Goldfarb Flashcards
Briefly explain how high growth rates affect dividends.
High growth rates and high dividends are not sustainable at the same time, which means high growth rates will be offset by lower dividend amounts
Briefly explain how high growth rates affect the risk-adjusted rate.
Firms with high growth rates tend to be riskier, which drives the risk-adjusted rate up
Explain the difference between private valuation and equilibrium market valuation.
Private valuation assumes that individual investors have their own views of “risk.” Potential investments are assessed relative to their existing portfolios, resulting in the same investment having different value to different investors. Equilibrium market valuation assumes that all investors hold the same portfolio and assess “risk” in identical fashions. Thus, investments will have the same value for all investors
a) Briefly describe two ways of determining beta used in the Capital Asset Pricing Model.
⇧ Use a firm beta – run a linear regression of the company’s returns against the market returns using historical stock price data ⇧ Use an industry beta – use an industry-wide mean or median value
b) If an industry beta is used to determine the risk-adjusted discount rates, briefly describe two adjustments that may need to be made to beta.
⇧ Mix of business – only use firms with comparable mixes of business. Unfortunately, this drops the number of firms significantly, which reduces the reliability of the result ⇧ Financial leverage – using debt to raise capital increases the risk to equity holders. This shows up in the beta estimate, making the betas of different firms difficult to compare. To correct this, beta can be defined to reflect solely business risk and not the effect of debt leverage
Briefly describe two limitations of the dividend discount model.
⇧ Actual dividend payments are discretionary and can be difficult to forecast ⇧ Due to increased use of stock buybacks as a vehicle for returning funds to shareholders, we may need to redefine “dividend”
a) Describe two approaches for implementing the discounted cash flow model.
⇧ Free Cash Flow to Firm (FCFF) • Focuses on free cash flow to the entire firm, prior to accounting for debt payments or taxes associated with debt payments • Discounting the FCFF gives the total firm value. The equity value of the firm is found by subtracting the market value of the debt from the total firm value ⇧ Free Cash Flow to Equity (FCFE) • Focuses on cash flows to equity holders only • Subtract the debt payments, net of their associated tax consequences, from the free cash flow to the firm to determine the free cash flow to equity. Discount the resulting free cash flows to determine equity value
b) Identify the preferred approach and explain why it is preferred. (FCFF or FCFE)
The preferred approach is FCFE. The FCFF method requires either a weighted average cost of capital or an all-equity cost of capital. Since policyholder liabilities make it difficult to precisely define either of these measures, the FCFE method is preferred
In theory, the dividend discount model and the discounted cash flow model should use different discount rates. Explain why.
The DDM and FCFE models should use different discount rates due to the riskiness of the cash flows paid to shareholders. With DDM, assumed dividends are paid to shareholders, and remaining income is reinvested in marketable securities. In contrast, the FCFE pays out all free cash flow to shareholders. This means that the DDM’s measure of risk is impacted by a larger proportion of the risk coming from marketable securities than from underwriting risk. Thus, the DDM model should theoretically use a larger discount rate than the FCFE model
Briefly describe three weaknesses of the discounted cash flow method.
⇧ Must forecast financial statements according to a specific set of accounting standards ⇧ Variety of adjustments must be made to the forecasts of net income to estimate free cash flows ⇧ Resulting free cash flows may not be very similar to those used internally for planning purposes
Define abnormal earnings in words.
Abnormal earnings represent the portion of earnings ABOVE the required earnings, where required earnings are based on the required rate of return for the firm
Briefly describe how the terminal value is calculated under the abnormal earnings method.
The abnormal earnings method assumes that abnormal earnings do NOT continue into perpetuity. Instead, they should decline to zero as new competition enters the market to capture some of those abnormal earnings
Explain why this is an appealing way to calculate the terminal value.
This is an appealing quality of the AE method since it forces analysts to explicitly consider the limits of growth from a value perspective (i.e. growth in earnings does not drive growth in value; we only grow in value if we exceed expected returns)
Briefly describe two adjustments to book value that may be needed in order to implement the abnormal earnings method.
⇧ Eliminate systematic bias in reported asset and liability values ⇧ Adjust reported book value to reflect tangible book value, which removes the impact of intangible assets such as goodwill (i.e. brand, reputation, etc.)
Briefly describe two benefits of the abnormal earnings method.
⇧ Uses assumptions that are more directly tied to value creation (abnormal profits) instead of those that are consequences of value creation (dividends and free cash flows) ⇧ De-emphasizes the terminal value, and reflects more of the firm value within the forecast horizon
Cost of Capital Equation
Growth Function to use in DDM
Growth function used for FCFE
Use the DDM model to value a firm with constant
growth rate in perpetuity
Formula for Free Cash Flow to Equity for an
Insurance Company
What is the difference between FCFE and DDM
approaches for calculating the value of an insurance
company
Formula for Abnormal Earnings in one year
Given the Abornomal Earnings each year, what is the
value of an insurance company
Formula for Price to Earnings Ratio
Price to Book Value Formula
