CHAPTER 8: Equity Valuation (Concepts & Tools)

Question 1

MARKET VALUE vs INTRINSIC VALUE

Answer 1

Overvalued: Market value > Intrinsic value

Fairly valued: Market value = Intrinsic value

Undervalued: Market value < Intrinsic value

Question 2

INTRINSIC VALUE

Answer 2

• Based on fundamentals (earnings, sales, dividends)
• Also called fundamental or estimated value
• Differs from market price when questioning market’s estimate

Question 3

Example:

Caterpillar Inc. trading at $84.53
Analyst estimates intrinsic value at $88.21

Undervalued or Overvalued?

Answer 3

Conclusion: Undervalued

Question 4

Factors to Consider if Market Value is NOT EQUAL to Intrinsic Value

Answer 4

• Percentage difference
• Confidence in your model
• Model sensitivity to assumptions
• Number of analysts
• Will market price move towards intrinsic value?

Question 5

Key Points:

Answer 5

• Large discrepancies warrant rechecking calculations
• High model confidence suggests price convergence over time
• Check model sensitivity if many securities appear mispriced
• More analyst coverage typically means less mispricing (Convergence & Value Triggers)

Question 6

Present value models (DCF)

Answer 6

• Estimate value as present value of expected future benefits.
• Future benefits are defined as either cash distributed to shareholders (dividend discount models) or cash available to shareholders after meeting the necessary capital expenditure and working capital expenses (free-cash-flow-to-equity models).

DDM or DCF

Question 7

Multiplier Models (Comps)

Answer 7

• Estimate intrinsic value based on a multiple of some fundamental variable.
• For example, either Stock price / earnings (or sales, book value, cash flow).
• Or Enterprise value / EBITDA (or sales).

Question 8

Asset-based valuation models

Book Value or Carrying Value models

Answer 8

Benjamin Graham’s NCAVPS: Net Carrying Asset Value Per Share= Total Assets – Total Liabilities

• Estimate the value of equity as the value of assets less the value of liabilities.
• Book values of assets and liabilities are typically adjusted to their fair values when using these models.

Choice of model depends on availability of information & the analyst’s confidence in the appropriateness of the model; generally analysts will try to use more than one model

Question 9

An analyst finds that all the securities analyzed have estimated values higher
than their market prices. The securities all appear to be:

A. overvalued.
B. undervalued.
C. fairly valued.

Answer 9

Undervalued

B is correct. The estimated intrinsic value for each security is greater than
the market price. The securities all appear to be undervalued in the market.

Note, however, that the analyst may wish to reexamine the model and inputs to check that the conclusion is valid.

Question 10

An analyst finds that nearly all companies in a market segment have common shares which are trading at market prices above the analyst’s estimate of the shares’ values. This market segment is widely followed by analysts.

Which of the following statements describes the analyst’s most appropriate
first action?

A. Issue a sell recommendation for each share issue.
B. Issue a buy recommendation for each share issue.
C. Reexamine the models and inputs used for the valuations.

Answer 10

C.

C is correct.

It seems improbable that all the share issues analyzed are overvalued, as indicated by market prices in excess of estimated value—particularly because the market segment is widely followed by analysts.

Thus, the analyst will not issue a sell recommendation for each issue. The analyst will most appropriately reexamine the models and inputs prior to issuing any recommendations.

A buy recommendation is not an appropriate response to an overvalued security.

Question 11

An analyst, using a number of models and a range of inputs, estimates a security’s value to be between ¥250 and ¥270. The security is trading at ¥265.

The security appears to be:
A. overvalued.
B. undervalued.
C. fairly valued.

Answer 11

C is correct.

The security’s market price of ¥265 is within the range estimated
by the analyst.

The security appears to be fairly valued.

Question 12

An analyst is estimating the intrinsic value of a new company. The analyst has one year of financial statements for the company and has calculated the average values of a variety of price multiples for the industry in which the company operates.

The analyst plans to use at least one model from each of the three categories of valuation models. The analyst is least likely to rely on the estimate(s) from the:

A. multiplier model(s).
B. present value model(s).
C. asset-based valuation model(s).

Answer 12

B.

Because the company has only one year of data available, the analyst is least likely to be confident in the inputs for a present value model.

The values on the balance sheet, even before adjustment, are likely to be close to market values because the assets are all relatively new.

The multiplier models are based on average multiples from the industry.

Question 13

Based on a company’s EPS of €1.35, an analyst estimates the intrinsic value of a security to be €16.60. Which type of model is the analyst most likely to be using to estimate intrinsic value?

A. Multiplier model.
B. Present value model.
C. Asset-based valuation model.

Answer 13

A.

The analyst is using a multiplier model based on the P/E multiple.

The P/E multiple used was 16.60/1.35 = 12.3.

Question 14

DIVIDENDS: Background for DDM

Definition & Types

Answer 14

Dividend: Distribution paid to SHs based on the number of shares owned

Not an obligation; must be authorized by BOD

Types:

1. Stock Dividends: Bonuses: does NOT affect market value of equity; thus not relevant for valuations
2. Cash Dividends:
   - Regular cash dividends: paid out consistently. A stable or increasing dividend is viewed as a sign of financial stability.
   - Extra dividend or Special Dividend: one-time cash payments when situation is favourable; Irregular dividends; Used by cyclical firms
   - Liquidating dividend: distributed to SHs when a company goes out of business
3. Share Repurchases:
   - Not considered for dividends, voting & EPS calculation

Reasons for repurchase:

• Signal belief that shares are undervalued
• Flexibility in amount & timing of distribution
• Tax efficiency
• Absorb increase in outstanding shares

Question 15

STOCK SPLIT

Answer 15

Number of shares outstanding: Increases
Stock Price: Decreases

Eg: 1:2 stock split= 1 for every 2 shares held

Similar to Stock Dividends
Doesn’t change the market value of equity; thus irrelevant for valuations

Question 16

REVERSE STOCK SPLIT (Consolidation)

Answer 16

Number of shares outstanding: Decreases
Stock Price: increases

Eg: 1:2 stock split= Each SH receives 1 share for every 2 held

Similar to Stock Dividends
Doesn’t change the market value of equity; thus irrelevant for valuations

Question 17

SHARE REPURCHASE (BUYBACKS)

Answer 17

Alternative to cash dividends

Company uses cash to buyback shares

BUYBACKS affect market value of equity & thus are relevant for valuations.

Impact on SH’s wealth is equivalent to a cash dividend.

Shares bought back are called Treasury Stock/Shares & this process is called a TREASURY OPERATION

Question 18

Key reasons why companies engage in share repurchases instead of cash dividends?

Answer 18

1. to support share prices. company believes in own share’s value so buys back.
2. flexibility in the amount and timing of cash distribution.
3. when tax rates on capital gains are lower than tax rates on dividends.
4. to offset the impact of employee stock options.

Question 19

DIVIDEND PAYMENT CHRONOLOGY/SCHEDULE:

Answer 19

DECLARATION= Announcement
Ex-Dividend Date= Too late to get dividend
Cum-Dividend Date= Last chance to get dividend
Holder-of-record Date= Company checks who gets dividend
Payment date= Money is paid out

1. Declaration date: Company declares dividend.
2. Ex-dividend date: Cutoff date on or after which buyers of a stock are not eligible for the dividend. Also is the first date when the stock trades without dividend.
3. Holder-of-record date: A record of shareholders who are eligible to receive the dividend is made (usually two days after the ex-dividend date).
4. Payment date: Dividend payment made to the shareholders.

Question 20

Reasons for repurchase:

Answer 20

• Signal belief that shares are undervalued
• Flexibility in amount & timing of distribution
• Tax efficiency
• Absorb increase in outstanding shares

Question 21

DDM & FCFF

Answer 21

Simplest PV model is DDM

PV= PV of Future Dividends + PV of Terminal Value

Question 22

For the next 3 years, the annual dividends of Stock X are expected to be 1, 1.1 & 1.2. The expected stock price at the end of Year 3 is expected to be $20. The required rate of return on the shares is 10%.

What’s the estimated value?

Answer 22

PV= CF/(1+r)^n

PV (1)= 1/(1.10)^1= 0.909
PV (2)= 1.1/(1.10)^2= 0.909
PV (3)= 1.2/(1.10)^3= 15.928

1+2+3= 0.909+0.909+15.928= 17.74

On Calc:

CF0 = 0; CF1 = 1; CF2 = 1.1; CF3 = 21.2; I = 10%, CPT NPV

Question 23

In practice FCFE models are often used.

FCFE Formula
What’s value?
When are FCFE models used?

Answer 23

FCFE= CFO - FC Inv + Net borrowing

Value= PV of all future FCFEs

Used when
- not paying dividends
- dividends too small
- dividends not indication of company’s ability to pay dividends
- unable to figure out company’s dividend payout policy

Use CAPM to calculate required rate of return on share

Ke= Rf + B(Rm-Rf) or Rf + Market Risk Premium

Jensen’s Alpha= Rpf - Ke

Question 24

FCFE MODEL

Answer 24

FCFE Model:

Measures dividend-paying capacity

Applicable for non-dividend paying stocks

Useful for companies with small or non-indicative dividends

Accounts for cash flow retention for future investments

Question 25

FCFE CALCULATION

Answer 25

FCFE Calculation:

FCFE = CFO - FCInv + Net borrowing
CFO = Cash Flow from Operations
FCInv = Fixed Capital Investment
Net borrowing = Borrowings - Repayments

Question 26

FCFE Advantages

Answer 26

Advantages of FCFE:

Flexibility in application
Considers dividend-paying potential
Accounts for retained earnings

Question 27

Required Rate of Return (Ke)

Answer 27

Required Rate of Return:

Typically calculated using CAPM
Formula: Risk-free rate + Beta * Market risk premium
Alternative methods available (e.g., bond yield plus risk premium)

Question 28

FCFE Assumptions

Answer 28

Key Considerations:

FCFE reflects available cash for shareholders

Model assumes infinite time horizon

Requires estimation of future cash flows and growth rates

Question 29

PREFERRED STOCK VALUATION

Answer 29

For a non-callable, non-convertible perpetual preferred share paying a level dividend D & assuming a constant required rate of return

V= D/r

Other types of preferred shares to consider:
1. Shares which mature on a given date
2. Callable (redeemable) shares
3. Shares with retraction option (Puttable shares)

Question 30

Preferred Stock Basics:

Answer 30

Preferred Stock Basics:

• Non-callable, non-convertible, perpetual
• Pays level dividends

Valued using perpetuity formula:

V₀ = D₀ / r

where,
V₀ = Present value
D₀ = Dividend
r = Required rate of return

Question 31

A $100 par value, non-callable, non-convertible perpetual preferred stock pays a 5% dividend.

The discount rate is 8%.

Calculate the intrinsic value of the preferred share.

Answer 31

Dividend is given at par value or face value

Expected annual dividend
= 0.05 x 100 = 5

Value of the preferred share
= 5.00/0.08 = 62.50

Question 32

Types of Preferred Shares:

Maturing, Callable & Puttable

Answer 32

Types of Preferred Shares:

Maturing Shares:

• Fixed maturity date
• Value: Present value of dividends + final payment

Callable Shares:
- Company can call share back
- Redeemable by issuer before maturity
- Trade at lower value due to call risk

Putable Shares (Retraction Option):
- Investors can put shares back to company
- Holder can sell back to issuer
- Trade at higher value due to put option

Based on traded value: P>M>C

Question 33

Case 1: Non-callable, Non-convertible, Perpetual Preferred Shares

The following facts concerning the Union Electric Company 4.75 percent perpetual preferred shares are as follows:

■ Issuer: Union Electric Co. (owned by Ameren)
■ Par value: US$100
■ Dividend: US$4.75 per year
■ Maturity: perpetual
■ Embedded options: none
■ Credit rating: Moody’s Investors Service/Standard & Poor’s Ba1/BB
■ Required rate of return on Ba1/BB rated preferred shares as of valuation
date: 7.5 percent.

Answer 33

Estimate the intrinsic value of this preferred share.

Basing the discount rate on the required rate of return on Ba1/BB rated
preferred shares of 7.5 percent gives an intrinsic value estimate of
US$4.75/0.075 = US$63.33.

Explain whether the intrinsic value of this issue would be higher or lower if the issue were callable (with all other facts remaining unchanged).

ANSWER:

The intrinsic value would be lower if the issue were callable. The option to redeem or call the issue is valuable to the issuer/company because the call will be exercised when doing so is in the issuer’s interest.

The intrinsic value of the shares to the investor will typically be lower if the issue is callable. In this case, because the intrinsic value without the call is much less than the par value, the issuer would be unlikely to redeem the issue if it were callable; thus, callability would reduce intrinsic value, but only slightly.

Question 34

Key Considerations for Preferred Share Valuations

Answer 34

Key Considerations:

Maturity affects valuation method
Call/put options impact share value
Market conditions influence pricing

Question 35

GORDON’S GROWTH MODEL (CGDDM)

Dividends grow INDEFINITELY @ constant rate

Also called CONSTANT-GROWTH DDM

Answer 35

Gordon Growth Model Basics:

Assumes constant dividend growth rate
Formula: V₀ = D₁ / (r - g)

Value (V₀) is based on Dividends of next year (D₁)

Key Components:

D₁: Next period’s dividend
r: Required rate of return
g: Dividend growth rate

Growth Rate Estimation Methods:

• Historical growth rate
• Industry median growth rate
• Sustainable growth rate: g = b × ROE

Ke= Rf + B(Rm-Rf)= Rf+(BMRP)
Retention Rate= (1-DPR)
(g)= ROERR= ROE(1-DPR)
Next Year’s Dividend (d1)= d0(1+g)
Intrinsic Value= D1/Ke-G

Question 36

GGM ASSUMPTIONS, CONSIDERATIONS & LIMITATIONS?

Answer 36

Model Assumptions:

Dividends reflect company earnings
Perpetual dividend growth
Constant required return
Growth rate < required return

Key Considerations:

Impact of dividend changes on value is complex
Remember to discount future values to present

Limitations:

Not suitable for non-dividend paying companies
May not work for currently unprofitable companies

Question 37

GGM IMPORTANT FORMULAE

Answer 37

Ke= Rf + B(Rm-Rf)= Rf+(BMRP)
Retention Rate= (1-DPR)
(g)= ROERR= ROE(1-DPR)
Next Year’s Dividend (d1)= d0(1+g)
Intrinsic Value= D1/Ke-G

Question 38

Estimate the intrinsic value of a stock given the following data:

Beta = 1.5
RFR = 3%
market risk premium = 5%
dividend just paid = $1.00
dividend payout ratio = 0.4
return on equity = 15%.

Answer 38

Ke= Rf + B(Rm-Rf)= Rf+(BMRP)
Retention Rate= (1-DPR)
(g)= ROERR= ROE(1-DPR)
Next Year’s Dividend (d1)= d0(1+g)
Intrinsic Value= D1/Ke-G

Calculate Ke
Ke= Rf + B(Rm-Rf)= Rf+BMRP
= (3+1.55)= 10.5%

Calculate Sustainable Growth Rate (g)

(g)= ROE(1-DPR)
= 1.515%= 0.225
or
15%(1-0.4)=15%0.6= 0.09= 9%

Next Year’s Dividend (d1)= d0(1+g)
= 1(1+0.09)= 1.09

Intrinsic Value= D1/Ke-G
= 1.09/10.5-9= 1.09/0.015= 72.66

Thus,
Intrinsic Value of Stock: $72.67

OR

V0 = D1/r−g = D0∗(1+g)/r−g

Note: the values of r, g and expected dividend are not given.

So, first calculate these values.

r = RFR + Beta x market risk premium
= 3+ 1.5 x 5 = 10.5%

g = b x ROE = (1 - 0.4) x 0.15 = 0.09 Applying the Gordon growth model, V0 = 1 x 1.090.105 – 0.09 = 72.67

Question 39

A company does not currently pay dividend but is expected to begin to do so in 4 years.

The first dividend is expected to be $2.00 and to be received at the end of year 4.

The dividend is expected to grow at 5% into perpetuity. The required return is 10%.

What is the estimated current intrinsic value?

Answer 39

• The first dividend is expected at the end of year 4.
• Use the Gordon growth model to find the value at the end of year 3.

To calculate the intrinsic value, first calculate the value of dividend at the end of period 3 and then discount it to t=0 using the Gordon growth model.

V3 = D4/r–g= 2/0.10–0.05 = 40

V0 = 40/(1.1)^3 = 30.05

Do not forget to discount 40 to the present value.

The undiscounted value is commonly presented as one of the answer options as a trap.

Question 40

Two-Stage Dividend Discount Model:

Answer 40

Two-Stage Dividend Discount Model:

Formula:
V₀ = Σ[D₀(1+gₛ)ᵗ / (1+r)ᵗ] + Vₙ / (1+r)ⁿ

Used for companies transitioning from growth to mature stage

First 3 years= dividend % is 10% then after company stabilizes, dividend rate. is 5%: 2 stage model.

Components:

D₀: Current dividend
gₛ: Short-term growth rate
r: Required rate of return
n: Number of years in high growth period
Vₙ: Terminal value at time n

Terminal Value Calculation:

Uses Gordon Growth Model
Vₙ = Dₙ₊₁ / (r - g)
g: Long-term growth rate

Question 41

The current dividend for a company is $4.00. The dividends are expected to grow at 20% a year for 4 years and then at 10% after that. The required rate of return is 18%. Estimate the intrinsic value.

Answer 41

Calculate terminal value (V₄):

D₄ = $4 * (1.20)⁴ = $8.29
D₅ = $8.29 * 1.10 = $9.12
V₄ = $9.12 / (0.18 - 0.10) = $114

Discount cash flows:

Year 1: $4.80 / 1.18 = $4.07
Year 2: $5.76 / (1.18)² = $4.13
Year 3: $6.91 / (1.18)³ = $4.20
Year 4: ($8.29 + $114) / (1.18)⁴ = $63.08

Sum all discounted values:

Intrinsic value = $4.07 + $4.13 + $4.20 + $63.08 = $75.48

Question 42

Three-Stage Models

Answer 42

Three-Stage Models:

Extends two-stage concept
Stages: Growth, Transition, Maturity
Allows for more nuanced valuation

Key Considerations:

Accurately estimating growth rates is crucial
Model complexity increases with more stages

Question 43

In GGM, what happens if Value of DIVIDENDS is increased?

Answer 43

V0= D1/r-g

If D1 goes up, we may think that V0 also goes up

But, when dividends increase, Retention Rate decreases. i.e. less money being retained.

and ROE*RR= g

Thus, growth rate (g) is going to be low

So, denominator goes up.

Both numerator & denominator going up.

So, can’t say that value may always increase

Question 44

For the next three years, the annual dividends of a stock are expected to be
€2.00, €2.10, and €2.20. The stock price is expected to be €20.00 at the end of three years. If the required rate of return on the shares is 10 percent, what is the estimated value of a share?

Answer 44

The present values of the expected future cash flows can be written as
follows:

V₀ = D₁/(1+r)¹ + D₂/(1+r)² + D₃/(1+r)³ + TV₃/(1+r)³

V0 = 2/(1.1)^1 + 2.1/(1.1)^2 + 2.2/(1.1)^3

Calculating and summing these present values gives an estimated share
value of

V0 = 1.818 + 1.736 + 1.653 + 15.026
= €20.23.

The three dividends have a total present value of €5.207, and the terminal stock value has a present value of €15.026, for a total estimated value of €20.23.

Question 45

An investor expects a share to pay dividends of $3.00 and $3.15 at the end of Years 1 and 2, respectively. At the end of the second year, the investor expects the shares to trade at $40.00. The required rate of return on the shares is 8 percent.

If the investor’s forecasts are accurate and the market price of the shares is currently $30, the most likely conclusion is that the shares are:

A. overvalued.
B. undervalued.
C. fairly valued.

Answer 45

V
= 3/(1.08)^1 + 3.15/(1.08)^2 + 40/(1.08)^3

= 39.7

Mkt. value= 30

IV>mkt value

Thus, Overvalued

Question 46

Two investors with different holding periods but the same expectations and
required rate of return for a company are estimating the intrinsic value of a
common share of the company. The investor with the shorter holding period will most likely estimate a:

A. lower intrinsic value.
B. higher intrinsic value.
C. similar intrinsic value.

Answer 46

C is correct.

The intrinsic value of a security is independent of the investor’s holding period.

IV= INDEPENDENT OF INVESTOR’S HOLDING PERIOD

Question 47

An equity valuation model that focuses on expected dividends rather than
the capacity to pay dividends is the:

A. dividend discount model.
B. free cash flow to equity model.
C. cash flow return on investment model.

Answer 47

A is correct.

Dividend discount models focus on expected dividends.

Question 48

The current dividend is $4.00.
Growth is expected to be 20% a year for 4 years then 10% after that.
Required rate of return is 18%

Estimate Intrinsic Value

Answer 48

D1= 4(1.2)= 4.8
D2= 4(1.2)^2= 5.76
D3= 4(1.2)^3= 6.91
D4= 4(1.2)^4= 8.29

g= 10%
r= 18%

V0= D1/r-g
V3= D4/r-g
V3= 8.29/0.18-0.10= 8.29/0.08= 103.68
IV= 103.68

Question 49

The current dividend, D0, is $5.00. Growth is expected to be 10 percent a year for three years and then 5 percent thereafter. The required rate of return is 15 percent. Estimate the intrinsic value.

D1 = $5.00(1 + 0.10) = $5.50
D2 = $5.00(1 + 0.10)2 = $6.05
D3 = $5.00(1 + 0.10)3 = $6.655
D4 = $5.00(1 + 0.10)3(1 + 0.05) = $6.98775
V 3 = _ 0$.165.9 −8 707.055 = $69.8775
V0 = _ ( 1 $+5 .05.01 5) + _ $6.05 ( 1 + 0.15 ) 2 + _ $6.655 ( 1 + 0.15 ) 3 + $69.8775 ( 1 + 0.15 ) 3 ≈ $59.68

Answer 49

D1= 5(1.1)= 5.50
D2= 5(1.1)^2= 6.05
D3= 5(1.1)^3= 6.65
D4= 6.65(1.05)= 6.98

g= 5%
r= 15%

V0= D1/r-g
V3= D4/r-g
V3= 6.98/0.15-0.05= 6.98/0.10= 69.8

Calculating present value:

V0 = D1 / (1 + r) + D2 / (1 + r)^2 + D3 / (1 + r)^3 + V3 / (1 + r)^3

V0 = $5.50 / (1 + 0.15) + $6.05 / (1 + 0.15)^2 + $6.655 / (1 + 0.15)^3 + $69.8775 / (1 + 0.15)^3

V0 ≈ $59.68

Question 50

MULTIPLIER MODELS

Answer 50

Price Multiple is a ratio that compares a company’s share price with some monetary flow/value for evaluation purposes

Question 51

PE Ratio

Answer 51

PE Ratio
- Trailing EPS
- Forward/Leading/Estimated EPS

Low PE companies usually outperform High PE companies

Question 52

PB Ratio

Answer 52

Price to Book Ratio

Price/BVPS or mcap/bv

BVPS= A-L/NUMBER OF SHARES OUTSTANDING

LOW PB companies usually outperform HIGH PB companies

Question 53

PS Ratio

Answer 53

Trailing or Leading

Can never be negative; used for companies with -ve earnings where PE fails

Question 54

PCF: Price to Cash Flow Ratios

Answer 54

FCFF or CFO may be used

Question 55

For a growing company, what will be higher- the leading PE or trailing PE?

Answer 55

Trailing PE is HIGHER than leading PE

Leading= Forward EPS
Trailing= Past EPS

If earnings increasing in future, denominator will increase, so overall PE is low for forward.

Thus, trailing is higher

Question 56

Relationships among Price Multiples, Present Value Models & Fundamentals

Based on fundamentals:
P0/E1= (D1/E1)/(r-g)
or
P0/E1= DPR/r-g

g= RRROE or (1-DPR)ROE

Answer 56

P0= D1/r-g

P0/E1= (D1/E1)/(r-g)
OR
P0/E1= DPR/r-g

So,
PE can be calculated if D1, r & g are given

This is called JUSTIFIED PE. Why?

because PE is justified based on fundamentals in RHS & E1 is used instead of E0

Question 57

Between 2008 to 2012= a company’s DPR has been 40% on average.

In 2008= the dividend was $1.00 & has grown steadily to $1.80 for 2012.

This growth rate is expected to continue in the future.

Using a discount rate of 20%, estimate the company’s justified forward PE

Answer 57

P/E1= DPR/r-g
= 40/20-g
= 0.4/0.2-g

2008= Y1
2012= Y2
n= 4

CAGR FORMULA
(Final/Initial)^1/n-1

g= (1.8/1)^1/4 - 1= 0.16

PE= 0.4/0.2-0.16
= 10

Question 58

Does a higher dividend payout ratio increase the PE?

Answer 58

Higher DPR
Lower RR
Lower g
Higher Price

Justified PE= DPR/r-g
numerator increases
g decreases; denominator increases

So, both numerator & denominator going up. Thus, PE impact is unknown.

Question 58

HOW TO CALCULATE g?

Answer 58

Use CAGR formula

(final/initial)^1/n -1

Question 59

Justified forward PE estimates can be sensitive to small changes in assumptions

Answer 59

PE= DPR/r-g

Must be careful with the numbers being used

Question 59

METHOD OF COMPARABLES (trading comps)

Answer 59

This method compares relative values using multiples & is based on the LAW OF ONE PRICE (Identical goods should sell for SAME price in efficient markets)

Law of One Price: Similar items must have same price

Question 60

Based on the P/S data below, which stocks appear undervalued?

GM: 0.01
Ford: 0.14
Daimler: 0.27
Honda: 0.49
Toyota: 0.66

Answer 60

CROSS-SECTIONAL ANALYSIS: Diff. companies @ same point in time

If all companies are similar-

GM is the most undervalued because we are paying 1 cents for every $1 of sales

Toyota= most expensive= because we’re paying 66 cents for every $1 of sales

But, other factors must be considered.

When this data was curated, GM was on the verge of bankruptcy

Question 61

CROSS-SECTIONAL VS TIME SERIES ANALYSIS

Answer 61

CROSS-SECTIONAL ANALYSIS: Diff. companies @ same point in time

TIME SERIES: One company over the course of time

Question 62

Is the Cannon stock overvalued or undervalued relative to historical levels?

2004= 14.3
2005= 15.9
2006= 19.6
2007= 13.8
2009= 11.3

Answer 62

Undervalued.

11.3 is lower than other years

But, other factors must be considered.

Might be down because expected growth rate is flat or down

In 2008, camera sales declined.

Question 63

What’s the difference between:

PE multiples based on comparables
&
PE multiples based on fundamentals

Answer 63

PE multiples based on comps are based on The Law of One Price (Similar items must have same prices in an efficient market)

This must be compared RELATIVE to others to arrive at the valuation

PE multiples based on fundamentals: PE= DPR/r-g or JUSTIFIED PE

Justified PE can tell us what the PE should be based on fundamentals

and can be compared directly with the ACTUAL PE ratio to see whether its overpriced or underpriced.

Question 64

ENTERPRISE VALUE

Answer 64

Total Value of Net Operating Assets to All SHs (debt+equity+minority)

A= L+SHE
A= Total Debt + Total Equity

Market Value of Debt + Market Value of Equity + Market Value of Preferred Shares - Cash

EV= MVE + MVD + MVP - Cash & Cash Equivalents

If market values aren’t available, use estimates (BV of debt is often equal to MV of debt)

Question 65

EV/EBITDA

Answer 65

Proxy for Cash Flow
since EBITDA is CASH OPERATING PROFIT

D&A= non-cash expenses

So, we’re looking at how much OPERATING CASH is company generating

Lower is better; but has other considerations

Question 66

The EV/EBITDA ratio of a company is 10

EBITDA is 20 million

MV of debt is 50 million

Cash is 2 Million

What’s MVE?

Answer 66

EV= MVD+MVE+MVP - Cash

= 50 + MVE - 2
= 48 + MVE

EV/EBITDA * EBITDA = EV
10*20= 200
EV= 200

SO,

200= 48 + MVE
MVE= 200-48
MVE= 152

Answer: 152

Question 67

ASSET BASED VALUATION

Answer 67

Estimates the Market Value or Fair Value of an entity’s assets & liabilities

Generally suitable for companies that have low proportion of intangible & “off the books” assets viz. IPR, patents etc

Used to value PVT. Enterprises

A= L-SHE
If assets are intangible, difficult to value them using this method

Question 68

CONSIDERATIONS FOR ASSET-BASED VALUATIONS

Answer 68

• Book Values might be very different from market values. So, BV must be adjusted to reflect MV.
• Some intangible assets are not reported; asset-based value (going to be based on tangibles) could be considered as a “floor value”
• Asset values are hard to estimate in a HYPER-INFLATIONARY environment

Question 69

ADVANTAGES OF COMPARABLES VALUATION USING MULTIPLES

Answer 69

Predict future returns (PE & PB)
Widely used
Easily available
Time-series comparison
Cross-sectional comparison

Question 70

DISADVANTAGES OF COMPARABLES VALUATION USING MULTIPLES

Answer 70

Lagging numbers tell about past (P/E0)*
Not always comparable across firms
Impacted by economic conditions
Might conflict with fundamental method (PE= DPR/r-g)
Sensitive to different accounting methods
Negative denominator (negative earnings)

*doesn’t apply if estimates are used

Question 71

DCF ADVANTAGES

Answer 71

Based on PV of future cash flows
Widely accepted & used

Question 72

DCF DISADVANTAGES

Answer 72

Inputs have to be estimated
Estimates sensitive to inputs
Stable mature companies

Price Multiples valuation based on fundamentals have advantages & disadvantages similar to DCF methods

Question 73

ASSET BASED MODEL: ADVANTAGES

Answer 73

Floor Values (uses tangible assets)
Works when assets have easily determinable market values
Works well for companies that report fair values

Question 74

ASSET BASED MODEL: DISADVANTAGES

Answer 74

Market values hard to determine
Market values often different from book values
Do not account for intangible assets
Hard to estimate in Hyperinflation