Equity valuation models

Question 1

When the discounted dividend model is most appropriate?

Answer 1

1) Firm has a history of dividend payments
2) Dividend policy is clearly linked to the firm’s profitability
3) Valuation is from the perspective of a minority stakeholder
If 1-3 apply DDM is the best one given its theoretical soundness

Question 2

When the free cash flow model is most appropriate?

Answer 2

1) Discounted dividend model is not applicable
2) FCFs are linked with profitability (for some years they are negative for years)
3) Valuation is from the perspective of a controling stakeholder

Question 3

When the residual income model is most appropriate?

Answer 3

When both DD and FCF models of valuation are not applicable.
Also RI is not as too dependent on calculation of terminal value.
This model requires financial reporting of a very good quality.

Question 4

List of valuation multipliers

Answer 4

Earning per share (EPS) = NI/(# of shares)

1) Price to earning (P/E) = Market cap / NI
2) Price to book (P/B) = Market cap / Common shareholder’s equity
3) Price to sales (P/S) = Market cap / Sales
4) Dividend yield (D/P) = Dividend / Market cap
5) EV / EBITDA - popular multiplier for acquisitions

Question 5

To what parts equity value breaks down?

Answer 5

V(t) = E(t+1)/r + PVGO
E/r - value from assets in place
r - required return on equity

Question 6

DDM under constant Gordon growth assumption

Answer 6

V(t) = D(t)*(1 + g)/(r - g)

Question 7

Value of fixed-rate perpetual preferred stock

Answer 7

V(t) = Dp/rp

Question 8

What growth rates of companies revert to in the long run?

Answer 8

real GDR growth rate + long-run inflation

Question 9

DDM under H-model of growth

Answer 9

V(t) = D(t)/(r - g_lr)((1 + g_lr) + (T/2)(g_sr - g_lr))
T - period of high growth
g_sr - rate of growth in the short run

Question 10

Sustainable growth rate

Answer 10

SGR = (1 - dividend rate)*ROE = retention rate * ROE

If current growth rate is higher than SGR the firm will have to issue equity in order to maintain D/E

Question 11

Valuation multipliers - fundamentally justified formulas

Answer 11

All formulas are for leading multipliers - multiply by (1 + g) to get trailing multipliers

1) P/E = (1 - b)/(r - g)
2) P/B = (ROE - g)/(r - g)
3) P/S = Net profit margin * P/E
4) D/P = r - g

Question 12

What is PEG and how it is used?

Answer 12

PEG = P/E / g

Used to compare firms with different growth prospects

Question 13

Momentum indicators

Answer 13

Compare current price with its historic patterns

1) Earnings surprise = actual EPS - expected EPS
2) SUE = Earning surprise / std(Earning surprise)

Question 14

What is best approach to describe the central tendency of a group of multipliers?

Answer 14

Harmonic mean or weighted harmonic mean

Question 15

EVA and MVA

Answer 15

EVA = NOPAT - WACC * Total capital
Total capital = net WC + net FA = book value of long-run debt + book value of equity
MVA = market value - total capital

Question 16

Residual income - formula

Answer 16

RI = NI - r * equity capital
RI(t) = EPS(t) - r * B(t - 1) = (ROE - r)*B(t - 1)

Question 17

Residual income - equity valuation

Answer 17

V(0) = B(O)*[1 - (ROE - r)/(r - g)], under the assumption of constant growth rate of income and dividends (g).

Question 18

Tobin’s Q

Answer 18

Total capital / replacement cost of total assets

Question 19

Continuing residual income model

Answer 19

PV(continuing RI in t-1) = RI(t)/(1 + r - w)
w - persistence factor
High w: low dividends, high historical persistence of RI
Low: high ROE, many non-recurrent events, high accruals
Alternative: (P(t) - B(t) + RI(t))/(1 + r)

Question 20

What is the clear surplus relation?

Answer 20

Absolutely critical assumption for RI-based valuation

B(t) = B(t - 1) + EPS(t)*(1 - dividend payoff rate)

Question 21

When the clear surplus relation is violated?

Answer 21

When items of equity is changes without passing PnL:

• FX translations
• AFS securities revaluation
• Pension adjustments
• Revaluation surplus of long-lived assets (IFRS only)

Question 22

Violations from Fair value

Answer 22

• Operating leases should be capitalized
• SPE could be consolidated
• LIFO inventory -> FIFO
• Reserves = EL
• Deferred tax liabilities should be reported as equity (if not expected to reverse)
• Pension assets and liabilities should be adjusted for future plan

Question 23

Excess earning method for valuation of private companies

Answer 23

Excess earnings = Normalized earnings (or FCFF) - WCrequired return on WC - FxArequired return on FxA
Intangible assets value = Excess earnings*(1 + g)/(r - g)
Value = Intangible assets + WC + FxA

Question 24

The Discount for lack of control

Answer 24

DLOC = 1 - [1/(1 + control premium)]
If DLOC is applied DLOM is usually applied as well:
Total discount = 1-(1 - DLOC)*(1 - DLOM)