Valuation Exam Flashcards
Goal of investor
find strong businesses and invest them at reasonable prices
Market Capitalization
total market value of all the company’s outstanding stock (share price*number of shares outstanding)
Problem with Market Cap
measures only the market value of a company’s equity
Enterprise value
used to get around problem with market cap. Measures how much it would cost someone to buy out all the owners of a company, pay off all debts and take out any cash left over (Equity market cap + long-term debt - cash)
Basic Valutaion (two parts)
current value of all assets and liabilities, including buildings, employees, inventories and so forth
Value the profits the business is expected to make in the future
What types of companies use current value of assets and liabilities?
Mature, stable business with a lot of growth prospects (utilities and real estate companies)
What types of companies use the value of the future profits?
Younger, with a lot of growth potential (biotechnology companies)
Two approaches to equity valuation
Ratio-based approach (relative value)
Intrinsic value approach (fundamental analysis)
Downside of ratio-based approach
requires context (competitors, history, and other info)
Intrinsic Value
projecting future cash flows. Comparing the market price of a stock with the intrinsic value to see if it is overpriced, underpriced or fair
Advantages of Fundamental Analysis
relatively easy to understand and does not require as much context
Disadvantage of Fundamental Analysis
Estimating future cash flows requires time and effort
Most common stock valuation approach
ratios between a stock’s market price and an element of the underlying company’s performance (earnings, sales, book value…etc)
Price/Sales (P/S)
Stock price / Sales per share
Hard to bump up sales, so usually pretty honest. More stable benchmark and can be be used for companies that don’t have positive earnings
Drawbacks of P/S ratio
sales may be worth a little or a lot depending on the company’s profitability (big sales, but losing money on transactions)
Price/Book (P/B) ratio
Share price / BV (equity balance on a firm’s balance sheet / number of shares outstanding)
Advantages of P/B ratio
good for conservative investors because it’s more tangible than earnings (Benjamin Graham big advocate)
Ties in with ROE- higher ROE means higher P/B
Drawbacks of P/B ratio
CV of an asset on a company’s B/S may not reflect the true value
The BV of a company doesn’t always accurately measure its true worth (esp. intangible assets)
Price/Earning (P/E) Ratio
Stock price / EPS
most popular valuation ratio
The higher the P/E ratio means investors are willing to pay more for a dollar’s worth of a company’s earnings
Advantages of P/E ratio
accounting earnings are a much better proxy for cash flow than sales
EPS results and estimates are easily available
Ways to use P/E ratio
compare it to a certain benchmark (P/E of another company or historical P/E)
Better growth prospects, lower risk, and lower capital reinvestment means higher P/E
Drawback of P/E ratio
- It only becomes useful with context
- Analysis can be skewed when comparing to other companies or the industry (internet P/E might be lower than rest, but the rest are overvalued)
- Firms that have sold off a business recently can have inflated EPS which decreases P/E
- Reported earnings can sometimes be inflated by one-time accounting charges and gains
- Cyclical firms require more investigation
- two kinds of P/E (forward is always lower than the trailing), Wall Street can be too optimistic at times
Two kinds of P/E ratios
Trailing- last 4 quarters
Forward- next 4 quarters
Price/Earnings Growth (PEG)
Forward P/E ratio / 5-year EPS Growth Rate
linking P/E with the company’s growth rate
Drawbacks of PEG
- risk and growth often go hand in glove (fast-growing firms tend to be riskier than average)
- if using PEG ration alone you are assuming that all growth is equal
- firms that are able to generate growth with less capital should be more valuable, as should firms that take on less risk
EV/EBITDA
Enterprise Value / EBITDA
Unaffected by a company’s capital structure
Compares value of a business, free of debt, to earnings before interest
Use forecast profits rather than historical
Advantages of EV/EBITDA ratio
EV includes the cost of paying off debt. EBITDA measures profits before interest and before non-cash costs of depreciation and amortization
Drawbacks of EV/EBITDA ratio
It is harder to calculate than P/E
It does not take into account the cost of assets or the effects of tax
Inappropriate for comparisons of companies in different industries, as capital expenditure requirements are different
Yield-Based Valuation Models
We can invert P/E and get an earnings yield
Can be compared with alternative investments to see what return we can expect from each investment
Dividend Yield
Annual Dividend per share / market price
Drawbacks of Dividend Yield
- Must be careful of stocks with very high dividend yields because they might be going through financial problems that have plunged their stock price
- useless for companies that don’t pay a dividend (many technology stocks)
Cash Return
(Free Cash Flow + Net interest expense) / Enterprise Value
Free Cash Flow
Cash from operations - Capital expenditures
Net interest expense
Interest expense - interest income
Goal of Cash Return method
measure how efficiently the business is using its capital (equity and debt) to generate free cash flow
Advantages of Cash Return
Helps find cash cows trading at reasonable prices
Drawbacks of Cash Return
not very meaningful for banks and other firms that earn money via their balance sheets
Advantages of DCF model
Much more flexible than ratios
Allow an investor to incorporate assumptions about factors like growth prospects, whether its profit margins are likely to expand or contract
DCF Model
stock’s worth is equal to the present value of all its estimated future cash flows
-using future sales growth and profit margins
What to consider when predicting revenue growth
industry trends, economic data and competitive advantages
Operating Leverage
as a company grows larger, it is able to spread its fixed costs across a broader base of production
-should grow at a faster rate than revenue
What kind of cash flows are an investor going to be using?
Free cash flows
-used to be based on dividend but not every company pays dividends
Free Cash Flow
the cash a company has left over after spending the money necessary to keep the company growing at its current rate
-estimate how much the company reinvests itself each year via capital expenditures
Two types of DCF models
free cash flow to equity
cash flow to the firm
Free cash flow to equity
cash flow available to stockholders
Cash flow to the firm
cash flow available to both debt and equity holders (more complicated)
PV of CF in Year N
CF at Year N / (1+r)^N
Cost of Capital
rate used to discount a company’s future cash flows back to the present
-company raises capital form its lenders and owners, both of them require a return on their investment
Types of Cost of Capital
Low= stable, predictable company High= risky company (future cash flows are worth less)
WACC Formula
it accounts for both the firm’s cost of equity and debt
-(weight of debt)(cost of debt) + (weight of equity)(cost of equity)
Using Cash flow to the firm method
discounts operating earnings before interest but after taxes
-very complicated adjustments for interest and taxes
Cost of Debt
the interest rate a company must pay to borrow money, based on the current yield on any of the bonds the company has issued
Cost of Equity
determined by measuring the risk-free rate investors can achieve and an equity premium (determined by company’s stock volatility)
-calculation= CAPM
Risk factors for valuation (Fundamental risk premium)
- how cyclical the business is
- how big it is
- how much cash flow it generates
- strength of its balance sheet
- economic moat
Debt usually costs less than equity
True
-interest payments associated with debt are tax deductible
Perpetuity Value
estimate future cash flows for a certain period (5-10 years), then estimate the rest in one lump sum
Perpetuity Value Equation
Cash flow in last individual year estimated * (1 + g) / r - g
Step 1 of DCF Model
Project future cash flow
- look at historical data for the past 4 or 5 years
- project future cash flows
- estimate the company’s perpetuity year
Step 2 of DCF Model
Determine the discount rate
-come up with the assumed cost of equity
Step 3 of DCF Model
Discount Projected Free Cash Flows to Present
Step 4 of DCF Model
Calculate discounted perpetuity value (generally use 3%)
Step 5 of DCF Model
Add it all up then divide by the number of shares outstanding
Issues in Calculating EPS
EPS dilution
Underlying earnings
Normalized earnings
Differences in accounting methods
Methods of Comparables
Industry peers
Industry or sector index
Broad market index
Own historical values
Price to Book rationales and drawbacks
Book value usually > 0, more stable than EPS, appropriate for firms that will terminate and financial firms
Doesn’t recognize nonphysical assets, misleading if asset levels vary or differ from accounting practices, less useful when asset age differs
Issues in calculating Book values
intangible assets
Inventory accounting
Off-balance-sheet items
Fair value
Price to Sales Rationales and Drawbacks
Sales less easily distorted, sales always positive, P/S more stable than P/E, appropriate for many firms
-Sales does not equal earnings and cash flow, numerator and denominator not consistent, does not reflect cost differences
Measures of Cash flow
CF: Earnings + Depr. + Amortization + Depletion
CFO: from statement of cash flows
FCFE: most valid but volatile
EBITDA: best used with enterprise value
Dividend Yield Rationales and Drawbacks
- A component of return, dividends less risky than future capital gains
- Only one component of return, dividends may displace future earnings
Porter’s Competitive Advantage
New entrants, supplier power, buyer power, rivalry, substitutes
Issues in Financial Statement Analysis
Nonnumerical analysis Regression to the mean Mature Firms vs. Start-ups Sources of info Quality of Earnings
Stable Dividend Discount Model
Value of stock= DPS/(k-g)
Two-Stage Model
Project future dividends then find perpetuity value. Add discounted versions of both together to find the value of the stock
What you can use to determine FCFF
Net income, EBIT and EBITDA, Cash flow from operations
FCFF vs. FCFE
FCFF= Cash flow available to all firm capital providers
FCFE= Cash flow available to common equityholders
(FCFF is preferred when FCFE is negative or when capital structure is unstable)
Issues in FCF Analysis
- Financial statement discrepancies
- Dividends vs. FCF
- Shareholder cash flows and leverage
- FCFF and FCFE vs. EBITDA and net income
- Country adjustments
- Sensitivity analysis
- Nonoperating assets
Issues with Gordon Growth Model
- Non applicable to non-dividend-paying firms
- g must be constant
- stock value is very sensitive to r-g
- most firms have nonconstant growth in dividends
