Equity Valuation Models Flashcards
What is the purpose of fundamental analysis in stock valuation?
To identify mispriced stocks by estimating their true value using public financial data and comparing them with industry peers.
What is “valuation by comparables” and why is it important?
It’s a method where a company’s financial ratios are compared to those of its peers to determine if the stock is priced fairly relative to the market.
so relative value
P/E
P/E = Price / earnings per share
Price/Earnings to Growth (PEG)
It helps determine a stock’s value while considering its earnings growth rate.
PEG = P/E Ratio / Earnings Growth Rate
How is book value calculated and what does it represent?
Book value is calculated as total assets minus total liabilities and intangible assets like goodwill and patents.
It represents the net asset value of a company, indicating the total value that shareholders would theoretically receive if the company were liquidated.
Operating Profit Margin
Operating Profit Margin = Operating Income / Net Sales (Revenue – cost of sales)
Return on Equity (ROE)
Measures how effectively a company uses its equity from shareholders to generate profits.
Return on Capital (ROC)
Similar to ROE but includes debt in the capital calculation, thus providing a broader view of how well the company uses all its available capital.
What is operating income?
EBIT
Net Profit Margin formula
Net Profit / Revenue
what percentage of revenue is converted into actual profit
book value per share is often seen as a —- to a company’s stock price
floor
but there are companies, mainly banks, trading
consistently below their book value.
What is a better way to estimate a stock’s floor?
book value is not really true floor (we can see in banks trading below)
liquidation value
like book value, it is what remains after all assets have been sold and all liabilities paid but valued at market prices (unlike book value, which is valued at historical prices)
When does a company become an instant takeover target?
if market cap goes below liquidation value
Other than book value and liquidation value, what is another measure for the firm’s value?
replacement costs
cost of replacing the firm’s assets minus the firms’ liabilities
What is Tobin’s Q?
This ratio compares the market value of a company to the replacement cost of its assets
It is calculated as Tobin’s Q = Company Market Value / Replacement Cost
or
Q = equity and liabilities market values / equity and liabilities book values
Over the long term, Tobin’s Q
ratio will
end towards 1
While balance sheet analysis is useful, generally an analyst must, and is expected to, turn to ———– to estimate’s a firm’s value as an ongoing concern.
the evaluation of expected future cash flows
Intrinsic value vs market price
Intrinsic value is an estimate of a stock’s true value based on expected future cash flows and profits. Market price is what the stock is currently selling for on the stock market.
Beta
it is the measure of an asset’s (or a portfolio) volatility in relation to the overall market
The CAPM provides an estimate of …
the return an investor can reasonably expect to earn on a security given its risk.
The Constant Growth DDM implies that the stock value will be greater when:
from sheet: V0= D1/k-g
- the larger the expected dividend per share (D1)
- the lower the market capitalization rate (k)
- the higher the expected growth of dividends (g)
k being lower and g being higher makes the denominator smaller, so makes the result bigger
Intrinsic value definition
the present value of all the cash flows an investor will receive from holding a security, including dividends and price appreciation, discounted at the relevant risk-adjusted rate
What if g is higher than k?
such dividend growth rate would be unsustainable
according to the Constant Growth DDM, when dividends grow at a constant rate, this constant g will =
expected price appreciation
stock price is expected to grow at the same rate as dividends
Dividend payout ratio
the fraction of earnings paid out as dividends
Plowback ratio, also called earnings retention ratio
earnings reinvested in the firm
PVGO
Net present value of a firm’s future investments
present value of growth opportunities (PVGO)
The main problem with the constant growth DDM is that is based on the simplistic assumption that
dividend growth will
remain constant forever
what if RoE is lower than k?
price will be affected negatively
what is the relationship between RoE, k and b when RoE>k?
if one goes up, the rest do as well
This means that the PEG ratio should be
equal to 1
PEG = (P/E) / g
If the P/E is less than the growth rate (PEG < 1), the stock may be undervalued.
All stock valuation models must comply with rule that riskier stocks will have —– P/E multiples
higher or lower?
lower
P/E analysis limitations
- as it is an accounting concept, it is influenced by rules and regulations (US GAAP and IFRS) and arbitary rules. An example of a bad GAP rule is that the depreciation cost is included, so the true economic earnings excluding costs of maintenance are not taken into account.
- in periods of high inflation, the historical costs of inventory are undervalued
- The practice of “Earnings Management” (manipulating to seem more flattering)
- volatility in reported earnings
the P/E ratio of the S&P500 generally goes
—– with inflation,
up or down?
down
probably reflecting that the market recognizes that earnings distorted by inflation are of “lower
quality”
many analysts suggest using a “cyclically adjusted P/E” (CAPE)
“cyclically adjusted P/E” (CAPE)
This means
dividing the stock price by an estimate of sustained long- term earnings (normally 10 years)
the CAPE is smoother than the conventional P/E
However, there seems to be a strong inverse correlation between the CAPE and market returns over the following decade, suggesting a that a high CAPE may signal an overpriced market
Other Comparative Valuation Ratios
Price to book
Ratio of price divided by book value per share
Price to Cash Flow
Price divided by operating cash flow or free (excluding new investment) cash flow per share
Cash flow is not as prone to accounting gimmicks as earnings, which is why many analysts use these ratios
Price to sales Ratio
price divided by annual sales per share. This is useful for start ups which rarely have earnings.
When valuing a company using cash flow methods, there are two main approaches:
Free Cash Flow to the Firm (FCFF): This calculates the cash a company generates after paying for its expenses, taxes, and investments in the business, but before paying any debts. It gives us a value for the entire company, including its debt.
Free Cash Flow to Equity (FCFE): This focuses only on the cash that would be available to the company’s shareholders after all expenses, taxes, investments, and debts are paid. It tells us what the equity (or shareholder portion) of the business is worth.
Both these methods involve projecting how much cash the company will generate in the future and then converting these amounts into today’s dollars using a discount rate (which adjusts for the risk and the time value of money).
How is FCFF calculated?
free cashflow for the firm
cash a company generates from its operations after paying for operating expenses and capital expenditures but before paying debt obligations. It represents the total value of the company, including debt.
FCFF = EBIT(1-Tax Rate) + Depreciation - Capital Expenditures - Increase in Net Working Capital
REMEMBER: Working Capital (capital circulante) = CURRENT ASSETS - CURRENT LIABILITIES
How is FCFE calculated?
Free Cash Flow to Equity
cash flow available to the company’s shareholders after all expenses, taxes, investments, and debt payments have been made. It represents the value of the company’s equity.
FCFE = FCFF - Interest*(1-Tax Rate) + Increases in Net Debt
As a general rule, estimates of intrinsic value depend critically on ——-
terminal value
Terminal value is an estimate of a company’s cash flow beyond the forecast period, continuing indefinitely at a constant growth rate. It is a crucial part of the valuation, representing the bulk of the company’s value.
