Chapter 9 - Valuing Stock Flashcards
Dividend Discount Model (DDM)
A procedure for valuing the price of a stock by using the predicted dividends and discounting them back to the present value.
If the value obtained from the DDM is higher than what the shares are currently trading at, then the stock is undervalued.
Dividend per share/discount rate - dividend growth rate
Equity Cost of Capital
The expected return of other investments available in the market with equivalent risks to the firm’s shares.
Dividend Yield
The expected annual dividend of the stock divided by its current price. The dividend yield is the percentage return the investor expects to earn from the dividend paid by the stock
Capital Gain and Capital Gain Rate
Capital Gain: Reflects the capital gain the investor will earn on the stock, which is the difference between the expected sale price and purchase price for the stock (P1-P0).
Capital Gain Rate: Divide the capital gain by the current stock price to express the capital gain as a percentage rate.
Total Return of the Stock
The sum of the dividend yield and the capital gain rate. The total return is the expected return that the investor will earn for a one-year investment in the stock.
Short Sale
Selling a security you don’t own
Short Interest
Number of shares sold short
Constant Dividend Growth Model
A model for valuing a stock by viewing its dividends as a constant growth perpetuity
Dividend Payout Rate
The fraction of its earnings that the firm pays as dividends each year
Retention Rate
The fraction of current earnings that the firm retains
Sustainable Growth Rate
The rate at which it can grow using only retained earnings
2 sources of cash flow from owning a stock:
- Firms pay shareholders in the form of a dividend
2. Investor chooses to sell the shares at a later (future) date
How do you calculate the total return of a stock?
It is the sum of the dividend yield and the capital gain rate.
What discount rate do you use to discount the future cash flows of a stock?
Equity Cost of Capital. Since the cash flow is risky, you cannot compute the present value using a risk-free interest rate.
Why will a short term and long-term investor with the same beliefs be willing to pay the same price for a stock?
The dividend discount model – single N-year investors that will collect dividends for N years (this holds for all Ns) and then sell the stock or to a series of investors who hold the stock for shorter periods and then resell it. These investors (who have the same beliefs) will attach the same value to the stock; independent of the investment. It doesn’t matter how long they intend to hold the stock.
The firm can increase its dividend in three ways:
- Increase its earnings (net income)
- Increase its dividend payout rate
- Decrease its shares outstanding
Firm can do one of two things with its earnings:
- Pay them out to the investors
2. Retain and reinvest them (by investing more today, a firm can increase its future earnings and dividends)
Cannot use the constant dividend growth model to value the stock of young firms because:
- Young firms often pay no dividends
2. Their growth rate continues to change over time until they mature
Limitations of the Dividends Discount Model:
- A lot of uncertainty is associated with any forecast of a firm’s future dividends
- Borrowing and repurchasing decisions are at the manager’s discretion
- Dividend growth rate may not be sustainable
- Not suitable for firms that don’t pay dividends
Share Repurchases
situation when a firm uses its own cash to buy back its own stock
Share Repurchases have two consequences for the dividend discount model:
- The more cash the firm uses to repurchase shares, the less it has available to pay dividends
- By repurchasing shares, the firm decreases its share count, which increases its earnings and dividends on a per-share basis.
Total Payment Model (alternative to the DDM)
Values all of the firm’s equity, rather than a single share
Discounted Free Cash Flow Model (DCF) (alternative to the DDM)
A valuation method used to estimate the attractiveness of an investment opportunity. In other words it determines the enterprise value of a firm.
Enterprise value = Market value of equity + debt - cash
It uses future free cash flow projections and discounts them to get the present value estimate, which is used to evaluate the potential for investment.
Investors who hold stock in a company are interested in their own personal equity in the company, represented by their shares. Yet, this kind of personal equity is a function of the total equity of the firm itself so the shareholder is concerned about the firm too.
The Enterprise Value
Value of the firm’s underlying business,unencumbered by debt and separate from any cash or marketable securities.
Basically, net cost of acquiring firm’s equity, using its cash to pay off all debt and then owning the unlevered business.
Advantage of the Enterprise Model
allows us to value the firm without forecasting its dividends, share repurchases or its use of debt
Net Investment
firm’s capital expenditures in excess of depreciation (or investment intended to support the firms growth, above and beyond the level needed to maintain the firm’s existing capital)
Investment intended to support the firm’s growth, above and beyond the level needed to maintain the firm’s existing capital.
Difference between the discounted free cash flow model and the dividend discount model
dividend discount model, the firm’s cash and debt are included indirectly through the effect of interest income and expenses on earnings.
discounted free cash flow model, we ignore interest income and expenses, but then adjust for cash and debt directly
Weighted Average Cost of Capital (WACC)
Average cost of capital a firm must pay to all its investors, both debt and equity holders.
Dividend Payments determine…
the stock price
Total payouts (all dividends and repurchases) determine…
Equity Value
Free Cash Flow (cash available to pay all security holders) determines…
Enterprise Value
Method of Comparables
An estimate of the value of a firm based on the value of other, comparable firms or other investments that are expected to generate very similar cash flows in the future.
To adjust for differences in scale between firms you…
express their value in terms of a valuation multiple
valuation multiple
ratio of the value to some measure of the firm’s scale.
What does EBITDA stand for?
Earnings before interest, taxes, depreciation and amortization
Limitations to the comparables approach are:
- Does not take into account important differences among the companies
- Only provide info on value of the firm relative to the other firms in the comparison list.
Advantage of the multiples approach are:
Based on actual prices of real firms
What does DCF mean
Discounted Cash Flow
What are some common valuation multiples?
- Enterprise value
2. Price Earnings Ratio (P/E)
What implicit assumptions are made when valuing a firm using multiples based on comparable firms?
- All firms are the same
2. Only firms being compared are valued
Efficient markets analysis means:
Idea that competition among investors works to eliminate all positive NPV trading opportunities
What are the implications of the efficient market hypothesis for corporate managers
- Focus on NPV and free cash flows
- Avoid accounting illusions
- Use Financial transactions to support investment
Probability distribution
A graph that provides the probability of every possible discrete state
Discount rate (Dividend Discount Model) equals
The rate the investor requires for their investment
Outstanding shares
A company’s stock currently held by all its stockholders
Free Cash Flow
Cash flow available to pay both debt holders and equity holders (after payments to keep firm running have been completed)
True or False: Use the rWACC for the rE if the firm has no debt
True
Asset cost of capital is also known as
WACC
When to use:
DDM
Total Payout Model
DFCF
DDM: valuing a share from the perspective of a single shareholder/share (this model also assumes all cash paid out is in dividend)
Total Payout Model: when a firm repurchases shares (this model values all of the firm’s equity)
DFCF: goes step further - determines total value of the firm to all investors - both equity and debt holders
Capital Expenditures
money spent by a business or organization on acquiring or maintaining fixed assets, such as land, buildings, and equipment.
Connection between DFCF Model and NPV
Firm’s free cash flow is = to sum of free cash flows from the firm’s current and future investments (Enterprise value). NPV of any project will affect the firm’s enterprise value. Should only accept projects with a positive NPV
