Valuation Flashcards
What are the two approaches to valuation?
- Income Perspective
- Asset Perspective
Valuation in terms of the income perspective
Predict future earnings and cash flows based on the available information
Valuation in terms of the asset perspecitve
Measure of the firm’s net assets
(Assets-Liabilities=BV of Common Equity aka SHE)
Why are there differences in P/E ratios?
- Expected growth rates differ (different strategies, strengths, lines of business, managerial expertise)
- Risks of expected cash flows differ
- Earnings are computed differently (accounting policies: revenue recognition, depreciation, inventories) (accounting estimates: bad debts, warranties)
- Earnings contain transitory items
What is the average PE ratio for the market?
30
Price Earnings Ratio
Earnings per Share/Share Price
Basic net income per common share attributable to the company/Share Price
What does share price indicate?
It is determined partially by the shares outstanding, by looking at the share price alone we can’t tell anything (instead look at price relative to earnings)
What affect do stock splits have?
Increased number of shares, for an decreased share price
In isolation, per-share stock prices reflect…
the number of shares the company chooses to issue
What do companies believe about their stock when they issue a stock split?
They often believe that the stock will trade around the same as it was prior to the split
Walmart’s EPS was $1.81 and its share price was $47.8 - what is the PE ratio?
26.4
How do unusual and non-recurring items affect PE ratios?
PE ratios are based on reported income, investors use recuring income to value the firm’s assets and it’s stock price
Why does the economy-wide PE ratio change over time?
World events
(ex: .com bubble, real estate crisis, COVID, inflation, war, energy and food crisis, supply chain snags, central bank tightening)
What are the advantages of the PE approach?
- Quick screening tool
- Easily understood summary measure
- Widely used
What are disadvantages of the PE approach?
- Based on one year’s earnings
- Ignores many causes of PE differnce (ex: growth)
What is noncontrolling interest?
Equity owned by owners that aren’t common shareholders
Book Value Ratio
(Shares outstanding*Price per share)/Shareholder’s Equity
What does the price to book ratio represent?
- Market valuation of owners’ equity (net recorded assets) on the balance sheet
- “Net recorded assets”=Assets-Liabilities=BV of Owner’s Equity
Why might PE and PB ratios diverge?
Nonrecurring items
If the price-to-book ratio equals one what does that mean?
Accountants and investors perfectly agree on the value
What might a PB ratio of 0.65 imply?
Overstated assets
If the PB ratio is more than one..
it could imply conservative accounting or intangible assets
If the PB ratio is less than one…
Why is the PE ratio not meaningful when earnings are negative?
The PE ratio calculation assumes that current earnings are representative of future earnings and subject to expected growth and risk
Why to PB ratios vary?
- Expected growth rates
- Risk
- BV computations differ: accounting policies and estimates
- Some assets are not recorded (R&D assets and advertising are sometimes labeled as “goodwill”)
Why is the PB ratio ever less than one?
- Outdated book values overstate market value or liquidation value
- Asset values may have fallen below historical cost (outdated and misleading accounting numbers)
- Specialized assets with no ready markets
- Liquidation is not immediate -> takeover target
Why do some firms’ PB ratios sharply exceed one?
- Unrecorded assets
- Balance sheets focus on historical cost and miss “intangible assets”
- For example: managerial expertise and technological advantages ->high expected growth->investors value the assets at more than the assets acquisition cost
What are advantages of the price-to-book ratio?
- Summary measure focused on the balance sheet
What are disadvantages of the price-to-book ratio?
- Ignores differences in growth and risk
- Ignores accounting differences
Dividend Discount Model
P0=D1/1+re + D2/(1+re)^2 +… DT/(1+re)^T + PT/(1+re)^T
The dividend discounting model with predicted steady-state growth
- In steady state, earnings and book value grow at a constant rate
- The firm’s dividend payout is a constant percentage of earnings
- The firm’s return on equity is constant
How realistic is the steady-state concept? Do firms experience long periods of above-normal growth?
- Growth is theoretically limited by the size and growth of the firm’s market
- Empirical evidence suggests that most firms only expeirence a few years of above-normal or below-normal growth
Outstanding shares
the number of shares held by investors
Shares Issued - Treasury Stock = Outstanding Shares
Authorized shares
The maximum number of shares the company can issue
Par Value
Historical fiction
Capital Surplus
APIC
Reinvested earnings
Retained earnings
Treasury stock
Stock bought back by the company from the shareholders
What do you do to find dividends in the dividend discount model?
Include all payments to and from shareholders (Issuance of Common Stock, Purchases of Treasury Stock, Dividends)
The dividend and earnings predictions are fundamentally different
Dividends: The board of directors could adopt whatever dividend policy they choose
Earnings: Economic performance achieved given its strengths and competitors’ actions
Clean Surplus
The only changes in SHE are from earnings and payments to and from shareholders
Dirty Surplus Items
- Adoption of accounting standards
- Other comprehensive loss
- Foreign currency translation
- Other activities
Payments to/from shareholders
Dividends
+Treasury Stock
- Issuance of Stock
- Proceeds from Stock Options
If the discount rate falls or the growth rate increases what happens to the PV of all future dividends?
It increases
Market value only exceeds book value if…
Residual income is positive, or if ROE exceeds the cost of capital
Market-to-book value only exceeds 1 if…
ROE exceeds the cost of capital
