Equity Flashcards
Holding period return
(Ending price - beginning price + CF)/(beginning price)
Porter’s five forces
- Threat of new entrants
- Threat of substitutes
- Bargaining power of buyers
- Bargaining power of suppliers
- Rivalry among existing competitors
If expected return > required return, then the asset is _____
Undervalued
Equity risk premium
Required return on equity index - risk free rate
Required return for a stock
Risk free rate + β*(equity risk premium)
β = adjustment for systematic risk of the stock
Ibbotson-Chen supply-side estimate of equity risk premium
(1+expected inflation)(1+expected real GDP growth)(1+expected changes in P/E ratio) - 1 + expected yield on the index - risk free rate
Fama-French model
RF + βm(market risk premium) + βs(small cap return - large cap return) + βb*(high book to market return - low book to market return)
Pastor-Stambaugh model
Add liquidity premium to Fama French model
Build-up method
RF + equity risk premium + size premium + industry risk premium + specific company premium
Best for closely held companies
How to unlever β
= levered β *(1/(1+D/E))
= levered β *(E/A)
WACC
[(MV of debt)/(MV of debt + equity)](required return on debt)(1-t) + [(MV of equity)/(MV of debt + equity)]*(required return on equity)
When to use dividend discount model
- Firm has a history of dividends
- Dividend policy is clear and tied to earnings
- Perspective of minority shareholder
When to use free cash flow model
- For firms with no dividend history or dividends have not been clearly tied to earnings
- For firms with free cash flow that correspond with profitability
- Perspective is as controlling shareholder
When to use residual income model
- Firm does not have dividend history or volatile payment stream
- Negative free cash flows for the foreseeable future
- Uncertain terminal value
- Firm with transparent financial reporting and high quality earnings
Gordon growth model
Assumes dividends increase at a constant rate indefinitely
D1/(r-g) or D0*(1+g)/(r-g)
PVGO (present value of growth opportunities)
Value of the firm - (no-growth earnings)/(required return on equity)
Justified leading P/E
P0/E1 = (1-b)/(r-g)
= D1/[E1*(r-g)]
where b=retention rate
Justified trailing P/E
P0/E0 = [(1-b)(1+g)]/(r-g)
= D0(1+g)/[E0*(r-g)]
where b=retention rate
Sustainable growth rate
Firm’s growth rate with current D/E ratio (using internally generated funds)
retention ratio*ROE
Long-term growth rate
PRAT
Profit marginretention rateasset turnover*financial leverage
[(NI-div)/NI] x (NI/sales) x (sales/total assets) x (total assets/total stockholders’ equity)
Rate to discount FCFF for firm value
WACC
Rate to discount FCFE for equity value
Required return on equity
Free cash flow to the firm (FCFF)
= NI + NCC - WCInv + Int(1-t) - FCInv + pref div
= CFO + Int(1-t) - FCInv + pref div
= EBIT(1-t) + Dep - FCInv - WCInv + pref div
NCC = non-cash charges
FCInv = change in fixed capital assets (CapEx)
= end gross PP&E - beg gross PP&E - gain on sale
WCInv = change in working capital (excluding cash)
Free cash flow to equity
= FCFF - Int(1-t) + net borrowing - pref div + net issuance of pref stock
= NI + NCC - FCInv - WCInv + net borrowing - pref div + net issuance of pref stock
Compare dividend discount models to free cash flow models
DDM - from minority shareholder perspective
FCFF - from controlling perspective
Types of FCFF models
Single stage model: similar to DDM, use WACC for firm value and required return on equity for equity value
Two stage model w/declining growth: apply proportionate discount rates corresponding CFs
Molodovsky effect
High P/E at bottom of business cycle due to low EPS and low P/E at top of business cycle due to high EPS
Justified P/B
(ROE-g)/(r-g)
Justified P/S
= (E0/S0)[(1-b)(1+g)]/(r-g)
= net profit margin * justified trailing P/E
Enterprise value
MV of common stock + MV of preferred stock + MV of debt + minority interest - cash and investments
Residual income
Net income - equity charge
Economic value added
EBIT*(1-t) - $WACC
Valued added for shareholders during the year
Valuing a firm with the residual income model
= BV0 + PV of expected future residual income
= BV0 + [(ROE-r)*BV0]/(r-g)
= BV0 + (PV of high growth RI) + (PV of continuing RI)
Forecasting residual income
= expected EPS in year t - (r* book value of equity in year t-1)
= (expected ROE - r)*book value of equity in year t-1
Valuing a private company with constant growth
(FCFF1)/(WACC-g)
Valuing a private firm with significant intangible assets
Excess earnings method
Guideline public company method
Use price multiples from trade data for public companies and adjust for differences (add control premium)
Guideline transactions method
Use acquisition values from historical transactions for entire companies (no additional control premium needed)
Prior transaction method
Use transaction data for the stock of the actual subject company (best for valuing noncontrolling interests)
Discount for lack of control (DLOC)
1-1/(1+control premium)
Use to value noncontrolling interest based on data for controlling interest
Discount for lack of marketability
1 - [(1-DLOC)(1-DLOM)]
Trailing dividend yield
(4 x most recent quarterly dividend)/market price per share
Leading dividend yield
forecasted dividends for next 4 quarters / market price per share
Strategic styles for industries
Adaptive - less malleable, less predictable
Shaping - more malleable, less predictable
Classical - less malleable, more predictable
Visionary - more malleable, more predictable
ROIC
NOPLAT/Invested capital
NOPLAT: net operating profit less adj taxes
Invested capital: op assets - op liabilities
ROCE (return on capital employed)
Operating profit/capital employed
Capital employed: debt capital + equity capital
Pretax measure of profitability of capital
Equity method
- Report proportionate share of income on income statement
- Report carrying value of proportionate share of income less dividends received
H-model
[D0(1+gL) + D0(H)(gS - gL)]/(r-gL)
Two stage model
Σ[D0(1+gS)^t]/(1+r)^t + [D0(1+gL)(1+gS)^n]/[(r-gL)(1+r)^n]
