Chapter 14 - Company Analysis And Business Valuation Methods Flashcards
What is the dividend pay-out ratio?
(Total Annual Dividend)/(Earnings (Profit after tax)) x 100
Measures proportion of earnings paid out as dividends.
What is the dividend cover ratio?
(Earnings (after tax))/Dividends (x times)
Ability to maintain dividend payments. Shows how many times the dividend could be paid out of profits. Dividend cover greater than 2 is considered good. Consistently below 1.5 will indicate concern on profitability and dividend pay-out
What is the dividend yield ratio?
(Annual Dividend per ordinary share)/(Market value of share) x 100
How much an investor receives relative to their investment
What is the EPS ratio?
(Earnings (Profit after tax))/(Average no. of outstanding shares)
Measure of profit attributable to each ordinary share. The higher the earnings per share, the more attractive the shares to potential investors and the higher the stock market value. EPS = measure of management performance. Sets an upper limit for dividends. EPS will improve if co buys back shares which doesn’t show the company performance has improved
What is the P/E ratio?
(Market value per share)/EPS (x times)
Measure of earnings growth. Shows how many years it would take investors to receive their investment in the company back (paid off by earnings). If not listed, can be manipulated to make their Co attractive to investors. P/E calculated on previous figures can’t project what is going to happen. Cannot project anticipated losses, cannot guarantee similar performances
What is the Dividend discount model (“DDM”)?
- AKA dividend growth model. Based on the principle that the current value of the share is the discounted value of all expected dividend payments that the share is expected to yield in future years.
- NPV is calculated using an appropriate risk-adjusted rate that discounts the value of future cash flows to today’s date. (discount rate = cost of capital/equity). Rate of return expected by shareholders to compensate for risk of holding securities.
- Future cash flows = dividends and sale price.
- Assumes the future income stream is the dividends paid out by the company, dividends will be paid in perpetuity and dividends will be constant or growing at a fixed rate.
What are the 3 models used in DDM?
1) Zero growth rate:
This model assumes that dividends paid by a company are constant and remain the same year after year
Intrinsic value of shares are calculated as annual dividends divided by required rate of return:
Intrinsic Value (Po) = dividend (Do) ÷ cost of equity/rate of return (K)
2) Constant growth rate:
This model assumes that dividends grow by a specific and fixed percentage every year. Useful in cases of mature and growing companies performing steadily over the years.
Intrinsic value of shares are calculated as:
Po = Do (1 + g) ÷ (k – g)
Implies higher dividends and higher growth in dividends will increase the value of the co and a lower cost of equity will increase the value of the company.
3) Variable growth model:
In real life, dividends paid do not remain constant over the years. This model divides growth into 3 phases: (1) an initial phase of fast growth, (2) a slower transition phase and (3) a sustainable ‘long run’ lower growth rate.
Intrinsic value is the present value of all stages added together
Growth rate is estimated as: Growth rate (g) = r x b
Where: r = annual rate of return from investing and b = proportion of annual earnings retained
How do you calculate the cost of equity under the capital asset pricing model?
Ke = Risk free rate + beta coefficient × market risk premium
Where the market risk premium (also called equity risk premium) = market return – risk free rate, or:
RADR = RFR + ß(RM – RFR)
Where:
RFR = Risk-free rate
RM = return on stock market portfolio
ß = risk premium statistically derived
What is Shareholder value analysis (“SVA”)?
- Management strategy focusing on the creation of economic value or wealth for shareholders.
- Basic assumption = a business is worth its ability to create value for shareholders which is measured as the net present value of its future cash flows, discounted at the appropriate cost of capital
- Value of a share is typically the amount the shareholders are willing to pay, dependent on 2 factors:
- Expected dividends to be earned
- Expected returns from the share
- NPV & internal rate of return are the most popular approach for estimating future cash flows
- NPV = difference between present value of cash inflows and cash outflows over a period of time. It estimates the number of years it will take to break even (when NPV reaches 0). High NPV indicates the company is able to generate sufficient cash to cover all costs involved in a project.
What are the strengths and weaknesses of SVA?
Strengths:
o Uses accounting values and is easy to understand, apply and interpret.
o Reliability is established by use of accepted techniques such as NPV and discounted cash flows
o Value drivers can be used to benchmark the firm against competition
Weaknesses:
o DCF technique uses a fixed rate for all future years but businesses fluctuate and generate different rates of returns
o Value drivers are assumed to grow at a constant rate, not the case in reality
o Calculations depend on accounting figures and sales. It is almost impossible to predict share value.
What is free cash flow and how is it calculated?
- Surplus cash available after the break even point (after recovering all costs needed to fund the project with a positive NPV)
- This is the amount free to be distributed to equity shareholders or reinvested for new investments/to absorb potential losses
• Calculated as:
o Net operating profit – tax – incremental investment in working capital – incremental investment in non-current assets = free cash flow
Calculation of shareholder value in SVA
SVA includes the following calculations:
• Calculate FCF
• Calculate NPV of FCF
• Estimate value attributable for the period beyond the planning horizon. This is known as the terminal period or residual period. Value is worked out by calculating the value of perpetuity over the last year of planning. Present value of a perpetuity is calculated using the discounting method
Application leads to corporate value. Total shareholder value is worked out by deducting the market value of total loan capital.
What is Economic Value Added and how is it calculated?
Measure of profitability and wealth created for shareholders over and above the cost of invested capital. Calculated as:
EVA = net operating profit after tax – (WACC x capital invested)
Capital invested = equity + long-term debt at beginning of the period
Positive EVA = project has recouped its cost of capital
Negative EVA = company has not made sufficient profits to recover costs of running the business
What are the strengths and weaknesses of Economic Value Added?
Strengths:
o Uses accounting concepts familiar to managers such as profit and cost of capital
o Looks at economic value and presents a better picture of the company based on ideas that the company must cover both operating costs as well as capital costs
o No requirement to produce any additional reports/data collection procedures
o Best used for asset-rich companies that are stable or mature
Weaknesses:
o Restricted to specific or short-term projects as it does not take into account the present value of cash flows
o Reliance on accounting profit makes it subjective
o Assets such as brand and reputation are not recorded in the balance sheet and are therefore not considered in EVA.
What is total shareholder return and how is it calculated?
Total amount returned to an investor, equal to the capital gain or loss on a share plus the dividend received. Calculated as:
((selling price + all dividends received) – purchase price) ÷ purchase price
Measures performance of different companies’ shares over time.
Subject to limitations = uses market price as a base and this is subject to market volatility.
