Lecture 16 Flashcards
What is the PE ratio and how to calculate it?
Price to earnings ratio. It compares the stock price to earnings per share.
What does a high PE ratio mean and what does a low PE ratio mean?
A high PE ratio means that investors pay more for each dollar of earnings because they expect the stock to grow.
A low PE ratio means that investors are skeptical about growth and the stock may be undervalued.
What is the intrinsic value?
Present value of expected cash flows considering its riskiness.
Why is the simple DDM without a growth rate not well enough?
Because the estimation of dividends is difficult so we use a growth rate to average the dividends over time.
What is the formula for a DDM with growth rate?
Perpetuity: V0 = Dividend / K - G
How to choose a rate ‘k’ for your DDM?
Use CAPM
How to calculate the dividend growth rate ‘g’?
Return on Equity * Plowback/Retention Rate
What is the plowback or retention rate?
The amount of earnings that is reinvested back into the company.
(1 - dividend payout) = retention rate
Dividends are a fixed fraction of earnings, therefore, dividend growth equals earnings growth.
Is reinvestment of earnings always a good idea for valuation?
No, because reinvestment destroys value when the ROE is smaller than ‘k’. Then the company should just pay dividends. You should see it as a negative NPV project.
How to calculate the PVGO?
Intrinsic Value (Future) - Intrinsic Value Now
How to determine if reinvestment makes sense using the PVGO?
If the PVGO is positive, then reinvestment makes sense.
What are the three trading signals using IV and MV?
IV is intrinsic value and MV is the consensus of all potential traders.
When IV > MV, you should buy.
When IV < MV, you should sell.
We can also compare k and E(R), what are the trading signals using these two metrics?
When k < E(R), you should buy because you expect more return than you demand (Alpha).
When k> E(R), you should sell because you expect less return than you demand (negative Alpha).
