing the overall stock market using an earnings multiplier

A

forecast corporate profits

derive an estimate of the earnings multiplies, the aggregate P/E ratio, based on a forecast of long-term interest rates

multiple EPS by P/E

66
Q

earnings yield =

A

EPS / price per share

67
Q

how does one forecast the P/E ratio of the market

A

can be derived from the relationship between the earnings yield and the YTM on 10-year bonds

They move in tandem over time

investments (14 decks)

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