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
