Chapter 7: Valuing Stocks Flashcards by Katrina Enros

What is the definition of common stock?

Ownership shares in a publicly held corporation.

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What is the definition of an IPO?

First offering of stock to the general public.

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What is the definition of a primary offering?

The corporation sells shares in the firm on the primary market (post-IPO).

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What is the primary market?

A market for the sale of new securities by corporations.

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What is the secondary market?

A market in which previously issued securities are traded among investors.

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What is the P/E ratio

Ratio of stock price to earnings per share, also known as the price-earnings multiple. It is a key tool of stock market analysts.

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What is book value?

The value shown in the firm’s balance sheet.

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What is liquidation value?

The net proceeds that could be realised by selling the firm’s assets and paying off its creditors.

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What is going-concern value?

Market value treats the firm as a going concern. Includes 3 factors: (1) the extra earning power of a company; (2) the company’s intangible assets that are not on the balance sheet; (3) the value of future investments.

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What is the definition of intrinsic value?

The PV of future cash payoffs from a stock or other security (V_0).

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What is the formula for intrinsic value (aka PV of cash payoffs expected)?

V_0 = (DIV_1 + P_1) / (1 + r)

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What is the formula for expected rate of return on stocks?

Expected rate of return = expected dividend yield + expected capital gain
OR
Expected rate of return = DIV_1/P_0 + (P_1 -P_0)/P_0

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In a well-functioning market, how are equally risky securities priced?

Priced to offer the same expected rate of return; this is a fundamental characteristic of prices in competitive markets.

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What is the definition of the dividend discount model (DDM)?

Discounted C.F. model that states that today’s stock price equals the PV of all expected future dividends.

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What is the formula for DDM?

P = [DIV_1 / (1+r)] + [DIV_2 / (1+r)^2] + … [DIV_H / (1+r)^H

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What happens to the DDM formula if the horizon is infinitely far away?

Forget about the final horizon price, and simply say:

Stock price = PV (of all future dividends per share)

What does the DDM formula look like with No Growth?

Value of a no-growth stock = P = DIV_1/r

What does the DDM formula look like with Constant Growth (aka the Gordon Growth model)?

P=DIV_1/(r-g)
OR rearrange as:
r=DIV_1/P_0 + g, which is the dividend yield + growth rate

What is the sustainable growth rate?

The firm’s growth rate if it plows back a constant fraction of earnings, maintains a constant return on equity, and keeps its debt ratio constant.

What is the payout rate?

Fraction of earnings paid out as dividends.

What is the plowback ratio?

Fraction of earning retained by the firm.

What is the formula for the plowback ratio?

plowed-back earnings / total earnings

What is the formula for growth rate?

plowed-back earnings / total earnings x total earnings / initial equity

Does plowing back earnings into new investments result in (a) growth in earnings, (b) growth in dividends, or (c) growth in current stock price.

It results in (a) and (b). It may result in a growth in (c) if investors are convinced that the reinvested earnings will earn a higher rate of return.

What is the Present Value of Growth Opportunities (PVGO)?

The net present value of a firm's future investments. The value of assets in place + the present value of growth opportunities (PVGO) = Total Value of Stock

What is free cash flow (FCF)?

Cash flow available for distribution to investors after firm pays for new investments or additions to working capital

What information is included in stock trading reports?

Large companies usually arrange for their stocks to be traded on a stock exchange. The stock listings report the stock's price, price change, volume, dividend yield, and price earnings ratio.

How can stock-price information about other firms be used to help you value a particular firm?

To value a stock, financial analysts often start by identifying similar firms and looking at how much investors in these companies are prepared to pay for each dollar of earnings or book assets.

How can one calculate the PV of a stock given forecasts of future dividends and future stock price?

Stockholders generally expect to receive (1) cash dividends and (2) capital gains or losses. The rate of return that they expect over the next year is defined as the expected dividend per share (DIV) plus the expected increase in price P(1) - P(0), all divided by the price at the beginning of the year P(0). The PV of a share is equal to the stream of expected dividends per share up to some horizon date plus the expected price at this date, all discounted at the return that investors require. This is the DDM.

How can stock valuation formulas be used to infer the value of an entire business?

Similar valuation methods can be used to est the value of an entire business. You need to forecast and discount the free C.F.s provided by the business. These are the C.F.s not plowed back into the business but can be used to pay dividends or repurchase stock.

How do a company's growth opportunities show up in its stock price and price-earnings ratio?

If forecast dividends grow at a constant rate, g, then the value of a stock is P(0) = DIV(1)/(r-g). This is the constant-growth DDM. The share's value is the sum of two parts: value of the assets in place and present value of growth opportunities (PVGO). The P/E ratio is a reflection of the market's assessment of a firm's growth opportunities.

How does competition among investors lead to efficient markets?

Competition between investors will tend to produce an efficient market -- that is, a market in which prices rapidly reflect new information and investors have difficulty making consistently superior returns.