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BU.232.701.32 Investments > Module 3: Equity Valuation and The Capital Asset Pricing Model > Flashcards

Module 3: Equity Valuation and The Capital Asset Pricing Model Flashcards

1
Q

What are the two core sets of assumptions of the Capital Asset Pricing Model (CAPM)?

A
  1. Individual Behavior
    a. Investors are rational, mean-variance optimizers.
    b. Their common planning horizon is a single period
    c.   Investors all use identical input lists, an assumption often termed homogeneous expectations. Homogeneous expectations are consistent with the assumption that all relevant information is publicly available.
  2. Market structure
    a. All assets are publicly held and trade on public exchanges.
    b. Investors can borrow or lend at a common risk-free rate, and they can take short positions on traded securities.
    c. No taxes.
    d. No trading costs.
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2
Q

What is the market portfolio under CAPM?

A

Aggregation of all investors’ risky portfolios, each of which is identical, it too will have those same weights. The value-weighted portfolio of all assets in the
investable universe.

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3
Q

What is the mutual fund theorem?

A

If all investors would freely choose to hold the market portfolio, they would not object if all stocks
were replaced with shares of a single mutual fund holding that market portfolio.

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4
Q

Why would someone invest in an index fund?

A

Broad diversification, low costs, solid returns.

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5
Q

What is the market price of risk?

A

E(Rm)/σ​^2
 ​​

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6
Q

What is the risk to reward ratio for investments in GE?

A

E(Rge)/Cov(Rge, Rm)

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7
Q

What is meant by beta?

A

The ratio Cov(R​ge​​ , ​ Rm​​)​ / ​σ^2m

Measures the contribution of GE stock to the variance of the market portfolio as a fraction of the total variance of the market portfolio.

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8
Q

What is the expected return–beta relationship?

A

The total expected rate of return is the sum of the risk-free rate (compensation for “waiting,” i.e., the time value of money) plus a risk premium (compensation for “worrying,” specifically about investment returns)

Makes specific prediction of the size of the risk premium (benchmark risk premium * Beta)

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9
Q

What is the security market line?

A

Graphs individual asset risk premiums as a function of asset risk. Valid for both efficient portfolios and individual assets.

Offers a benchmark for the evaluation of investment performance. It provides the expected rate of return investors demand as compensation for both beta risk as well as the time value of money

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10
Q

What does the alpha of a stock represent?

A

Difference between the equilibrium and actually expected rate of return on a stock

A positive alpha implies reward without risk.

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11
Q

What does the CAPM offer for a new project?

A

Provide the required rate of return that the project needs to yield, based on its beta, to be acceptable to investors.

Can obtain a cutoff internal rate of return (IRR), or “hurdle rate,”

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12
Q

What does the CAPM predict?

A

The prediction of the CAPM is that for every stock, the equilibrium value of αi is 0.

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13
Q

Why are short sales important?

A

When prices rise above intrinsic values, rational inves-
tors will take short positions, thus holding down the price

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14
Q

What is a zero-beta portfolio?

A

a “companion” portfolio on the bottom (inefficient) half of the frontier with which it is uncorrelated

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15
Q

How do risk tolerant investors leverage?

A

Up their position in the tangency of their portfolio.

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16
Q

What is the Merton ICAMPM expected return-beta equation?

A

E ( R​  i​​ ) = β​  iM​​ E ( R​  M​​ ) + ​ ∑​​ ​ β​  ik​​ E ( R​  k​​ )​​

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17
Q

What is the consumption CAPM?

A

the portfolio with the highest correlation with
consumption growth; βiC is the slope coefficient in the regression of asset i’s excess returns,
Ri , on those of the consumption-tracking portfolio; and, finally, RPC is the risk premium
associated with consumption uncertainty, which is measured by the expected excess return
on the consumption-tracking portfolio

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18
Q

What is meant by liquidity?

A

Ease and speed an asset can be sold at fair market value.

Can affect prices when reduced and affects others at a systemic level depending on exposure. Modifies stock beta.

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19
Q

What is the intrinsic value of a stock?

A

True value derived from financial data. (V0)

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20
Q

What is the ratio of market to book value of a stock?

A

the net worth of the company as reported on the balance sheet

21
Q

What are limitations of the book value?

A

The book value of an asset equals the original cost of acquisition less some adjustment for depreciation, even if the market price of that asset has changed over
time. Moreover, depreciation allowances reflect the original cost of the asset rather than loss of actual value.

22
Q

What is a better measure for a stock floor price?

A

The liquidation value per share.

This is the amount of money that could be realized by breaking up the firm, selling its assets, repaying its debt, and distributing the remainder to the shareholders.

23
Q

What is the replacement cost?

A

Firm value of assets less liabilities. If firm above this value for too long than competitors enter the market.

24
Q

What is the Tobin q?

A

Ratio of market price to replacement cost.

25
Q

How is the expected holding period return calculated?

A

Expected HPR = E(r) =
E(D1) + [E(P1) − P0]
__________________
P0

26
Q

But what rate of return do investors require of a given stock?

A

The CAPM may be viewed as providing an estimate of the rate of return an investor can reasonably expect to earn on a security given its risk as measured
by beta

27
Q

What does it mean if a stock is priced correctly?

A

expected return will equal its required return

28
Q

What is the market capitalization rate?

A

consensus value of the required rate of return, k,

29
Q

What is the dividend discount model of stock prices?

A

The DDM asserts that stock prices are determined ultimately by the cash flows accruing to stockholders, and those are dividends

V0 =
D1
_____
1 + k
 ​​ +
D2
_______
(1 + k)2 ​​ +
D3
_______
(1 + k)3 ​​ + …

30
Q

How is the constant-growth DDM estimated?

A

V0

Aka Gordon Model, generalizes the perpetuity formula for the case of a growing perpetuity

D0(1 + g)
_________
k − g
 ​​ =
D1
_____
k − g
 ​​

31
Q

What are the implications of the constant growth rate DDM for greater stock values?

A
  1. The larger its expected dividend per share.
  2. The lower the market capitalization rate, k.
  3. The higher the expected growth rate of dividends.
32
Q

What is the discounted cash flow formula?

A

E(r) = Dividend yield + Capital gains yield

D1
___
P0 ​​ +
P1 − P0
_______
P0 ​​
=
D1
___
P0 ​​ + g

33
Q

What is the dividend payout ratio?

A

The fraction of earnings paid out as dividends

34
Q

What is the plowback ratio?

A

The fraction of earnings reinvested in the firm. Aka earnings retention ratio.

35
Q

What is the present value of growth opportunities?

A

Investment opportunities have positive net pres-
ent value, and the value of the firm rises by that NPV

Used to get price:

Price = No-growth value per share + PVGO
P0
=
E1
___
k
 ​​ + PVGO

36
Q

What is a two-stage dividend discount model allow for?

A

An initial high-growth period before the firm settles down to a sustainable growth trajectory.

37
Q

What is a price-earnings multiple?

A

The ratio of price per share to earnings per share, commonly called the P/E ratio. Reflects the market’s optimism concerning a firm’s growth prospect

P0
___
E1 ​​ =
1
__
k
*
 ​​​ (1 +
PVGO
_________
E / k
 ​ )​​

or

P0
___
E1 ​​
=
1 − b
___________
k − ROE × b
 ​​

38
Q

What is the Wall Street rule of thumb on why P/E ratios are proxies for expected growth in dividends or earnings?

A

Growth rate ought to be roughly equal to the P/E ratio.

The ratio of P/E to g, often called the PEG ratio, should be about 1.0.

Peter Lynch:
“The p/e ratio of any company that’s fairly priced will equal its growth rate. I’m talking here about growth rate of earnings here. . . . If the p/e ratio of Coca Cola is 15, you’d expect the company to be growing at about 15% per year, etc. But if the p/e ratio is less than the growth rate, you may have found yourself a bargain.”

39
Q

What is the importance of growth opportunity in valuation of a start up?

A

Growth prospects are intrinsically difficult to tie down; ultimately, however, those prospects drive the value of the most dynamic firms in the economy.

40
Q

What are the limitations of p/e analysis?

A

P/E ratios generally have been inversely related to the inflation rate

41
Q

What is a forward P/E?

A

Ratio of today’s price to the trend value of future earnings.

Different from trailing p/e: ratio of price to the most recent past accounting earnings.

42
Q

Why are cyclically adjusted P/E ratios important?

A

avoid the problems associated with using P/E ratios over different phases of the business cycle

43
Q

Do conventional P/E differ for different sectors?

A

Yes and they should be used to reference the type of business a given firm operates in.

44
Q

What is the free cash flow to the firm?

A

the after-tax cash flow generated by the firm’s
operations, net of investments in fixed as well as working capital.

FCFF = EBIT(1 − tc ) + Depreciation − Capital expenditures − Increase in NWC

45
Q

What is the free cash flow to the equity holders?

A

FCFE = FCFF − Interest expense × (1 − tc ) + Increases in net debt

46
Q

How can a firm value be derived from free cash flow?

A

Firm value = ​​  ∑
t=1
T
FCFFt
____________
(1 + WACC)t ​​ +
VT
____________
(1 + WACC)T ​​ , where VT =
FCFFT + 1
__________
WACC − g
 ​​

47
Q

How can the equity value be found using the free cash flow?

A

Intrinsic value of equity = ​​ ∑
t=1
T
FCFEt
________
(1 + kE )t +
ET
________
(1 + kE)T

where ET =
FCFET +1
________
kE − g ​​

48
Q

How do value investors view hierarchy of firm valuation?

A

They view the most reliable components of value as the items on the balance sheet that, in principle, can be sold and for which estimates of market value are readily available

49
Q
A

BU.232.701.32 Investments (3 decks)

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