Lecture 6: Fundamental Analysis - Company valuation

Question 1

2 main approaches of company valuation:

1. ? valuation
2. ? valuation

Answer 1

2 main approaches of company valuation:

1. Intrinsic valuation
2. Relative valuation

Question 2

1. Intrinsic valuation: ? Cash Flows techniques:
2. 1. Present value of ? (DDM)
3. 2. Present value of ? cash flow
4. 3. Present value of ? cash flow
5. 4. Present value of free cash flow to ?

Answer 2

1. Intrinsic valuation: Discounted Cash Flows techniques:
2. 1. Present value of dividends (DDM)
3. 2. Present value of operating cash flow
4. 3. Present value of free cash flow
5. 4. Present value of free cash flow to equity

Question 3

2. Relative valuation techniques:
3. 1. Price / ? (P/E) ratio
4. 2 Price / ? (P/CF) ratio
5. 3. Price / ? value (P/B) ratio
6. 4. Price / ? (P/S) ratio

Answer 3

2. Relative valuation techniques:
3. 1. Price / Earnings (P/E) ratio
4. 2 Price / Cash flow (P/CF) ratio
5. 3. Price / Book value (P/B) ratio
6. 4. Price / Sales (P/S) ratio

Question 4

Supporters of ?? Efficient Market Hypothesis argue that market value reflects intrinsic value.

Answer 4

Supporters of Semi-strong Efficient Market Hypothesis argue that market value reflects intrinsic value.

Question 5

1. General equation of Discounted Cash Flow:
   Intrinsic value = V = sum_t=1^∞ [ ???? ]
   C_t: cashflows (e.g. dividends, free cash flow, ….)
   k: discount rate

Answer 5

1. General equation of Discounted Cash Flow:
   Intrinsic value = V = sum_t=1^∞ [ C_t / (1+k)^t ]
   C_t: cashflows (e.g. dividends, free cash flow, ….)
   k: discount rate

Question 6

--1.1. Constant-growth dividend discount model:
Value of common stock = V0
= ???
g = constant growth rate of dividends
k: required rate of returns

Answer 6

--1.1. Constant-growth dividend discount model (DDM):
Value of common stock = V0
= D1 / (k-g)
g = constant growth rate of dividends
k: required rate of returns

(Formula for zero-growth & multiple-growth DDM are in lecture slides)

Question 7

–1.2. Present value of operating cash flow:
V0 = ????

OFC1: operating CF in period 1
WACC: weighted average cost of capital
g_OFC: long-term constant growth of OFC

Answer 7

–1.2. Present value of operating cash flow:
V0 = OCF1 / (WACC - g_OFC)

OFC1: operating CF in period 1
WACC: weighted average cost of capital
g_OFC: long-term constant growth of OFC

Question 8

— 1.3-4. formula in lecture slide

Answer 8

—1.3-4. formulas in lecture slide

Question 9

1. DCF: Pros & Cons:
   - ? appealing
   But:
   - require ? of discount rates & ? of growth rate

Answer 9

1. DCF: Pros & Cons:
   - theoretically appealing
   But:
   - require estimates of discount rates & forecasts of growth rate

Question 10

2. Relative valuation - Problems:
   - Finding ?:
   e. g. if we compare an overvalued firm to a hugely overvalued one, we may think it’s undervalued.
   - Many relative valuation metrics are based on ? (not current) data: e.g. P/E

Answer 10

2. Relative valuation - Problems:
   - Finding comparables:
   e. g. if we compare an overvalued firm to a hugely overvalued one, we may think it’s undervalued.
   - Many relative valuation metrics are based on historical data, not current one: e.g. P/E

Question 11

2.1. RV - Earnings Multiplier model (P/E ratio):
= Current ?? / Expected 12-month ?

Pi / E1 = ????

D/E = expected ?? ratio
k = estimated required rate of return
g = expected growth rate of dividends

Answer 11

2.1. RV - Earnings Multiplier model (P/E ratio):
= Current Market Price / Expected 12-month earnings

Pi / E1 = (D1 / E1) / (k - g)

D/E = expected dividend payout ratio
k = estimated required rate of return
g = expected growth rate of dividends

Question 12

2.1. RV - P/E:
- Analysts usually compare P/E ratio across ‘?’ firms
> but it’s inevitably ? how ‘comparable’ is defined.
- Analysts could also use PEG ratio (??) (g = expected growth in ??):
PE ? g: (usually but not necessarily (e.g. if firm is high risk) ) undervalued
PE ? g: overvalued

Answer 12

2.1. RV - P/E:
- Analysts usually compare P/E ratio across ‘comparable ‘ firms
> but it’s inevitably subjective how ‘comparable’ is defined.
- Analysts could also use PEG ratio (PE/g) (g = expected growth in future earnings):
PE < g: (usually but not necessarily (e.g. if firm is high risk) ) undervalued
PE > g: overvalued

Question 13

2. 1. RV - Issues of PE ratio in real world:
      - Use of ?? (which may have been ? to the benefit of t’ firm)
      - ? may need to be taken into account
      - Reported earnings actually fluctuate around ??.
      - PE ratio is derived based on fundamentals of ???
      - differ from figures reported in newspapers & online that is ????? (ignore ???)

Answer 13

2. 1. RV - Issues of PE ratio in real world:
      - Use of accounting earnings (which may have been manipulated to the benefit of t’ firm)
      - Inflation may need to be taken into account
      - Reported earnings actually fluctuate around business cycle.
      - PE ratio is derived based on fundamentals of DDM
      - differ from figures reported in newspapers & online that is current price / most recent EPS (ignore future earning growth)

Question 14

2. 1. RV - P/E:
      - Value stocks : ? P/E ratio
      - Growth stocks: ? P/E ratio

Answer 14

2. 1. RV - P/E:
      - Value stocks : low P/E ratio
      - Growth stocks: high P/E ratio

Question 15

2.2. RV - P/CF:
- Firms can use accounting techniques to manipulate ?.
- Cash flow is less prone to manipulation & is important for fundamental valuation & in credit analysis:
P / CFi = ???

CF_(t+1) = expected cash flow per share

Answer 15

2.2. RV - Price to Cash Flow:
- Firms can use accounting techniques to manipulate earnings.
- Cash flow is less prone to manipulation & is important for fundamental valuation & in credit analysis:
P / CFi = Pt / CF_(t+1)
CF_(t+1) = expected cash flow per share

Question 16

–(less important) 2.3. RV - P/B ratio:
P / BVj = Pt / BV_(t+1)

BV_(t+1) = estimated end of year book value per share

? P/B ratio: lower excess returns
- widely used to measure bank values

Answer 16

– 2.3. RV - Price to Book ratio:
P / BVj = Pt / BV_(t+1)

Pt = end of year stock price
BV_(t+1) = estimated end of year book value per share

High P/B ratio: lower excess returns
- widely used to measure bank values

Question 17

–2.4. RV - Price to ? ratio:
Pj / Sj = Pt / S_(t+1)

Pt = end of year stock price
S_(t+1) = annual sales per share 

• strong consistent growth in sales is a requirement for ? companies.

Answer 17

–2.4. RV - Price to Sales ratio:
Pj / Sj = Pt / S_(t+1)

Pt = end of year stock price
S_(t+1) = annual sales per share 

• strong consistent growth in sales is a requirement for growth companies.

Question 18

2.5. RV - Return on capital: measure of ? with which assets are employed to generate income

• Return on ? (ROE): how much earnings firms can generate from $1 of equity capital invested:
  ROE = ???
• Return on ?? (ROCE): Return of capital of equity & debt investors:
  ROCE = ???

Answer 18

2.5. RV - Return on capital: measure of efficiency with which assets are employed to generate income

• Return on Equity (ROE): how much earnings firms can generate from $1 of equity capital invested:
  ROE = Profit after tax_(t+1) / Shareholders’ equity_t
• Return on Capital employed (ROCE): Return of capital of equity & debt investors:
  ROCE = Operating profit_(t+1) / Capital employed_t

Question 19

2. Implement RV:

- compare relative valuation ratio of a company to that of t’ market/ industry/ other firms in t’ industry

Answer 19

2. Implement RV:

- compare relative valuation ratio of a company to that of t’ market/ industry/ other firms in t’ industry

Question 20

2. RV - Empirical evidence:
   - Basu (1977): ? PE stocks offer higher returns
   - Fama & French (1996): returns are affected by ? & ? ratio.
   …

Answer 20

2. RV - Empirical evidence:
   - Basu (1977): low PE stocks offer higher returns
   - Fama & French (1996): returns are affected by size & BM ratio.
   …