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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
For a given ROE and plowback ratio, the firm can grow at this rate indefinitely so g is called the:
Sustainable growth rate
26
Sustainable growth rate
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
27
If MP = V0 and the ROE and payout ratios are consistent the stock should sell at:
P0 = D1 / k-g
28
Present value of growth opportunities (PVGO):
Net present value of a firm’s future investments
29
when do planned investments have a positive NPV
when investments provide an expected RoR greater than the required rate
30
how can we think about the value of the firm as it relates to PVGO
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
why do dividend cuts almost always cause a drop in stock price
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
two-staged DDM
Dividend discount model in which dividend growth is assumed to level off to a steady, sustainable rate only at some future date
33
Common three-stage growth model
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
price/earnings multiple
- 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
P/E formula
P0/E1 = 1/k x [1 + (PVGO/(E1/k))] If PVGO = 0, P0 = E1/k (perpetuity) And P0/E1 = 1/k
36
PVGO to E/k ratio
the component of the firm value reflecting growth opportunities to the value of assets already in place
37
more precise P/E formula
P0/E1 = 1-b / [k - (ROE x b)]
38
PEG ratio
Ratio of P/E multiple to earnings growth rate
39
P/E ratios and stock risk relationship
Risker stocks will have lower P/E ratios (holding all else equal) P/E = 1-b / k-g Will have higher RoR (k)
40
Pitfalls in P/E analysis
- 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
earnings management
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
pro forma earnings
operating earnings
43
why are pro forma earnings (operating earnings) an example of earnings management
no precise generally accepted definition Ignoring certain expenses E.x. restructuring charges or write-down of assets from continuing operations
44
forward P/E
ratio of today’s price to the trend value of future earnings
45
trailing P/E
ratio of price to the most recent past accounting earnings
46
Cyclically adjusted P/E ratio (CAPE)
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
how can you use P/E and EPS to estimate a future price
P/E x EPS = estimated future price
48
what price should you use in the DDM
P/E x EPS = estimated future price
49
price/book ratio
Price per share / book value per share An indicator of how aggressively the market values the firm
50
price/cash flow ratio
Price per share / cash flow per share Operating cash flow or free cash flow
51
what is the difference between operating cash flow and free cash flow
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
price/sales ratio
- Price per share / annual sales per share - For firms with no earnings - Ratio depends on industry
53
free cash flow
cash flow available to the firm or equityholders net of cap ex
54
Free cash flow to firm (FCFF)
- 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
Free cash flow to firm (FCFF) formula
FCFF = EBIT(1-tc) + depreciation - cap ex - increase in NWC
56
FCFF valuation
- 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
FCFF valuation model
Firm value = ∑Tt=1 [ (FCFFt / (1+WACC)^t) + (VT / (1+WACC)^T) ] VT = FCFFT+1 / (WACC-g)
58
Free cash flow to equity holders (FCFE)
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
Intrinsic value of equity formula
= ∑ Tt=1 [ (FCFEt / (1+kE)^t) + (ET / (1+kE)^T) ] VT = FCFET+1 / (kE-g)
60
how is terminal value calculated
Terminal value calculated by the PV of a constant growth perpetuity or a multiple of EBIT, BV, earnings, or FCF
61
how is terminal value calculated?
Terminal value calculated by the PV of a constant growth perpetuity or a multiple of EBIT, BV, earnings, or FCF
62
FCFF valuation example
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
problem with DCF models
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
what is the most popular approach to valuing the overall stock market?
earnings multiplier
65
steps to valuing the overall stock market using an earnings multiplier
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
earnings yield =
EPS / price per share
67
how does one forecast the P/E ratio of the market
can be derived from the relationship between the earnings yield and the YTM on 10-year bonds They move in tandem over time

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