Financial Valuation Methods Flashcards
What are absolute value models?
they assign an intrinsic value to an asset based on the present value of its future cash flows; estimates of cash flows are derived and discounted based on interest rates applicable to the level of risk and required return associated with the asset and its projected cash flows
What is a perpetuity (perpetual annuity)?
the periodic cash flow paid by an annuity that lasts forever; the formula is as follows:
present value of a perpetuity = stock value per share = p = d/r
P = stock price
D = dividend
R = required return
the assumptions must specify the dividend (and assume that it will never change) and it must specify the required return
What is the constant (Gordon) growth dividend discount model (DDM)?
it assumes that dividend payments are the cash flows of an equity security and that the intrinsic value of the company’s stock is the present value of the expected future dividends; the assumptions: must specify (or allow for the calculation of) dividends one year beyond the year in which you are determining the price, must include a required return, must include a constant growth rate of dividends, implies that the stock price will grow at the same rate as the dividend in perpetuity, and it assumes that the required rate of return is greater than the dividend growth rate (if this relationship does not hold true, the formula will not work)
What is the discounted cash flow analysis (DCF)?
it attempts to determine the intrinsic (true) value of an equity security by determining the present value of its expected future cash flows; to apply DCF analysis, an analyst takes the following steps: chooses an appropriate model, forecasts the security’s cash flows using one of the model approaches, selects a discount rate methodology (CAPM is popular), estimate the discount rate and apply to the appropriate DCF model, and calculate the equity security’s intrinsic value and compare to its current market value
What are relative valuation models?
they use the value of comparable stocks to determine the value of similar stocks; price multiples are useful metric in relative valuation
price multiples represent ratios of a stock’s market price to another measure of fundamental value per share; investors use price multiples to determine if a stock is undervalued, fairly valued, or overvalued
What is the price-earnings (P/E) ratio?
it is the most widely used multiple when valued equity securities; the rationale for using this measure is that earnings are a key driver of investment value (stock price); this multiple is widely used by the investment community and empirical research has shown that changes in a company’s P/E are tied to the long-run stock performance of that company
P/E = stock price/value today / EPS expected in one year
trailing P/E ratio = stock price/value today / EPS for the past year
when past earnings are used in the P/E ratio, the ratio calculated is the trailing P/E; when expected earnings are used in the P/E ratio, the ratio calculated is the forward P/E
the trailing P/E is the preferred calculation method when a company’s forecasted earnings are unavailable, while the forward P/E is the preferred method when the company’s historical earnings is not representative of its future earnings
What is the PEG ratio?
it is a measure that shows the effect of earnings growth on a company’s P/E, assuming a linear relationship between P/E and growth; generally, stocks that have lower PEG ratios are more attractive to investors than stocks that have higher PEG ratios
PEG = (stock price/value today / expected EPS) / growth rate
What is price-to-sales ratio?
the rationale for using this ratio is that sales are less subject to manipulation than earnings or book values; sales are always positive so this multiple can be used even when EPS is negative; this ratio is not as volatile as the P/E ratio, which include the effect of financial and operating leverage; empirical studies have shown that P/S is an appropriate measure to value stocks that are associated with mature or cyclical companies
P/S = stock price/value today / expected sales in one year
What is the price-to-cash ratio?
the rationale for using this ratio is that cash flow is harder for companies to manipulate than earnings; P/CF is a more stable measure than P/E; empirical research has shown that changes in a company’s P/CF ratios over time are positively related to changes in a company’s long-term stock returns
P/CF = stock price/value today / expected cash flow in one year
What is the price-to-book ratio?
the rationale for using this ratio is that a firm’s book value of common equity (assets minus liabilities and preferred stock) is more stable than EPS, especially when a firm’s EPS is extremely high or low for a given period; because P/B is usually positive, this multiple can be used even when a firm’s EPS is negative or zero; research indicates that the P/B ratio can explain a firm’s average stock returns over the long run
P/B = stock price/value today / book value of common equity
What is an option?
it is a contract that entitles the owner (holder) to buy (call option) or sell (put option) a stock (or some other asset) at a given price within a stated period of time
American-style options can be exercised at any time prior to their expiration while European-style options can be exercised only at the expiration or maturity date of the option
a commonly used method for option valuation is the Black-Scholes model, which is useful for valuing European-style options
another option pricing model is the binomial or Cox-Ross-Rubinstein model, which is useful for valuing American-style options
Valuing debt instruments
the value of a bond is equal to the present value of its future cash flows (which consist of interest payments and principal payment at maturity); the cash flows may be discounted using a single interest rate or multiple interest rates aligned with the degree of risk for each cash flow
bonds paying a fixed coupon rate equal to the market rate for comparable bonds are issued at par/face value; if a bond’s coupon rate at issuance is less (more) than the market rate, the bond will be issued at a discount (premium); as market interest rates change, the market value of the bond will also change; for fixed-rate bonds, when market interest rates rise, the market value of the bond falls, and vice versa
Valuing tangible assets
the actual value of these assets can be determined using the following methods:
cost method - based on the original cost paid to acquire the asset; adjustments may be made for depreciation in order to reduce the value of the asset to reflect current utility
market value method - requires that similar assets be available in the marketplace in order to find a comparable value; two iterations of the market value method are the replacement cost method (what it would cost to replace the valued asset) and the net realizable value method (the price at which the asset could be sold in the marketplace, reduced by any costs associated with selling the asset)
appraisal method - a professional appraiser determines the value of the asset, assuming that the company can find an appraiser with knowledge and experience working with the specific asset in question
liquidation value - if the asset had to be sold today, the liquidation value represents the amount that the company would get upon sale assuming that there is an active market for the asset
Valuing intangible assets
the following methods may be used to value intangible assets:
market approach - requires that actual arm’s-length transactions in similar markets be used as a reference for the asset to be valued; although this is a preferred approach to valuation, the unique nature of individual intangible assets and relative trading infrequency present challenges
income approach - the future expected cash flows over the estimated useful life of the intangible asset are discounted to present value using discount rates reflected the level of risk associated with the income stream
cost approach - when there are no similar assets or transactions involving similar assets, and no reasonable estimates of future income, this approach is used; iterations of the cost approach include replacement cost and reproduction cost
Valuation using accounting estimates
when preparing accounting estimates, management must consider the following data and factors: historical information, market information, expected usage, and estimates from experts
accounting estimates should be supported by documentation that shows the assumptions and calculations upon which the estimates are based; management should regularly review the support for material accounting estimates and should approve each estimate when reviewed
