Section B Flashcards
Give two reasons why the choice of accounting rules is still important
- Can influence the perception of the business’ performance by those performing the valuation, resulting in incorrect equity value
- More accurate accounting system will reflect more of the firm value in the book value than in the terminal value
Describe two limitations of the DDM
- Dividends are highly discretionary
2. Use of sotck buybacks to return funds to shareholders would imply to redefine “dividend”
Describe three weaknesses of FCF
- Must forecast statements according to a specific set of rules
- Variety of adjustments must be made to the forecasts of net income to estimate FCF
- Resulting FCF may be different than those used internally for planning purposes
Why is FCFE more appropriate than FCFF?
FCFF method requires an average cost of capital or an all-equity cost of capital. Policyholder liabilities make it difficult to precisely define either of these measures (how to account forthe policyholders liabilities)
Define Abnormal earnings
Portion of earnings above the required earnings, where the required earnings are based on the required rate of return for the firm
Describe tw obenefits of Abnormal earnigns method
- Use assumptions more directly tied to value creation than consequences of value creation (dividends and free cash flows)
Describe two adjustments that must be made to book value
- Intangible value must be removed
2. Eliminate systematic bias in asset/liability valuation
Describe how the terminal value is calculated in the abnormal earnings method
Assumes that they don’t continue in perpetuity and decline to zero as new competition enters the market to capture some of those abnormal earnings
What are the four uses of ratios
- Valuing firms (if no access to detailed data or horizon used stretch the limits of our forecasting ability)
- Validation of assumptions (be able to explain differences in ratios between comparable firms with key variables)
- Shortcut to valuation (when industry average performance is expected)
- Terminal value
Describe 1 advantage and 3 disadvantages of using transaction multiples to value firms (instead of market multiples)
**Trx multiples: are based on mergers and acquisitions instead of market prices and financial statments.
Advantage: price is based on a complex negotiation between two parties so multiples are more meaningful
Disadvantages:
- Control premiums: buyer may pay more to gain control
- Overpricing in M&A
- Reported financials: Reported multiples may not be accurate if they don’t reflect the buyer’s underlying assumptions (growth rates, ROE and k)
Price to book value
P/V = 1 + (ROE-k)/(k-g)
Price to Earnings (t=1)
P/E = (1-plowback ratio)/(k-g)
Define growth rate for DDM and FCFE
ROE*Plowback ratio
NI/Beginning Equity * Retained NI (NI-Dividends)/NI
ROE*Reinvestment rate
NI/Beginning Equity * Change in capital/NI
Difference between private valuation and equilibrium valuation
Equilibrium valuation assumes all investors have the same portfolio so investments have the same worth.
Private valuation considers the investor’s view of risk according to its portfolio.
Formula for discount rate
k = Risk free rate + Beta ( Market premium) k = Risk free rate + Beta (Market return - Risk free rate)
Two adjustements for Beta
- Mix of business
2. Financial leverage (reflect only business risk and not debt risk to make firms comparable)
Describe two choices for the Beta used
- Firm’s beta : Firm’s return vs market return
2. Industry beta
