Equity Valuation

Question 1

What type of firms market price is available

Answer 1

private firms market price is not always available

Question 2

What does fair price mean?

Answer 2

Firms price is not overvalued or undervalued

Question 3

What are the downfalls of book value equity as a form of valuation

Answer 3

Historical costs
Does not incorporate Exclude intangible assets (e.g. patents, trademarks)
A useful benchmark but not great

Question 4

What are the difficulties with valuing common stocks or shares

Answer 4

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

Question 5

Definition of the law of one price dividend discount model

Answer 5

Computation of today’s stock price: share value equals present value of all expected future dividends

Question 6

Know formulae for dividend discount model in general

Answer 6

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Question 7

What happens if principal amount on equity is to be paid an infinte time into the future

Answer 7

you ignore it. Value of shares becomes just the present values of all dividends with no principal

Question 8

What is the relationship between the horizon period and the PV of the principal amount

Answer 8

As horizon period the closer the present value of principal gets to zero

Question 9

What are the limitations of the dividend growth model

Answer 9

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

Question 10

What are the three types of dividend growth models

Answer 10

Zero growth
constant growth
differential growth

Question 11

What is the formula for a zero growth model

Answer 11

P0=Div1 / R

simple perpetuity with g=0

Question 12

Why would firm use the constant growth model with expected dividends

Answer 12

Many firms make steady growth in dividends an explicit goal

Question 13

What is the constant formulae for a dividend that is constantly growing at a constant rate

Answer 13

Dt = D0 x (1+g)^t

Question 14

What does the constant growth model for dividends assume?

Answer 14

Value of investment grows as cash flows on the investment grow

Question 15

What is the formulae for the present value of equity under the constant growth dividend model?

Answer 15

P0 = D1/(R-g)

Question 16

What does the non-constant growth model mean?

Answer 16

There is variable growth in dividends - most common as firms experiences supernormal growth for a time then levels to constant g

Question 17

Explain the two stage growth model

Answer 17

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

Question 18

Know formula for two stage growth model

Answer 18

-

Question 19

How to find Pt - PV of price at start of second stage of two stage growth model

Answer 19

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

Question 20

Why would the growth rate of a dividend change

Answer 20

Competition from other companies - sales growth decreases

Dividend payout policy may change

Question 21

What are the components of required return

Answer 21

Dividend Yield + Capital Gains Yield = Total Return

R =(P1-P0+D1)/P0

Question 22

Define Dividend Yield

Answer 22

An equity’s expected cash dividend divided by its current price

Question 23

Define Capital Gains Yield

Answer 23

The dividend growth rate (assuming constant growth), or the rate at which the value of an investment grow

Question 24

How does a Constant dividend growth rate change the formula for total return

Answer 24

With constant dividend growth rate, the capital gains yield is equal to the dividend growth rate

So:
R = D1/P0 + g

Question 25

What will owners of equity expect if dividend yield is low

Answer 25

Growth rate must be high to provide return needed

Question 26

What will owners of equity expect if growth rate

Answer 26

High dividend yield will be expected to provide return needed

Question 27

Define Price Earnings Ratio

Answer 27

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

Question 28

What is the PE ratio influenced by

Answer 28

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

Question 29

How does the growth rate affect a firms P/E Ratio

Answer 29

High PE ratios with high growth rate. P/E ratio changes with industry

Question 30

Define ordinary shares

Answer 30

Equity without priority for dividends or in bankruptcy. Has residual claim but shareholders have voting rights

Question 31

Define Preference Shares

Answer 31

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

Question 32

What does 4% Pref share mean

Answer 32

Cash dividend is usually described as % of stated value ex: £4 per share or 4% per share

Question 33

Define primary market

Answer 33

market in which new securities are originally sold to investors.

Question 34

Define secondary market

Answer 34

The market in which previously issued securities are traded among investors

Question 35

Define underwriting

Answer 35

estment bank helps the firm to issue and market new securities

Question 36

Define prospectus

Answer 36

scribes the issue and the prospects of the company. (describes company,) must be filed with regulatory authorities

Question 37

Define road shows

Answer 37

When investment banks travel around to publicise new securities to asses market demand

Question 38

Define book building

Answer 38

Process of recording the interest - helps investment banks in setting offering price of shares

Question 39

How does investment banking and selling of shares work with private placements

Answer 39

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

Question 40

What does IPO stand for

Answer 40

Initial Public offering

Question 41

Why does underpricing occur

Answer 41

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

Question 42

From research what did you discover about the average Underpricing and IPO of european vs non european countries

Answer 42

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

Question 43

Give an example of a dramatic IPO increase beacsue it was underpriced

Answer 43

Snapchat increased by 44% in first day of trading

Question 44

Give an example where IPO wasnt actually underpriced

Answer 44

Facebook

Question 45

Define dealer

Answer 45

agent who buys and sells securities from inventory.

Question 46

Define bid price

Answer 46

ce dealer is willing to pay

Question 47

Define Ask price

Answer 47

Price at which dealer is willing to sell

Question 48

Define Broker

Answer 48

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)

Question 49

Define auction market

Answer 49

Organised security exchanges in a physical location