Chapter 18: Equity Valuation Models Flashcards
Fundamental Analysis
Fundamental analysis models a company’s value by assessing its current and future profitability.
The purpose of fundamental analysis is to identify mispriced stocks relative to some measure of “true” value derived from financial data.
Models of Equity Valuation
Balance Sheet Models
Dividend Discount Models (DDM)
Price/Earnings Ratios
Free Cash Flow Models
Valuation by Comparables
Compare valuation ratios of firm to industry averages.
Ratios like price/sales are useful for valuing start-ups that have yet to generate positive earnings.
Limitations of Book Value
Book values are based on historical cost, not actual market values.
It is possible, but uncommon, for market value to be less than book value.
“Floor” or minimum value is the liquidation value per share.
Tobin’s q is the ratio of market price to replacement cost.
Intrinsic Value vs. Market Price
The return on a stock is composed of dividends and capital gains or losses.
The expected HPR may be more or less than the required rate of return, based on the stock’s risk.
Expected HPR = E(r) = (E(D1) + E(P1)) - Po/ Po
Required Return
CAPM gives the required return, k:
If the stock is priced correctly, k should equal expected return.
k is the market capitalization rate (market consensus value of the required return).
k= Rf +B{E(Rm) - Rf}
Intrinsic Value
is the “true” value, according to a model.
PV of future cash flows, discounted at appropriate risk-adjusted interest rate
The market value (MV)
is the consensus value of all market participants
Trading Signal:
IV > MV Buy
IV < MV Sell or Short Sell
IV = MV Hold or Fairly Priced
Preferred Stock and the DDM
No growth case:
Value a preferred stock paying a fixed dividend of $2 per share when the discount rate is 8%: What is the current value? 25 What is the value in one year? 25
A stock just paid an annual dividend of $3/share. The dividend is expected to grow at 8% indefinitely, and the market capitalization rate (from CAPM) is 14%.
What is the current value?
3*1.08= 3.24
3.24/14%-8%
= 54
What is the value in one year?
DDM Implications
The constant-growth rate DDM implies that a stock’s value will be greater:
The larger its expected dividend per share.
The lower the market capitalization rate, k.
The higher the expected growth rate of dividends.
The stock price is expected to grow at the same rate as dividends.
Present Value of Growth Opportunities
The value of the firm equals the value of the assets already in place, the no-growth value of the firm,
Plus the NPV of its future investments,
Which is called the present value of growth opportunities or PVGO.
Pitfalls in P/E Analysis
Use of accounting earnings
Earnings Management
Choices on GAAP
Inflation
Reported earnings fluctuate around the business cycle
Free Cash Flow to the Firm
Value the firm by discounting free cash flow at WACC.
Free cash flow to the firm, FCFF, equals: After tax EBIT Plus depreciation Minus capital expenditures Minus increase in net working capital
Value of equity equals value of firm minus value of existing debt
