Equity Flashcards
Justified Forward P/E Ratio
Payout ratio / (req. return on equity - sustainable growth rate)
Where payout ratio = 1 - b
sustainable growth rate = ROE x b
Normalized EPS
Calculate the average of historical EPS
Residual Income Model
States that the intrinsic value of a stock is its BVPS + PV of expected (future) per share residual income
Note: the higher intrinsic value per share relative to book value per share, the PV of expected per share residual income is positive
Explicit Variable Costs of Trading
Direct costs of trading such as broker commission costs, transaction taxes, stamp duties, and fees paid to exchanges
Cost for which a trader could receive a receipt
Implicit Variable Cost of Trading
Caused by the market impact of trading
Bid-ask spread: Traders who want to trade quickly buy at higher prices and sell at lower prices than those willing to wait for others to trade with them
Price Impact: Traders who want to fill large orders often must move prices to encourage others to trade with them
Delay Costs (slippage): Arises from traders unable to complete their desired trade immediately. Traders fail to profit when they fill their orders after prices move as they expect
Inside Spread
Spread between the best bid price and the best ask price in market
It will be smaller than an individual dealer’s bid-ask spread if the dealer with the highest bid price is not also the dealer with the lowest ask price
Adjusting beta for a thinly traded stock based on a comparable public company
Step 1: Unlever the beta
= (1 / 1 + D/E) * Beta of public company
Step 2. Re-levered beta
Unlevered beta * (1 + D/E)
Define what a PVGO model is and how to calculate it.
Also known as the value of growth, sums the expected value today of opportunities to profitably reinvest future earnings
Present Value of Growth Opportunities =
V0 = E1 / r + PVGO
E1/r is the present value of a perpetuity and is the per-share value of assets in place to support growth in earnings the next year
E1/r is also known as the no-growth value per share
Justified forward P/E and its GGM equivalent
The P/E that is fair, warranted, or justified on the basis of fundamentals based on expecting earnings in future
Forward P/E derived from GGM=
P0 / E1 = (D1 / E1) / r -g = 1-b / r-g
D1 = D0 (1+g)
Justified trailing P/E and its GGM equivalent
The P/E that is fair, warranted, or justified on the basis of fundamentals from current year
Trailing P/E derived from GGM =
P0 / E0 = (D1 / E0) / r -g = (1-b)(1+g) / r-g
D1 = D0 (1+g)
How to conduct fundamental valuation of a company based on H-model?
H model is a two-stage DDM for a company that experiences high growth for some period of time before leveling off to sustainable growth
H model =
{D0 * (1+ LT growth) + D0 x H x (ST growth - LT growth)} / r - LT growth
Where h = number of high growth years / 2
**The decline from high growth to a normal growth occurs linearly
Three-stage Dividend Discount Model
Can be treated as a single stage DDM + H model as the growth rate in the second stage declines linearly to the mature growth stage
Calculate the expected dividend cash flows for each year using the appropriate growth rate
Calculate the terminal value / r-g
Discount to PV
Single-Stage Residual Income Valuation
V0 = B0 + (ROE - r /r-g) x B0
This assumes that a company has a constant return on equity and constant earnings growth rate through time
Where r = cost of equity
If ROE > r, Market value of company > BV
If ROE = r, Market value of company = BV
Assumptions of the continuing residual income
RI continues indefinitely at a positive level
RI is zero from terminal year forward
RI declines to zero as ROE mean reverts to the cost of equity through time
RI reflects the reversion of ROE to some mean level
Multi Stage Residual Income Valuation
V0 =
B0 + Sum {(ROE-r)x B(t-1) / (1+r)^t} + P(t) - B(t) / (1+r)^t
