Exam 4 Flashcards
A technique for identifying underpriced or overpriced stocks based on ratios of the stock price to accounting fundamentals, like book value per share or EPS
Stock valuation using multiples
Stock Valuation using multiples:
Set a ____. If the ratio of price to fundamental is below average, the stock is considered relatively ___, and if above average, relatively ___.
Benchmark
Cheap
Expensive
Price to book value is the ratio of the market value of the ____ to its latest quarterly ____
Common stock
Book value
A low P/B is an indicator of a possibly ____ stock, while a high P/B might indicate that the stock price is well ___ the cost of replacing the company’s assets, and hence _____.
Undervalued
Above
Overvalued
In an efficient market, the P/B ratio will exceed 1 if the company is able to earn a ____ that exceeds the cost of _____.
Return on equity
Equity capital
Return on equity is ___ divided by ___, or the net income “return” as a percentage of book value
Net income divided by beginning book value
If net income return exceeds r, then the company is able to earn a higher return on its investments than the stockholder could earn elsewhere on comparable risk investments. Thus, the company is generating economic value, sometimes called “____”, on its available assets, and its stock will be priced ____ of book value
Residual income
In excess
If book value accurately measures replacement cost, there must be some _______ (government regulations, high fixed costs, economies of scale) for the long-term average P/B ratio to ___ one. Otherwise, if a company was able to earn an ROE above the cost of equity, you would expect increased ____ in the business, that would drive down ROE in the future
Barriers to entry
Exceed
Competition
Can the P/B be less than one in an efficient market?
Yes
If an industry is in decline, and there is little or no new investment into the industry, ____ often do not accurately reflect _____
Book values
True asset values
When book value does not accurately measure replacement cost, then the long-run or “_____” P/B is not equal to one. Book value differs from replacement cost because of _____ and _____
Equilibrium
Hidden assets and inflation
internally-developed patents and trademarks, past research and development expenditures, past advertising and other marketing expenditures, past start-up costs for employee training, customer relationships, and developed managerial expertise
Hidden assets
P/B’s should logically be ____ after a period of sustained inflation than after a period of stable or falling prices
Higher
Companies with long-lived “real” assets, particularly land and buildings, are most subject to this ___ bias
Inflation
Hidden assets of an acquired company are captured in ____, whereas hidden assets of a comparison firm without acquisitions are left out of ____
Goodwill
Book value
Merger-related comparability problem can be avoided by using ____ as an alternative to P/B
Price/Tangible Book Value
Tangible book value excludes ___ and other ____ assets from book value, so is unaffected by merger purchase accounting
Goodwill
Intangible
Historically, stocks with relatively ___ P/B ratios have earned higher future returns than stocks with relatively ___ P/B ratios
Low
High
Stocks with ___ book-to-market value, tend to outperform stocks with ___ book-to-market ratios
High
Low
Different measures of EPS in the P/E ratio (4):
- Most recent 12 months trailing EPS
- EPS forecast for the current fiscal year
- EPS forecast for a future fiscal year
- GAAP earnings versus ‘operating’ earnings
All else equal, it is better to have a ____ EPS and hence a ___ P/E, than to have ___ EPS and hence a ____ P/E
Positive and positive
Negative and negative
If EPS is negative for two different stocks, the ____ is not a meaningful tool for comparison between them
P/E ratio
The P/E ratio measures the cost of buying a stock as a multiple of the ____ or ___ per share
Earnings or profits
a stock with a P/E of 15 costs $___ to buy for every $__ of per share profits
$15
$1
In a simple analysis, a stock with a low P/E relative to others in the industry, sector, or overall stock market is considered ____
Underpriced
All else equal, in an efficient market, the forward P/E will be higher (3):
- The lower is r, the equity discount rate or cost of equity capital
- The higher the ROE, the return on equity - “good” growth from higher ROE
- The lower the payout ratio if ROE > r, the higher the payout ratio if ROE < r
The lower the perceived risk of a sock or stock index, the ___ the P/E
Higher
For individual stocks, beta from the CAPM measures the systematic risk of a stock relative to the overall market. The lower the systematic (beta) risk of a stock, the ___ the cost of equity capital r, and thus the ___ the P/E
Lower
Higher
Holding the payout ratio constant, firms with higher ROE will have ___ growth rates, and thus will have ___ P/Es than low ROE firms
Higher
Higher
The ____ the ROE, the greater is the opportunity for profitable reinvestment
Higher
For firms with high ROE, lower payout ratios are associated with ____ P/Es, because if the firm can earn a higher ROE than the cost of capital, more reinvestment into the business adds ___
Higher
Value
For firms with ROE below the cost of capital, a ____ payout is a good thing, increasing the ___
Higher
P/E
If ROE is less than r, stockholders would rather
Invest extra cash themselves than have the firm invest on their behalf
In order for the P/E to be a good investment indicator, the analyst must control for ____, ___, and ____.
Risk
Payout ratio
Return on equity
Growth resulting from a _____ is not as attractive, and can actually be value-destructive, compared with growth resulting from a _____
Low payout ratio
High ROE
Recession -> Temporarily ____ -> ____
Economic boom -> Temporarily _____ ->
Low profits -> High P/E
High profits -> Low P/E
Economic cycles have a big impact on P/E’s for ___ industries, such as autos, appliances, construction, basic materials, etc., because their earnings will _____ with the economy
Cyclical
Rise and fall dramatically
For cyclical industries, like auto, at the peak of the cycle, earnings are ___, and thus P/Es ___, if investors predict a future decline in earnings
Very high
Low
Historically, stocks with relatively ___ P/E ratios have outperformed stocks with relatively ___ P/E ratios
Low
High
P/E is a useful indicator of ___ value
Relative
Stocks with ____ E/Ps tend to outperform stocks with ___ E/Ps
High
Low
All else equal, stocks of companies with high leverage will be ____, and will therefore have a higher cost of equity r and low P/E in an efficient market
Riskier
The extent to which a company’s assets are financed with debt rather than equity
Financial leverage
A stock could appear “cheap” based on its P/E, when in fact it deserves a low price because of its high ___ and hence high ___
High Leverage and cost of equity
To get around the impact of leverage on the P/E ratio, analysts often compute multiples using (2):
- The total market value of equity, plus interest-bearing debt, minus cash and marketable securities in the numerator, defined as enterprise value
- Earnings before interest, taxes, depreciation, and amortization (EBITDA) in the denominator
Enterprise Value/EBITDA = [_____+____-____]/____
[Market Value of Equity + Book Value of Debt - Cash] / EBITDA (Earnings before interest, taxes, depreciation, and amortization)
A company with a low EV/EBITDA ratio is considered ____ in the market
Underpriced
The Enterprise Value/EBITDA essentially disregards ___ and ___ as expenses
Depreciation and Amortization (and taxes)
Price-Earnings to Growth (PEG) ratio is defined as the ratio of the ___ to the expected _____
P/E to the expected growth rate in earnings
The expected growth rate g (in percent) is typically assumed to equal the _______ forecast of Wall Street analysts
Consensus long-term (5 years) earnings growth
A stock with a ___ P/E, relative to the expected future growth of earnings, is more attractive to buy than a stock with a ___ P/E relative to its earnings growth rate
Low
High
The major advantage of the PEG ratio over the P/E is that it incorporates a ______
Forward-looking, long-term growth rate
P/E ratios are both theoretically (through ROE) and empirically positively associated with expected ____. If a stock has a low P/E simply because future growth prospects are poor, it is probably not a ___ stock
Earnings growth
Bargain
The major disadvantage of the PEG ratio is that it depends upon Wall Street’s earnings forecast, which tend to be overly ____ for popular stocks with ____ P/Es
Optimistic
High
Another disadvantage of PEG is that it does not distinguish between growth created by a ______ rate and growth create by a _____
High earnings reinvestment rate
High ROE
If two stocks have the same PEG, the stock with the higher ____ is better, all else equal
Higher dividend yield
A revenue multiple compares the total value of ___ or total value of ____ to the ___ generated
Equity or value of the firm to the revenue generated
Sales = ___
Revenue
Price/Sales = ___ per share/___ per share
Stock price per share/Revenue per share
Enterprise Value/Revenue = ____/____
Enterprise Value/Total Company Revenue
Enterprise Value = ____ + ____ or ____ + ____ - _____
Market Value of Equity + Net Debt
Market Value of Equity + Book Value of Debt - Cash and Marketable Securities
EV/Revenue
Price/Sales
Which should be used and why?
Ev/Revenue
Much more sensible because the entire firm, not just the equity, generates sales for the business
Price/Sales and EV/Revenue can be distorted by recent acquisitions. After an acquisition, the _____ immediately adjusts, but trailing-twelve-months revenue will take ___ to fully adjust
Enterprise value
A year
Advantages of EV/Revenue vs. P/E (3):
- Revenue figures are less subject to manipulation than earnings figures (“Operating” earnings differ, R&D, advertising)
- Revenue is more stable over time than earnings (Ex. Cyclical companies like auto industry with high fixed costs and variable earnings)
- Revenue is always non-negative, while earnings can be negative, making P/E uninterpretable
Disadvantage of EV/Revenue vs P/E (1):
It ignores the profit margin that the company is able to earn on its sales
The profit margin is obviously crucial to generating earnings, and ultimately free cash flow, from each dollar of sales
Stocks with relatively ___ market capitalization tend to earn higher future returns than stocks with ___ market capitalization
Small firm effect
Low
High
