Intrinsic Valuation Flashcards
What does intrinsic value mean in business?
An intrinsic value refers to a valuation method used in measuring the financial status or strength of a company. this method of business valuation uses Discounted cash Flows (DCF) in assessing the wealth of a company.
Is the absolute value of a business same from its relative value?
No
What is the difference between the absolute value and relative value of a company?
An absolute value examines a company’s wealth using the time value of money and accumulate interest, while relative value models gauge a company’s wealth by comparing it to its competitors’ wealth.
Compare and Contrast enterprise value and equity value
Enterprise value and equity value are two common ways that a business may be valued in a merger or acquisition. Both may be used in the valuation or sale of a business, but each offers a slightly different view. Enterprise value gives an accurate calculation of the overall current value of a business, similar to a balance sheet, while equity value offers a snapshot of both current and potential future value.
What is enterprise value?
It constitutes more than just outstanding equity. It theoretically reveals how much a business is worth, which is useful in comparing firms with different capital structures since the capital structure doesn’t affect the value of a firm.
How to calculate enterprise value?
By adding up the market capitalization, or market cap, plus all of the debts in the company, substract any cash or cash equivalents that the company holds. You then get the enterprise value
Debts may include interest due to shareholders, preferred shares, and other such things that the company owes.
What is equity value?
Equity value constitutes the value of the company’s shares and loans that the shareholders have made to the business
How to compute equity value?
The calculation for equity value adds enterprise value to redundant assets ( non-operating assets)and then substracts the debt net of cash available.
Total equity value can then be further broken down into the value of shareholders’ loans and (both common and preferred) shares outstanding
Are preferred shares and shareholders’ loans considered debt?
Yes. Equity value includes these instruments in its calculation
What is the difference between the calculation of enterprise value and equity value?
Equity value uses the same calculation as enterprise value but adds in the value of stock options, convertible securities and other potential assets of liabilities for the company
What sets equity value apart from enterprise value?
Because equity value consider factors that may not currently impact the company, but can at any time, equity value offers an indication of potential future value and growth potential.
What is the intrinsic value of a business
It is the present value of all expected future cash flows, discounted at the appropriate discount rate.
What makes intrinsic value different from relative forms of valuation?
Unlike relative forms of valuation that look at comparable companies, intrinsic valuation looks only at the inherent value of a business on its own.
What are the two main methods of risk adjusting the intrinsic value?
Discount Rate and Certainty Factor
What is the discount rate approach?
It uses a discount rate that includes a risk premium in it to adequately discount the cash flows.
In the discount rate approach, a financial analyst will typically use a company’s weighted average cost of capital.
What is the formula of WACC?
the formula for WACC includes the risk-free rate plus a premium based on the volatility of the stock multiplied by an equity risk premium.
What is the rationale behind the discount rate approach?
The rationale behind this approach is that if a stock is more volatile it’s a risker investment. therefore, a higher discount rate is used, which has the effect of reducing the value of cash flow that would be received further in the future (because of the greater uncertainty.)
What is the certainty factor method?
it uses a factor on a scale of 0-100% certainty of the cash flows in the forecast materializing. In this approach, only the risk-fee rate is used as the discount rate, since the cash flows are already risk-adjusted.
How can a certainty factor be assigned?
A certainty factor, or probability, can be assigned to each individual cash flow or multiplied against the entire net present value (NPV) of the business as a means of discounting the investment.
How are the two approach similar?
They are both attempting to do the same thing—to discount an investment based on the level of risk inherent in it
Why does intrinsic value matters to an investor?
Analysts employ these methods to see whether or not the intrinsic value of a security is higher or lower that its current market price, allowing them to categorize it as “overvalued” or “undervalued”
It calculates the present worth of business by forecasting their future income streams
Intrinsic Valuation. a.k.a Absolute valuation
Why is the absolute valuation method reductive?
The absolute valuation method is reductive as the analysis is focused on the characteristics of the company in isolation. There is no comparison to its competitors in the same indusctry or complementary sectors.
Why is the process in absolute valuation problematic?
The process is problematic because the competitive analysis is important to assess the overall market movement in a particular sector. Disruptive innovation due to new technology, major mergers, and acquisitions, regulatory change, new market entrants, or bankruptcy may impact the trajectory of an entire sector.
What are the two main types of intrinsic valuation models?
Discounted Cash Flow Model
Dividend Discounted Model
TRUE OR FALSE: The discount rate equals the rate of return for the investor
True
TRUE OR FALSE: Appropriate discount rates does not need to be calculated to arrive at the present value of the company
FALSE
Appropriate discount rates need to be calculated
TRUE OR FALSE: The discounted cash flow model can be used for the valuation of anything that can affect cash flow
TRUE
It uses a formula to calculate the rate of return of a business by evaluating anticipated payments and amounts receivable in the near future
DCF model
TRUE OR FALSE:
The conclusion of using the DCF model is a projected cash flow that can be used to predict how long the company can sustain a growth trajectory.
TRUE
What are the components of DCF model?
Free Cash Flow
Discount Rates
Period Number
Terminal Value
It measure a company’s financial performance. It shows the cash that a company can produce after deducting the purchase of assets. In other words, it measure a company’s ability to produce what investors care most about: cash that’s available to be distributed in a discretionary way
Free Cash Flow (FCF)
- a component of DCF model
What are the most common types of FCF
Unlevered Cash Flow
Levered Cash Flow
Unlevered Cash Flow
This measure requires a multi-step calculation and is used in Discounted Cash Flow analysis to arrive at the Enterprise Value (or total firm value).
Levered Cash flow
this measure is derived from the statement of cash flows by taking operating cash flow, deducting capital expenditures, and adding net debt issued (or substracting net debt repayment. This includes interest expense paid on debt and net debt issued or repaid, so it only represents the cash flow available to equity investors. ( interest to debt holders has already been paid)
It is a hypothetical figure, an estimate of what it would be if the firm was to have no debt
Unlevered Cash Flow
Why is free cash flow important?
knowing the company’s free cash flow enables management to decide on future ventures that would improve the shareholder value.
What does an abundant Free cash flow indicates?
it indicates that a company is capable of paying its monthly dues. Companies can also use their FCF to expand business operations or pursue other short-term investments.
What are Discount Rates? (Component of DCF)
the rate of return used to discount future cash flows back to their present value. It is often the company’s WACC, required rate of return, or the hurdle rate that investors expect to earn relative to the risk of the investment.
