Valuation of Bonds and Stocks Flashcards
Efficient Market Hypothesis (EMH)
all information about an investment is known to the market
Capitalization of income method of valuation
security’s value is equal to the value of its future payments and its principal discounted for present value.
Net Present Value (NPV)
Difference between intrinsic and market value/purchase price
Intrinsic value of bond
Present value of the bond discounted by the appropriate yield to maturity or required rate of return.
Intrinsic value of stock
Sum of present values of expected cash flows
IRR
Implied return, if greater than required return or market capitalization rate, then favorable.
Zero-growth model
future dividend remain at fixed amount, eg high grade preferred stock
Constant-growth model
dividends will grow at the same rate: D1=Dividend (D0 x (1+g))
How do analysts determine whether stock is under/overvalued?
-Underpriced if P/E <normal V/E
-Overpriced if P/E >normal V/E
How are Earnings per share (Et) related to dividends per share (Dt)?
Payout Ratio: Pt
Dt=(Pt)(Et)
Sustainable Growth Rate
ROE x Retention rate
g (sustainable growth rate) = Roe x b(retention ratio: 1-payout ratio)
Highest ROE and retention rate = greatest sustainable growth
What are the common developmental stages of a company with relation to earnings?
- Growth: rapidly expanding sales, high profit margins, high earnings per share
- Transitional: increased competition, reduced profit margins, slower earnings growth
- Maturity: new investment offers slightly attractive returns as earnings growth rate, payout ratio and return on equity stabilize
Estimate Intrinsic Value
PV of cash flows from growth stage + PV of cash flows of transition stage + PV of cash flows of maturity stage, where maturity stage would be constant growth model
When calculating the intrinsic value of a stock using expected earnings, which variables are used to replace dividends?
Payout ratio and expected earnings
What factor would be most consistent with a relatively high growth rate of firm earnings and dividends, with all other things being equal?
Low dividend payout ratio: Assuming that no new capital is obtained externally and no shares are repurchased, the portion of earnings not paid to stockholders as dividend will be used to pay for the firm’s new investments. The portion not paid out is the retention ratio. Growth rate depends on the proportion of earnings that are retained and the average return on equity for the earnings that are retained.
a stock’s “normal” price/earnings ratio will be higher if the following conditions are satisfied
The greater the expected payout ratios,
The greater the expected growth rates in earnings per share, and
The smaller the required rate of return.
Liquidity ratios
- Working Capital: current assets- current liabilities
- Current Ratio: current assets/current liabilities
- Quick Ratio (acid test): (current assets-inventory)/current liabilities
- Cash Ratio: (cash+marketable securities)/current liabilities
Activity ratios
- Inventory Turnover: COGS/Ave Inventory
- Days to Sell Inventory: 365/ Inventory Turnover
- A/R Turnover: Sales/Ave A/R
- Receivable Collection Period: 365/A/R Turnover
- Working Capital Turnover: Sales/Ave Working Capital
- Total Asset Turnover: Sales/Ave Total Assets
- Fixed (Net) Asset Turnover: Sales/Ave Fixed Assets
- Equity Turnover: Sales/Ave Equity
Profitability Ratios
- Gross Profit Margin: Gross Profit/Sales
- Operating Profit Margin: EBIT/Sales
- Net After Tax Profit Margin: EAT/Sales
- Net Before Tax Profit Margin: EBT/Sales
- Return on Assets (ROA)= EAT/Total Assets
- Return on Total Capital (ROTC)= (EAT + I)/Total Capital I=Interest expense and Total Capital=Total Assets?
- Return on Equity (ROE) = EAT/Equity
Debt/Solvency Ratios
- Total Debt to Equity: Total Liabilities/Equity
- Debt to Equity: Total LT Debt/ Equity
- Assets to Equity (leverage multiplier)= Total Assets/Equity
- Times Interest Earned - EBIT/I (I=Int Exp)
Decomposition of ROE (DuPont Method)
- Assets to Equity: Total Assets/Equity
- Asset Turnover: Sales/Total Assets
- Net After Tax Profit Margin: EAT/Sales
Three determinants of P/E ratio
A risk-adjusted discount rate that exceeds the stock’s average growth rate, k
A growth rate, g
A cash dividend payout ratio, D1/E1
Free cash flow
Company’s cash earnings from operations (net income + depreciation + amortization, adjusted for working capital changes) - plant, property and equipment purchases and dividend payouts: Gives clear idea of how much cash is available after capital spending
Price/Sales Ratio
Company’s price/sales or revenue
Good for analyzing large cap companies, less appropriate for service companies that don’t have sales
Price/Earnings Growth (PEG)
P/E / Projected expected earnings growth rate as a percent- works better for smaller/growth companies; however it is dependent on earnings estimates which are less reliable than free cash and revenue
Book value of company stock
(assets - liabilities)/common stock shares
Price to Book Value Ratio
Price/Book value ratio=Market price per share for stock i at time t/book value per share for stock i at time t (higher ROE increases stock’s PBV ratio) good for new company that is not publicly traded
Under the _____________________, the focus is on a time in the future (denoted by T), after which dividends are expected to grow at a constant rate (g)
Under the Multiple-Growth Model, the focus is on a time in the future (denoted by T), after which dividends are expected to grow at a constant rate (g).
The ______ of a company is forecasted based on the results of the Multiple Growth Model calculation.
Once investment analysts calculate a required rate of return, it is easy to compute various values required for determining the Multiple Growth Model. The intrinsic value of a company is forecasted based on these figures.
