Reading 41: Equity Valuation: Concepts and Basic Tools Flashcards
Identify the advantages of price to sales.
Sales are less prone to manipulation by management than earnings and book values.
Sales are positive even when EPS is negative.
The P/S ratio is usually more stable than the P/E ratio.
Price to sales is considered an appropriate measure for valuing mature, cyclical, and loss-making companies.
Studies have shown that differences in price to sales ratios are related to differences in long-term average returns on stocks.
Explain the disadvantages of price to book value.
Book values ignore nonphysical assets such as the quality of a company’s human capital and brand image.
P/BV can lead to misleading valuations if significantly different levels of assets are being used by the companies being studied.
Accounting differences can impair the comparability of P/BV ratios across companies.
Describe why the assumptions of the infinite-period DDM do not hold for growth companies.
They do not have a constant dividend growth rate. The growth rate of dividends can be impressively high, but only for a temporary period. Eventually, competition catches up with these firms, and their growth rate slows down.
In addition, during periods when they experience extremely high growth rates, their growth rate can exceed the cost of equity.
List the chronology of a dividend payment.
Declaration date
Ex-dividend date
Holder-of-record date
Payment date
Describe the free-cash-flow-to-equity (FCFE) mode and give the formula.
Many analysts assert that a company’s dividend-paying capacity should be reflected in its cash flow estimates instead of estimated future dividends. FCFE is a measure of dividend-paying capacity and can also be used to value companies that currently do not make any dividend payments.
FCFE = CFO − FC Inv + Net borrowing
List the advantages and disadvantages of the price to earnings ratio.
Advantages:
Earnings are key drivers of stock value.
Simple to calculate and widely used in the industry.
Empirical research shows differences in ratios are significantly related to long-term stock returns.
Disadvantages:
Companies with losses have negative EPS and P/Es, which are useless for comparisons.
Earnings of some companies are volatile, which make it challenging to determine a fundamental stock value.
Management can use different accounting assumptions, which reduces the comparability of P/E ratios across companies.
How is EBITDA used?
As a proxy for operating cash flow, as it excludes noncash depreciation and amortization expenses. However, it may include other noncash expenses and revenues.
Describe an infinite period and multistage Dividend Discount Model (DDM).
The infinite period dividend discount model assumes that a company will continue to pay dividends for an infinite number of periods. It also assumes that the dividend stream will grow at a constant rate (gc) into the future.
P0=D1r/g
The multistage DDM combines the multi-period and infinite-period dividend discount models.
Why can’t a company pay out a dividend in the Gordon growth model?
It has a lot of lucrative investment opportunities available, and it wants to retain profits to reinvest them in the business.
It does not have sufficient excess cash flow to pay out a dividend.
List the advantages and disadvantages of price to cash flow.
Advantages:
Cash flows less prone to management manipulation than earnings
More stable than the P/E ratio
Reduces differences in accounting methods used by companies
Differences in price to cash flow ratios over time are related to differences in long-term average returns on stocks
Disadvantages:
When “EPS plus noncash charges” is used as the definition for cash flow, noncash revenue and changes in working capital items are ignored
Free cash flow is more appropriate for valuing a company than cash flow
For what companies does asset-based valuation work well?
Companies that do not have a significant number of intangible or “off-the-book” assets, and have a higher proportion of current assets and liabilities.
Private companies, especially if applied together with multiplier models.
Financial companies, natural resource companies, and companies that are being liquidated.
Identify the major categories of equity valuation models.
Present value models (also known as discounted cash flow models)
Multiplier models
Asset-based valuation models
Define price multiples and give a common criticism of them.
They are ratios that compare the price of a stock to some sort of value. Price multiples allow an analyst to evaluate the relative worth of a company’s stock.
They do not consider the future, in that their values are calculated from trailing or current values of the divisor.
Explain stock splits and reverse stock splits.
A stock split is similar to a stock dividend, as it has no economic effect on the company or shareholders. The stock split results in an increase in the number of shares outstanding and a consequent decrease in share price.
The reverse stock split involves a reduction in the number of shares outstanding with a corresponding increase in share price.
