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
What will owners of equity expect if dividend yield is low
Growth rate must be high to provide return needed
What will owners of equity expect if growth rate
High dividend yield will be expected to provide return needed
Define Price Earnings Ratio
Its a multiplier applied to current earnings to determine the value of a share of stock in the market.
P/e Ratio = Share Price /EPS
What is the PE ratio influenced by
Earnings and sales growth of a firm Risk (or volatility in performance) The debt-equity structure of the firm The dividend policy The quality of management
How does the growth rate affect a firms P/E Ratio
High PE ratios with high growth rate. P/E ratio changes with industry
Define ordinary shares
Equity without priority for dividends or in bankruptcy. Has residual claim but shareholders have voting rights
Define Preference Shares
Equity with dividend priority over ordinary shares, normally with a fixed dividend rate, sometimes without voting rights
If cumulative any dividends not paid one year are carried forward as an arreage
Could be treated as debt security
What does 4% Pref share mean
Cash dividend is usually described as % of stated value ex: £4 per share or 4% per share
Define primary market
market in which new securities are originally sold to investors.
Define secondary market
The market in which previously issued securities are traded among investors
Define underwriting
estment bank helps the firm to issue and market new securities
Define prospectus
scribes the issue and the prospects of the company. (describes company,) must be filed with regulatory authorities
Define road shows
When investment banks travel around to publicise new securities to asses market demand
Define book building
Process of recording the interest - helps investment banks in setting offering price of shares
How does investment banking and selling of shares work with private placements
uses underwriter to sell securities to a small group of institutional or wealthy investors.
Cheaper than public offerings
Private placements not traded in secondary markets: reduces their liquidity and hence the price investors will pay
What does IPO stand for
Initial Public offering
Why does underpricing occur
Means there is high 1st day return. Underwriter needs to offer the security at bargain to induce investment and sharing of the opportunity
Very common- can see this as stock prices jump alot on day 1 of trading
Underpricing makes it easier to market an issue
From research what did you discover about the average Underpricing and IPO of european vs non european countries
Average first day in Europe is about 20% increase. In asian countries in particular and middle east but all outside of europe increase jumps. It has been known to be up to 150% in Jordan This shows irrationality of investors - they are too enthusiatic
Give an example of a dramatic IPO increase beacsue it was underpriced
Snapchat increased by 44% in first day of trading
Give an example where IPO wasnt actually underpriced
Define dealer
agent who buys and sells securities from inventory.
Define bid price
ce dealer is willing to pay
Define Ask price
Price at which dealer is willing to sell
Define Broker
An agent who arranges security transactions among investors. (does not maintain an inventory)
Ex: Real estate market or primary market (where investment banks are agents)
Define auction market
Organised security exchanges in a physical location
