Equity Valuation Flashcards
What type of firms market price is available
private firms market price is not always available
What does fair price mean?
Firms price is not overvalued or undervalued
What are the downfalls of book value equity as a form of valuation
Historical costs
Does not incorporate Exclude intangible assets (e.g. patents, trademarks)
A useful benchmark but not great
What are the difficulties with valuing common stocks or shares
Cash flows are uncertain.
Life of investment is uncertain because an equity can theoretically last forever.
Difficult to measure the expected return the market expects
Definition of the law of one price dividend discount model
Computation of today’s stock price: share value equals present value of all expected future dividends
Know formulae for dividend discount model in general
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What happens if principal amount on equity is to be paid an infinte time into the future
you ignore it. Value of shares becomes just the present values of all dividends with no principal
What is the relationship between the horizon period and the PV of the principal amount
As horizon period the closer the present value of principal gets to zero
What are the limitations of the dividend growth model
Firms do not necessarily pay cash dividends regularly
Internet growth firms Google and eBay, pay no dividends
DCF model is difficult to use when cash dividends are far in the future
Firms may pay dividends by repurchasing shares from stockholders. This makes model, difficult to use
What are the three types of dividend growth models
Zero growth
constant growth
differential growth
What is the formula for a zero growth model
P0=Div1 / R
simple perpetuity with g=0
Why would firm use the constant growth model with expected dividends
Many firms make steady growth in dividends an explicit goal
What is the constant formulae for a dividend that is constantly growing at a constant rate
Dt = D0 x (1+g)^t
What does the constant growth model for dividends assume?
Value of investment grows as cash flows on the investment grow
What is the formulae for the present value of equity under the constant growth dividend model?
P0 = D1/(R-g)
What does the non-constant growth model mean?
There is variable growth in dividends - most common as firms experiences supernormal growth for a time then levels to constant g
Explain the two stage growth model
Special case of non-constant growth.
Idea is that dividend will grow at a rate of for years and then grow at a rate of forever.
Used over the constant growth method if t1 is longer period
Know formula for two stage growth model
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How to find Pt - PV of price at start of second stage of two stage growth model
You need to find the dividend at time t+1 time so grow current dividend for t periods then grow it at rate for 1 period
Why would the growth rate of a dividend change
Competition from other companies - sales growth decreases
Dividend payout policy may change
What are the components of required return
Dividend Yield + Capital Gains Yield = Total Return
R =(P1-P0+D1)/P0
Define Dividend Yield
An equity’s expected cash dividend divided by its current price
Define Capital Gains Yield
The dividend growth rate (assuming constant growth), or the rate at which the value of an investment grow
How does a Constant dividend growth rate change the formula for total return
With constant dividend growth rate, the capital gains yield is equal to the dividend growth rate
So:
R = D1/P0 + g
