Equity Valuation

Question 1

why is it difficult to value shares?

Answer 1

• cash flows are uncertain
• life of investment uncertain
• difficult to measure the expected return the market expects

Question 2

What happens to the price of a share if the required rate of returns increases?

Answer 2

It will decrease

Question 3

What are the advantages of the constant growth model?

Answer 3

• useful for valuing stable-growth, dividend paying co.s
• useful for valuing broad-based equity indexes
• Model features simplicity and clarity (understanding relationship among value and growth, req. rate of return and Payout ratio.
• provides an approach to estimating the expected Rate of Return given efficient prices

Question 4

what are the advantages of the non-constant growth model?

Answer 4

useful as many scenarios exist in which a company can achieve a super-normal growth rate for a few years after which it falls to a more sustainable level.

Question 5

why might a company achieve super-normal profits and then a decline?

Answer 5

May be due to a patent, first mover advantage, or another reason that provides a temporary lead in the marketplace. The earnings growth must decline to a level that is more consistent with competition and growth in the overall economy.

Question 6

What is the Dividend Growth Model?

Answer 6

A model that determines the current share price divided by the discount rate less the dividend growth rate

Question 7

Why may the dividend growth rate change in the future?

Answer 7

• Competition from other companies
• Change in the dividend payout policy:
  if total dividend increases as a proportion of its total earnings, growth will have to fall as less money is retained to invest in value-making projects

Question 8

What are the components of the required rate of return?

Answer 8

Dividend yield + Capital gains yield

R = D1/Po + g

Question 9

what is the Capital Gains Yield?`

Answer 9

The dividend growth rate

/the rate at which the value of an investment grows.

Question 10

What is the price-earnings ratio and what is it used for?

Answer 10

hare price/ earnings per share

Used by analysts to compare equity values across an industry and used to complement other methods of equity valuation

Question 11

Why do some industriy sectors have high P/E ratios?

Answer 11

because they are perceived to have high growth rates

Question 12

What is the denominator effect?

Answer 12

That P/E ratios are exceptionally high because average earnings in the past year are low.

Question 13

what is ordinary equity?

Answer 13

equity without priority for dividends or inevent of bankruptcy

Question 14

what are preference shares?

Answer 14

equity with dividend priority over ordinary shares, normally with a fixed dividend rate, sometimes without voting rights.

Question 15

What are primary markets?

Answer 15

market in which new securities are originally sold to investors

Question 16

what are secondary markets

Answer 16

markets in which previously issued securities are traded among investors

Question 17

What are the components of the Required Return?

Answer 17

Dividend Yield + Capital Gains Yield

R = D1/Po + g

Question 18

What is ordinary equity?

Answer 18

equity without priority for dividends or in event of bankruptcy

Question 19

What are preference shares?

Answer 19

equity with dividend priority over ordinary shares, normally with a fixed dividend rate sometime without voting rights

Question 20

What is a ‘stated value’?

Answer 20

Preference shares have a stated liquidating value (usually £100 per share), the cash dividend is described as a percentage of stated value.

Question 21

What are cumulative dividends?

Answer 21

if cumulative preferred dividends are not paid in a particular year, they will be carried forward as an arrearage.

Question 22

Why may preference shares be classed as equity?

Answer 22

• can be seen as an equity-bond: receive a stated dividend only, and upon liquidation get a stated value
• often callable and can be converted to ordinary shares
• often have obligatory sinking funds

Question 23

What is the difference between a broker and dealer?

Answer 23

The dealer is an agent who buys and sells securities from inventory and a broker brings, buyers and sellers together but does not maintain an inventory.