Topic 6 Security Analysis Flashcards
Book value
- Net worth of a company as reported on its balance sheet
- Book value of an asset equals the original cost of acquisition less some amount for depreciation. Depreciation allocates costs over several years but does not reflect loss of actual value
Market value
MV of a firm’s equity investment equals the difference between current values of all assets and liabilities.
MV reflects value of the firm as a going concern (may include value of brand name or specialty expertise)
Liquidation value
A measure of a floor for the stock price
Represents amount of money that could be realized by breaking up the firm, selling its assets, repaying the debt and distributing the remainder to shareholders
Ways of valuing a company
- Book value
- Market value
- Liquidation value
- Replacement cost
What is intrinsic value
Intrinsic value is the PV of all cash payments to the investor in the stock, incl divs and ultimate sale price, discounted at the appropriate discount rate.
In market equilibrium the current market price reflects?
Reflects the intrinsic value estimates of all market participants
What is the market capitalization rate
Market capitalization rate is the market consensus value of the required rate of return (k)
Name issues with dividend discount models
- No divs
- Issues with constant growth DDM
- Substantial change to the organization , eg mergers and acquisitions.
- If no dividend is expected, then the model implies the stock has no value. Need to adjust
- Constant growth DDM is valid only when g (growth) is less than the k (required rate of return). Otherwise value of stock is infinite
Solution may be multistage DDM
Constant growth DDM implies that a stock’s value is greater when:
- The larger its expected dividend per share
- The lower the market capitalization rate k
- The higher the expected growth rate of dividends
What is the plough back ratio
Plough back ratio is the fraction of earnings invested with the firm
Also known as the earnings retention ratio
What is the dividend payout ratio
Div payout ratio is the fraction of earnings paid out as dividends
Define present value of growth opportunities (PVGO)
Value of the firm rises by the NPV of the investment opportunities.
Value of the firm =
No growth value of the firm plus the present value of growth opportunities (PVGO)
Explain why growth per se is not what investors desire
- Growth enhances company value only when achieved by investments in attractive opportunities ie ROE greater than k.
When is a firm subject to takeover offer
A firm is subject to takeover offer when the PVGO is negative. That is, when the NPV of a firms projects is negative, the rate of return on those assets is less than the cost of capital. Another firm can therefore purchase and change the investment policy.
Return on Assets measures…
ROA measures income per dollar of total assets, regardless of whether debt or equity is used
Estimate market return (use as an input to CAPM)
Market return=risk free rate + market risk premium
CAPM = r(f) + B(E(rm) - rf)
= k
Issues:
- Estimates of inputs. If wrong, estimate of intrinsic value can be altered substantially
- Highlights the need for sensitivity analysis
Multi stage DDM (define)
Multi stage DDM captures the way projected growth may change significantly of different stages of a company’s life.
Estimate shirt to medium term growth, then use constant growth DDM to estimate contribution to intrinsic value made by long term growth.
Price Earnings Multiple (define) (aka PE ratio)
Ratio of price per share to earnings per share
May serve as useful indicator of expectations of future growth opportunities
High PE can indicate that a firm enjoys ample growth opportunity, rather than that a higher relative PE means a firm is overpriced.
Plow back ratio and the PE ratio (3)
- The higher the plough back rate, the higher the growth rate
- BUT a higher plough back rate does not necessarily mean a higher PE ratio.
- PE ratio increases only if investments undertaken offer a higher expected return than the market capitalization rate(otherwise more money goes to projects with inadequate rates of return)
P/E ratios
- Low PE ratios can represent good value as long as they are low relative to expected growth
- DDM equation can imply that low PE ratio could reflect relatively high required return (k)
- high required return correspond to high levels of systematic exposure (ie beta)
- high returns observed on low PE stocks could be attributed to risk premium for the higher risks they represent
Pitfalls of PE
- Denominator is accounting earnings. These are influenced by historical cost in depreciation and inventory valuation. Inflation can distort
- Earnings management (using accounting rules to improve apparent profitability of the firm)
- Business cycle: model assumes a smooth trend line growth rate whereas reported earnings can fluctuate dramatically around a trend line. DDM looks at economic earnings, but reported earnings are computed based on generally accepted accounting principles.
- Note PE ratios vary across industries. Those with lower PEs are generally more mature
Comparative ratios
- PE
- PV
- Price to Cash Flow (cashflows in and out of company less likely to be affected by accounting decisions. Can use operating cash flow, or free cash flow
- Price to Sales (note profit margins vary widely, but can be useful for start ups)
Name 2 factors that have substantial impact on stock prices
- Interest rates
2. Corporate profits