Goldfarb Flashcards by Jordan Lastnik

Insurance company valuation methods (5)

dividend discount model
discounted cash flows (FCFF and FCFE)
abnormal earnings
relative valuation using multiples
option pricing methods

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Present value of dividends with growth into perpetuity

E[next div] / (k - g)

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

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

g = plowback ratio * ROE

alternative = extrapolate growth rate during the forecast horizon

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

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

expected market return - risk free rate = market risk premium

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Beta in CAPM represents

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

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Primary considerations in beta selection (2)

mix of business
financial leverage

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Options for basis of risk free rate (3)

90-day T-bills
maturity matched T-notes
T-bonds – 20-year bonds but first remove liquidity premium (usually 1.2%)

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ROE formula

net income after tax / beginning equity

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Ending equity formula

= beginning equity + net income after tax - dividends paid

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Limitations of DDM (2)

dividend payments are discretionary and difficult to forecast
may need to re-define dividend with increased use of stock buybacks

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Implicit assumption of FCF methods

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

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Free cash flow to the firm (FCFF) method

equity = firm value - market value of debt

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

unclear how to deal with leverage from PH liabilities
unclear how to discount PH liabilities–no single fixed expiration

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Distinction b/w FCFF and FCFE

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

FCFE - reflects only CFs/risk to equity holders

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FCFE formula

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

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

Examples of net working capital expense (2)

inventory
accounts receivable

Examples of capital expenditures (3)

investments in:

property
plant
equipment

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

Differences b/w DDM and FCFE methods (2)

growth rates - difficult to define reinvestment under FCFE method
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

Reinvestment rate for FCFE growth rate

reinvestment rate = change in capital / net income after tax

Horizon growth rate for FCFE method

g = selected reinvestment rate * selected ROE

Weaknesses of the DCF methods (3)

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

Book value for AE method

book value = beginning capital

AE formula

= (ROE - k) * book value

OR = net income - required return

required return = k * BV

Value of firm under AE method

value = book value + PV (AE)

Key difference b/w AE and other methods

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

Benefits of the AE method (2)

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)

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

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

Uses for P/E ratios (3)

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

Price-earnings ratio for relative valuation

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

Price-book value ratio for relative valuation | >> assuming growth and AE continue into perpetuity

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

Total firm value under relative valuation using multiples

= weighted average of segment values often average multiples to avoid relying on a single one

Multiple in relative valuation reflects (3)

combined effect of: 1. dividend payout ratio 2. growth rate 3. discount rate

Advantage of using transaction multiples

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

Reasons to exercise caution when using transaction multiples (4)

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

General rule for calls/puts in real option pricing

call - options to expand/postpone put - options to contract/abandon