LM 8: Equity Valuation: Concepts & Basic Tools Flashcards
What is the difference between market value and intrinsic value?
market value determined by market quotes and transactions
intrinsic value objective true value investors would get if they had all relevant quantitative and qualitative information
Will the intrinsic value be less than the market value or more than the market value for undervalued and overvalued securities?
undervalued = intrinsic value > market price
overvalued = intrinsic value < market price
fairly valued = intrinsic value = market price
What are the 3 major categories of equity valuation models? PMA
- Present Value Models (Discounted Cash Flow Models) (FCFE)
- Multiplier Models (Market Multiple Models)
- Asset-based Valuation Models
What is the difference between present value models and asset based valuation models?
present value models = intrinsic value is the present value of future benefits from the security.
asset based valuation models = intrinsic value is estimated as the market value of assets minus the estimated value of liabilities and preferred stock.
What are multiplier models?
Relative valuation of stock based on some fundamental multiplier of value like price to earnings, price to sales, etc.
What is the formula for asset based valuation models?
ABV intrinsic value = estimated value of assets - estimated value of liabilities - preferred shares
What is forward basis vs trailing basis?
forward basis = projected earnings per share next year
trailing basis = earnings per share for the past year
What is enterprise value formula?
EV = total market value of a company - cash and short-term investments
What is declaration date?
This is the day that the dividend’s authorization is announced.
What is ex-dividend date?
Starting this day, new owners will not be eligible to receive the previously declared dividend.
What is holder of record date?
On this day, the company records the list of owners who held shares at the close of trading on the day before the ex-dividend date.
What is payment date for dividends?
This is when the dividend is actually paid
What is extra special dividends vs liquidating dividend?
extra special = may be paid at any time outside the regular schedule, often when companies does well
liquidating dividend = paid to return capital to shareholders when a company goes out of business.
What are stock dividends?
grant extra shares to investors rather than cash
What is stock split vs reverse stock split?
Stock splits = increase the number of shares outstanding,
Reverse stock splits = reduce the number of shares outstanding
What is share repurchase?
Management can choose to repurchase shares if they believe that they are trading below their intrinsic value.
What is the basis of the dividend discount model?
intrinsic value of a share of stock = PV of expected future dividends
What is the formula for the dividend discount model?
v0 = (Dt / (1+r)^t) + (Pn / (1+r)^n)
v0 = intrinsic value of 1 share of stock
Dt = expected dividend in year t
r = require rate of return
Pn = expected selling price at end of investment horizon
How is free cash flow to equity valuation model different than dividend discount model?
FCFE = focuses on how much they can pay dividends
dividend discount model = focuses on expected dividends
What is FCFE formula?
FCFE = CFO - FCInv + Net Borrowing
CFO = cash flows from operations
FCInv = fixed capital investments
What is the intrinsic value of stock using the FCFE?
v0 = (FCFEt / (1+r)^t)
What is one method investors use to estimate R?
using CAPM
What is CAPM formula?
E (Ri) = Rf + Bi [E(Rm) - Rf)]
E (Ri) = expected return
Rf = risk free rate
Bi = beta, stock sensitivity to equity market
E(Rm) - Rf = market risk premium
E(Rm) = expected return of market
What is the preferred stock valuation formula, and the preferred stock valuation formula with a known maturity date?
preferred stock valuation = V0 = D0 /r
preferred stock valuation formula with a known maturity date = V0 = (Dt / (1+r)^t) + (F / (1+r)^n)
D0 & Dt = dividend
r = required rate of return
F = preferred stocks par value
What is a retraction option of preferred stock?
essentially a put option, allow investor to sell preferred stock back to issuer at a set price on a set date
What is the gordon growth model?
Gordon constant growth model (GGM) estimates future dividend payments by assuming a constant dividend growth rate (g
) and the required return on equity.
What is the formula for the gordon growth model, and the simplified formula?
v0 = D0 (1+g)^t / (1+r)^t
V0 = D0 (1+g)^t / (r-g)
D1 = dividend in next period
D0 = dividend now
r = required rate of return
g = growth rate
What is sustainable growth rate, and formula, and how is it used in the gordon growth model?
the maximum rate of growth that a company or social enterprise can sustain without having to finance growth with additional equity or debt
G = b (earnings retention rate) * ROE
used as the growth rate for gordon growth model
What is the formula for retention rate and return on equity for the gordon growth model?
retention rate = 1 - dividend payout ratio
ROE = net income / average total equity
What are price multiples?
ratios of the share price to some other value related to the relative worth of the company’s stock. eg. Price-to-earnings (P/E),
Price-to-book (P/B)
What is enterprise value formula?
EV=Market capitalization (common stock)+MV of preferred stock+MV of debt−(Cash+Short-term investments)
short term investments doesn’t include inventory or accounts receivable
What is asset base valuation?
uses difference between estimates of a company’s market value (fair value) of current assets & current liabilities
What is the law of one price and what equity model does it apply too?
states that identical assets should sell for the same price. In theory, a company trading at 14 times earnings is attractively priced compared to a similar company with a P/E ratio of 20.
applies to multiplier models or fundamental models
What is formula for intrinsic value of preferred share given issue rate, par value, and required rate of return?
Issue rate * par value for = annual dividend
Annual dividend/ required rate of return = stock price intrinsic value
What is EV/EBITDA?
enterprise value / EBITDA
used to determine fair market value of a company
When is it most appropriate to use Gordon growth vs two stage dividend discount model vs three stage dividend discount model?
Gordon growth: suited for mature companies
Two stage: companies transitioning from growth to mature stage
Three stage: young companies entering the growth phase
What is the ratio used to get P/E forward P/E from retention ratio, and growth rate?
D1/EPS / R-G
D1/EPS = payout ratio (1- earnings retention)
R = required rate of return
G = growth
