Equity Flashcards
Size (Capitalization)
Value of a company
= share price X # of outstanding common shares
Style
Value: Market price is LOWER than fundamental valuation
Growth: higher
Volatility
Defensive: less susceptible to economic cycles/conditions (ie pharma, food, power, water, gas)
Dynamic: more susceptible
Domestic vs. Intl
Developed mrkts typically have higher valuation (PE Ratio) and income
Developing markets typically have higher growth prospects and risk
Ordinary Shares vs ADRs
Ordinary shares are held in local currency. holders have voting rights and are last in liquidation (opposed to preferred shares)
ADRs: a negotiable certificate/note issued by a US bank representing ownership in foreign stock that’s traded on a US exchange. Denominated in USD.
Dividend Discount Model
on formula sheet
value of stock = dividend per share / (discount rate - growth rate)
discounts future cash flows (dividends) to PV
Free Cash Flow
= operating cash - capital expenditures
FCF = EBIT (1-tax rate) + Depreciation and
Amortization – Change in Working Capital –
Capital Expenditure
measurement of company’s ability to enhance shareholder experience
not on formula sheet
Weighted Average Cost of Capital (WACC)
not on formula sheet
WACC = (mrkt value of equity / [MV of equity + MV of debt]) X cost of equity + (mrkt value of equity / [MV of equity + MV of debt]) X cost of debt X (1 - corporate tax rate)
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
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.
* High book value (high BtoM) indicates a stock may be
undervalued
* Low book value (low BtoM) indicates a stock may be
overvalued
Questions can be worded as book to market, or market to book so watch out
Intrinsic v. Market Value
The intrinsic value (IV) is the “true” value,
according to a model.
The market value (MV) is the consensus value
of all market participants
P/E and Growth Rate Relation
The growth rate is roughly equal to the P/E ratio.
“If the P/E ratio of Coca Cola is 15, you’d expect the
company to be growing at about 15% per year, etc. But if
the P/E ratio is less than the growth rate, you may have
found yourself a bargain.”
Current Ratio
current assets/current liabilities
Quick Ratio
[cash + cash equiv. + short-term investments + receivables] /
current liabilities
Children Stab Things Repeatedly
Consequences Later = Quick Recovery
Price-Weighted Average
= [final price - initial price] / initial price
Cap Weighted Index
“Market value weighted index”
ex. S&P 500, Russell 2000, MSCI EAFE
this index weights individual
companies or stocks based on their market
capitalization thus larger stocks receive more
proportional representation in the index; the
value of a cap-weighted index may be
computed by summing the value of all market
capitalizations and dividing by the number of
stocks in the index
pros/cons of cap weighted index
Advantages
* The total return of the index roughly mirrors the change in the total market value of all stocks.
* Rebalancing this type of index is simple.
* Since the index automatically adjusts to changes in stock prices, it
is easy to create a tax efficient mutual fund or ETF to track this type of index.
Disadvantages
* If stock prices reflect emotions over the short term, then the index will systematically own too much of overpriced stocks and too little of bargain priced stocks.
* The index is heavily influenced by the few companies with the
largest market capitalizations. For instance, the top 20 stocks in the S&P 500 index can account for one-third of the total index
Fundamentally Weighted Index
a type of equity market index where selection
and weighting criteria are based on factors
such as revenue, dividends, or book value
(i.e., measurements of fundamental analysis)
pros/cons of fundamentally weighted index
Advantages
* Since the index is not influenced by price, it is not
influenced by short term emotions. Unlike market cap
weighted indexes, pricing errors are random.
* Since fundamental rankings between companies are
based upon sales, book value and other measures of
economic size that change relatively slowly, the index
can be managed through ETFs or mutual funds on a
relatively tax efficient basis.
Disadvantages
The index does not use relative or absolute value to
determine company weights in the index
pros/cons of equally weighted index
Advantages
* The index is highly diversified with all stocks in the universe equally weighted.
* As opposed to market cap weighting, the index does not overweight overpriced stocks and underweight underpriced stocks. Pricing errors are
random.
* Easy to construct relatively tax efficient ETFs and mutual funds.
* Usually adds 1 – 2 percent in annual return over long periods after expenses vs. market cap weighted indexes.
Disadvantages
* No distinction is made between the relative or absolute valuation of stocks
within the universe.
* Difficult to keep the stocks in the index equally weighted due to constant price fluctuations.
* Difficult for this type of index to manage substantial amounts of money due
to the need to invest equal amounts in both the largest and smallest stocks.
Recent Increase in Correlations
Since the 1990’s there has been an increase in
correlation in equity prices of many international
developed markets.
* There is a fair amount of speculation as to why this has
occurred and if correlations will remain at this level or
possibly move even higher.
- Possible reasons for increased correlations:
– Globalization (advances in technology, communication, etc.)
– Increased volatility and crises lead to higher correlations
– Increase in emerging market capitalization
PEG Ratio
Price-Earnings-Growth Rate (PEG Ratio)
PEGR = (P/E) / EGR
This ratio employs the P/E ratio and relates it to a firm’s expected growth rate per year
(EGR). It reflects the firm’s potential value of a share of stock.
Suppose that a firm with a P/E of 8.72 expects an annual growth rate of 8%. Its PEGR
would be
=8.72/8 = 1.09
It is theorized that PEGRs represent the following:
If PEGR = 1 to 2: The firm’s stock is in the normal range of value.
If PEGR < 1: The firm’s stock is undervalued.
If PEGR > 2: The firm’s stock is overvalued.
Book-to-Market
- a measure of an asset’s value calculated by
dividing the asset’s book (accounting) value
by its market value - a positive ratio indicates that the market is
discounting the asset
Book Value
Defined
A valuation based on a company’s assets minus its
liabilities.
Formulae
Book Value = assets minus liabilities
Book Value Per Share
= (assets-liabilities) / shares outstanding
= shareholder equity / shares outstanding
Price to Book Ratio
P/B ratio = share price/[(assets-liabilities)/shares outstanding]
can also be calculated by dividing the market capitalization by
the book value (assets – liabilities).
Price to Sales Ratio
- good for startups who do not have income yet
- lower values may indicate market undervaluation
P/S ratio = stock price/12 month sales per share
Return on Assets
Defined
* ROA is a ratio that measures how well company management
is utilizing its assets to generate operating income. It is calculated by dividing earnings before interest and tax payments by total assets.
Example
* ROA = EBIT/assets or
= EBIT/(liabilities + owner equity + retained earnings)
Note: sometimes ROA may be defined as Net earnings
(i.e., after taxes and interest payments)/assets.
Return on Equity
Defined
ROE is a ratio that measures how well company management is
performing for shareholders (i.e., profitability). It is calculated
by dividing after-tax earnings by shareholder’s equity (i.e.,
book value). It can also be calculated by dividing earnings per share by book value per share.
ROE = net earnings/shareholder’s equity
= net earnings/book value
= earnings per share (aka EPS)/(book value per share)
Formula for P/B, P/E and ROE:
P/B = P/E * ROE
Retention Ratio
Example: Company has return on equity of 17%, earnings of $1.75 per share, and pays a dividend of $0.25 per share. The retention rate (i.e., amount used to keep
growing the company – and is not paid out to shareholders) is calculated as follows:
One method for calculating a company’s growth rate is to use something called a
retention rate (or ratio). You multiply the ROE x the retention rate. Retention rate is basically 1 minus the dividend rate paid out.
Example: Company has return on equity of 17%, earnings of $1.75 per share, and pays a dividend of $0.25 per share. The retention rate (i.e., amount used to keep
growing the company – and is not paid out to shareholders) is calculated as follows:
1 – (dividend/earnings)
1 – (0.25/1.75)
1 – .1429
Retention Rate = 85.71%
Growth = ROE x retention rate
= 17% x 85.71%
=14.57% (answer)
What is the best valuation metric for small companies including start-ups with no
earnings?
Answer: it depends (of course). So, you’ll want to dissect the information given about the company in question very carefully.
Price to Earnings – no, if the company does not have earnings
Price to Discounted Cash Flow – this metric is used in practice but depends
greatly on the skill of the analyst to predict future cash flows
Price to Book – this could be used, but in some cases will not be very helpful
(e.g., a company in which assets like intellectual property are hard to value)
Price to Sales – this is often one of the better metrics for a start-up, assuming
the company has sales already
ROE and ROA – these metrics will not prove helpful until the company has
income (earnings)
A firm has a P/E ratio of 12 and a ROE of 13%. What is the price-to-book value?
1.56
P/B = P/E * ROE
= 12 * 0.13
= 1.56
Note that the above formula is derived from the definitional formulas for the ratios: P/B (Price to Book), P/E (Price to Earnings) and ROE (Return on Equity).
Recall, the denominator in ROE is Equity, which is based on book value and NOT a stock’s market price. See CIMA textbook pages 426-433 for more detail about these ratios.
For the specific derivation of the formula:
P/E * ROE = [(Price/share) / (Earnings/share)] * [(Earnings/share) / (Book Value/share)]
= [(Price/share) / (Earnings/share)] * [(Earnings/share) / (Book Value/share)]
= [(Price/share)] * [ 1 / (Book Value/share)]
= (Price/share) / (Book Value/share)
= P/B
Reminder: the denominator of Equity in ROE is
= [(Price/share) / (Earnings/share)] * [(Earnings/share) / (Equity/share)]
= [(Price/share) / 1 ] * [ 1 / (Equity/share)]
= [(Price/share) / (Equity/share)]
= P/Eq
= P/B
A firm has an ROA of 14%, a debt/equity ratio of 0.8, a tax rate of 35%, and the interest rate on the debt is 10%. The firm’s ROE is ______________.
11.18%
ROE = (1-tax rate) X (ROA+ (ROA - interest)D/E Ratio)
ROE = (1 - 0.35)[14% + (14% - 10%)0.8] = 11.18%.
Bulldog Stock enjoyed earnings last year of $21,000,000 while holding $100,000,000 in assets and $10,000,000 in liabilities. Bulldog’s book value and return on equity last year were:
$90,000,000 and 23.3%
Book Value = assets minus liabilities = $100m - $10m = $90m
ROE = earnings / shareholder equity = $21m / $90m = 23.3%
Market capitalization can be calculated by…
multiplying the share price by the number of shares outstanding.
Calculate the current and quick ratios, respectively, for IVY League stock.
Cash $10,000,000
Receivables $42,000,000
Inventories $35,000,000
Capital long-term investments $75,000,000
Property and equipment $225,000,000
Short-term accounts payable $27,000,000
Long-term debt $150,000,000
3.22, 1.93
Current Ratio = current assets divided by current liabilities.
Current Assets for this company = cash, receivables, inventories = $87m
Current Liabilities = short-term accounts payable = $27m
$87m / $27m = 3.22
Quick Ratio = (cash and equivalents + ST investments + receivables) / current liabilities
Quick Ratio assets for this company = cash, receivables = $52m
Current Liabilities = short-term accounts payable = $27m
$52m / $27m = 1.93
What is the CAPE ratio of the following stock?
Stock price $45.10/share
Forward looking PE ratio = 22.2
Current PE ratio = 31.6
Current earnings per share = $2.08
Inflation adjusted 10-year historical earnings per share = $1.12
40.27
Shiller PE Ratio
also known as the “cyclically adjusted (CAPE) PE”
smoothes out fluctuations in earnings due to the business cycle
uses earnings per share figures adjusted for inflation and averaged over 10 years as the denominator
CAPE Ratio formula:
share price / 10-year earnings average adjusted for inflation
$45.10 / $1.12 = 40.27
What is the PEG ratio of the following stock and determine whether it is over or undervalued?
Stock price = $60.00/share
Current PE ratio = 32
Current earnings per share: $1.87
Projected earnings per share: $1.96
6.65, overvalued
PEGR = P/E divided by expected growth rate
Solve for growth rate: ($1.96 - $1.87) / $1.87 = 4.81%
32 / 4.81 = 6.65
This ratio employs the P/E ratio and relates it to a firm’s expected growth rate per year (EGR). It reflects the firm’s potential value of a share of stock.
It is theorized that PEGRs represent the following:
If PEGR = 1 to 2: The firm’s stock is in the normal range of value.
If PEGR < 1: The firm’s stock is undervalued.
If PEGR > 2: The firm’s stock is overvalued.
Use the retention rate to determine growth rate for the following company.
ROA = 2.12
ROE = 3.57
EPS = $0.87
PE Ratio = 17.25
Dividends = $0.12
3.08%
Solve for retention rate: 1 – (dividend/earnings)
1 – (0.12 / 0.87) = 86.21%
Growth = ROE x retention rate
= 3.57 x 86.21% = 3.08%
Using Retention Ratio to solve for growth rate
One method for calculating a company’s growth rate is to use something called a retention rate (or ratio). You multiply the ROE x the retention rate. Retention rate is basically 1 minus the dividend rate paid out.
Another example: Company has return on equity of 17%, earnings of $1.75 per share, and pays a dividend of $0.25 per share. The retention rate (i.e., amount used to keep growing the company – and is not paid out to shareholders) is calculated as follows:
1 – (dividend/earnings)
1 – (0.25/1.75)
1 – .1429
Retention Rate = 85.71%
Growth = ROE x retention rate
= 17% x 85.71%
=14.57% (answer)
Example: Company has return on equity of 17%, earnings of $1.75 per share, and
pays a dividend of $0.25 per share. The retention rate (i.e., amount used to keep
growing the company – and is not paid out to shareholders) is calculated as follows:
1 – (dividend/earnings)
1 – (0.25/1.75)
1 – .1429
Retention Rate = 85.71%
Growth = ROE x retention rate
= 17% x 85.71%
=14.57% (answer)
