Financial Valuation Methods Pt. 1 Flashcards
Fact: absolute value models 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 an annuity?
a series of equal cash flows to be received over a number of periods
Fact: when the periodic cash flows paid by an annuity last forever, the annuity is called a perpetuity or perpetual annuity
the traditional annuity formula for perpetual cash flow streams is simplified because no duration is known; when a company is expected to pay the same dividend each period, the perpetuity formula can be used to determine the value of the company’s stock
stock price = dividend / 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; if dividends are assumed to grow at a constant rate, the constant (Gordon) grown DDM can be used to determine the value of the company’s stock
How do you calculate free cash flow?
net income + noncash expenses - increase in working capital - capital expenditures
T/F: discounted cash flow analysis attempts to determine the intrinsic (true) value of an equity security by determining the present value of its expected future cash flows
True
Fact: the P/E ratio (price-earnings) is the most widely used multiple when valuing equity securities; the rationale for using this measure is that earnings are a key driver of investment value (stock price)
changes in a company’s P/E ratio are tied to the long-run stock performance of that company; this is also dubbed the forward P/E
formula: stock price or value today / EPS expected in one year
formula for trailing P/E: stock price or value today / EPS for the past year
Fact: the PEG ratio shows the effect of earnings growth on a company’s P/E, assuming a linear relationship between P/E and growth
usually, stocks with lower PEG ratios are more attractive to investors
formula: (stock price or value today / expected EPS) / growth rate (where 100 * expected growth rate)
Fact: the price-to-sales ratio is similar to the P/E ratio in that it can estimate the current stock price, but it is not as volatile; it is an appropriate measure to value stocks that are associated with mature or cyclical companies
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
formula: stock price or value today / expected sales in one year
Fact: the price-to-cash-flow ratio can also be used to calculate the current stock price and it is a more stable measure than P/E
the rationale for using this ratio is that cash flow is harder for companies to manipulate than earnings; changes in this ratio over time are positively related to changes in a company’s long-term stock returns
formula: stock price or value today / expected cash flow in one year
Fact: the price-to-book ratio focuses on the balance sheet rather than the income statement or statement of cash flows
the rationale for using this ratio is that a firm’s book value of common equity (assets less liabilities and preferred stock) is more stable than EPS; it can be used when a firm’s EPS is negative or zero; it can explain a firm’s average stock returns over the long run
formula: stock price or value today / book value of common equity
