Equity valuation models Flashcards
When the discounted dividend model is most appropriate?
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
When the free cash flow model is most appropriate?
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
When the residual income model is most appropriate?
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.
List of valuation multipliers
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
To what parts equity value breaks down?
V(t) = E(t+1)/r + PVGO
E/r - value from assets in place
r - required return on equity
DDM under constant Gordon growth assumption
V(t) = D(t)*(1 + g)/(r - g)
Value of fixed-rate perpetual preferred stock
V(t) = Dp/rp
What growth rates of companies revert to in the long run?
real GDR growth rate + long-run inflation
DDM under H-model of growth
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
Sustainable growth rate
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
Valuation multipliers - fundamentally justified formulas
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
What is PEG and how it is used?
PEG = P/E / g
Used to compare firms with different growth prospects
Momentum indicators
Compare current price with its historic patterns
1) Earnings surprise = actual EPS - expected EPS
2) SUE = Earning surprise / std(Earning surprise)
What is best approach to describe the central tendency of a group of multipliers?
Harmonic mean or weighted harmonic mean
EVA and MVA
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
Residual income - formula
RI = NI - r * equity capital RI(t) = EPS(t) - r * B(t - 1) = (ROE - r)*B(t - 1)
Residual income - equity valuation
V(0) = B(O)*[1 - (ROE - r)/(r - g)], under the assumption of constant growth rate of income and dividends (g).
Tobin’s Q
Total capital / replacement cost of total assets
Continuing residual income model
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)
What is the clear surplus relation?
Absolutely critical assumption for RI-based valuation
B(t) = B(t - 1) + EPS(t)*(1 - dividend payoff rate)
When the clear surplus relation is violated?
When items of equity is changes without passing PnL:
- FX translations
- AFS securities revaluation
- Pension adjustments
- Revaluation surplus of long-lived assets (IFRS only)
Violations from Fair value
- 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
Excess earning method for valuation of private companies
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
The Discount for lack of control
DLOC = 1 - [1/(1 + control premium)]
If DLOC is applied DLOM is usually applied as well:
Total discount = 1-(1 - DLOC)*(1 - DLOM)
