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Exam 7 > Goldfarb > Flashcards

Goldfarb Flashcards

1
Q

Insurance company valuation methods (5)

A
  1. dividend discount model
  2. discounted cash flows (FCFF and FCFE)
  3. abnormal earnings
  4. relative valuation using multiples
  5. option pricing methods
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2
Q

Present value of dividends with growth into perpetuity

A

E[next div] / (k - g)

*remember to also discount back to time 0 if terminal value

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3
Q

Formula for growth rate beyond forecast horizon and alternative method for DDM

A

g = plowback ratio * ROE

alternative = extrapolate growth rate during the forecast horizon

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4
Q

CAPM required return (aka risk-adjusted discount rate, or cost of capital)

A

k = risk free rate + beta * (expected market return - risk free rate)

expected market return - risk free rate = market risk premium

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5
Q

Beta in CAPM represents

A

firm’s systemic/non-diversifiable risk (high beta = high risk)

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6
Q

Primary considerations in beta selection (2)

A
  1. mix of business
  2. financial leverage
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7
Q

Options for basis of risk free rate (3)

A
  1. 90-day T-bills
  2. maturity matched T-notes
  3. T-bonds – 20-year bonds but first remove liquidity premium (usually 1.2%)
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8
Q

ROE formula

A

net income after tax / beginning equity

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9
Q

Ending equity formula

A

= beginning equity + net income after tax - dividends paid

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10
Q

Limitations of DDM (2)

A
  1. dividend payments are discretionary and difficult to forecast
  2. may need to re-define dividend with increased use of stock buybacks
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11
Q

Implicit assumption of FCF methods

A

any FCF not paid as dividends are invested to earn an appropriate risk-adjusted return (k)

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12
Q

Free cash flow to the firm (FCFF) method

A

equity = firm value - market value of debt

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13
Q

Reasons FCFF method is difficult to apply to P and C companies (2)

A
  1. unclear how to deal with leverage from PH liabilities
  2. unclear how to discount PH liabilities–no single fixed expiration
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14
Q

Distinction b/w FCFF and FCFE

A

FCFF - reflects CFs/risk to equity and debt-holders

FCFE - reflects only CFs/risk to equity holders

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15
Q

FCFE formula

A

FCFE = net income after tax
+ non-cash charges
- net working capital investment
- increase in required capital (aka capital expenditures)
+ net borrowing

exclude reserves

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16
Q

Reason change in reserves is excluded from non-cash charges in FCFE equation

A

added as a non-cash charge, but also subtracted as a capital expenditure, so the net effect cancels out

17
Q

Examples of net working capital expense (2)

A
  1. inventory
  2. accounts receivable
18
Q

Examples of capital expenditures (3)

A

investments in:

  1. property
  2. plant
  3. equipment

in addition to changes in regulatory, rating agency, or management requirements

19
Q

Differences b/w DDM and FCFE methods (2)

A
  1. growth rates - difficult to define reinvestment under FCFE method
  2. discount rates - FCFE pays out all free cash flow, DDM pays out only a portion and invests the rest. DDM has greater investment risk and FCFE has greater UW risk; different rates should be used but in practice they aren’t
20
Q

Reinvestment rate for FCFE growth rate

A

reinvestment rate = change in capital / net income after tax

21
Q

Horizon growth rate for FCFE method

A

g = selected reinvestment rate * selected ROE

22
Q

Weaknesses of the DCF methods (3)

A
  1. financial statements must be forecast using specific accounting standards
  2. variety of adjustments are made to estimate FCFs from forecasted net income
  3. resulting CFs may not necessarily = plan
23
Q

Book value for AE method

A

book value = beginning capital

24
Q

AE formula

A

= (ROE - k) * book value

OR = net income - required return

required return = k * BV

25
Q

Value of firm under AE method

A

value = book value + PV (AE)

26
Q

Key difference b/w AE and other methods

A

AE does not assume constant growth in perpetuity

*instead, AE decline linearly to 0 as new competition enters the market to capture AE
decrease by 1/(n + 1) per year

27
Q

Benefits of the AE method (2)

A
  1. uses assumptions more directly tied to the source of value creation vs. effect (dividends and FCFs)
  2. de-emphasizes terminal value (more of value reflected w/in forecast horizon)
28
Q

Reasons to use relative valuation instead of other methods (3)

A
  1. insufficient data available
  2. difficult to obtain growth and rate adequacy estimates w/o market knowledge and planning data
  3. horizon used may stretch limits of forecasting ability
29
Q

Uses for P/E ratios (3)

A
  1. reasonability check/validation of assumptions
  2. shortcut to valuation
  3. method to estimate terminal value
30
Q

Price-earnings ratio for relative valuation

A

P0/E1 = (1 - p) / (k - p * ROE)

recognize that p * ROE = g

31
Q

Price-book value ratio for relative valuation

|&raquo_space; assuming growth and AE continue into perpetuity

A

P_0 / BV_0 = 1 + (ROE - k) / (k - g)

32
Q

Total firm value under relative valuation using multiples

A

= weighted average of segment values

often average multiples to avoid relying on a single one

33
Q

Multiple in relative valuation reflects (3)

A

combined effect of:

  1. dividend payout ratio
  2. growth rate
  3. discount rate
34
Q

Advantage of using transaction multiples

A

often based on a complex negotiation w/sophisticated calculations on both sides

35
Q

Reasons to exercise caution when using transaction multiples (4)

A
  1. control premium embedded in the price overstates the multiple
  2. the purchasing company usually overpays in M&As
  3. IPOs are historically underpriced
  4. economic conditions may have changed since the time of the transaction
36
Q

General rule for calls/puts in real option pricing

A

call - options to expand/postpone

put - options to contract/abandon

Exam 7 (20 decks)

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