Goldfarb Flashcards
Cost of Capital
k = risk free + B[(market - risk free)]
Valuation Methods
DDM
FCFE
AE
Multipliers
Growth function, DDM
g = (ROE x plowback ratio)
Growth function, FCFE
g = (ROE x reinvestment rate)
DDM model with constant growth into perpetuity
V(0) = E[Div(1)]/(k-g)
Sensitivity test on DDM assumptions
Table showing different options of discount rate vs. growth rate
When growth rate is high, discount rate tends to be high as well – high expected growth tends to be high risk
Assumptions of DDM
Need EXPECTED DIVIDENDS for forecast horizon
Need dividend GROWTH RATES after horizon
Need DISCOUNT RATE
Why not use FCF to the Firm method to value insurance company
FCFE uses cash flow and discounts it at weighted average cost of capital (WACC); unclear how to determine WACC, since leverage exists for policyholders and debtholders
FCFE formula
FCFE = Net income + Noncash charges - change in capital + change in debt
Advantages of Discounted Cash Flow compared to DDM
DDM focuses on dividends, which are highly discretionary
Stock buybacks are another way to return cash to shareholders
DCF focuses on Free Cash Flows
Differences between FCFE and DDM
Growth rate is ROE x Reinvestment Rate (vs. ROE x plowback ratio)
Abnormal Earnings formula
AE = Net Income - Cost of Captial AE = NI - BV * k
Benefits of AE
Focuses on value creation
Removes large leverage on terminal value
Working with income may be more accurate than cash flow
Price to Earnings Ratio
p/E = (1 - rho)/(k - rho*ROE)
Price to Book value
p/BV = 1 + (ROE - k)/(k - g)
