Valuation of Stocks and Bonds Flashcards
Zero-Growth Model
Makes the assumption that the dividend per share will not change over time.
In this model the:
Value of the stock is equal to Dividend / Required Rate of return.
IRR = Dividend / Stock price
Where does the Zero-Dividend model work
Preferred stock valuation. Since, the same dividend is paid year over year.
Constant-Growth Model
The constant-growth model assumes that dividends will grow from period to period at the same rate forever. Specifically, the dividends per share that were paid over the previous year (D0) are expected to grow at a given rate (g), so that the dividends expected over the next year (D1) are expected to be equal to D0(1+g). Dividends the year after that are again expected to grow by the same rate g, meaning that D2=D1(1+g)
.
Stating that D1=D0(1+g)
and that the growth rate is constant is equivalent to assuming that D2=D0(1+g)(1+g)
and, in general:
Dt=Dt−1(1+g)=D0(1+g)(1+g)(1+g)….t
NPV for Constant Dividend Growth Stock
V = D0 (1+g) / (k−g)
or V = D1 / (k−g)
because D1 = D0/(1+g)
IRR for Constant Dividend Growth Stock
IRR = (1st Year Dividend / Value of Stock+ + Growth Rate or
r = (D1 / P) + g
Multiple-Growth Model
A more general DDM for valuing common stocks is the multiple-growth model. With this 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).
Advantage of Multiple-Growth Model
The most realistic of the dividend discount models is the two-stage model because it is the only one that allows for a fast growth phase where g>k
, followed by a “normal” phase where k>g
Liquidity Ratios
Liquidity ratios provide information about the liquidity or short-term debt paying ability of the firm. These are the common ones you should be familiar with.
Working Capital = current assets - current liabilities
Current Ratio = current assets / current liabilities
Quick Ratio = (current assets - inventory) / current liabilities. (This ratio is also known as the acid test.)
Cash Ratio = (cash + marketable securities) / current liabilities
Activity Ratios
Activity ratios measure the firm’s operating efficiency. They show how efficiently management is using the assets at their disposal.
Inventory Turnover = Cost of Goods Sold / Average Inventory
Days to Sell Inventory = 365 / Inventory Turnover
Accounts Receivable Turnover = Sales / Average Accounts Receivable
Receivable Collection Period = 365 / Accounts Receivable Turnover
Working Capital Turnover = Sales / Average Working Capital
Total Asset Turnover = Sales / Average Total Assets
Fixed Asset Turnover = Sales / Average Fixed Assets
Equity Turnover = Sales / Average 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 (Where I = Interest Expense)
Return on Equity (ROE) = EAT / Equity
Debt Ratios
Debt (or Solvency) ratios measure the financial strength of the firm. Creditors are very interested in these ratios. Bankruptcy is actually predictable when a firm meets certain criteria in relation to deteriorating solvency ratios.
Total Debt to Equity = Total Liabilities / Equity
Debt to Equity = Total Long-term Debt / Equity
Assets to Equity (leverage multiplier) = Total Assets / Equity
Times Interest Earned = EBIT/I (Where I = Interest Expense)
Decomposition of ROE
Asset to Equity Ratio * Asset Turnover Ratio * Net After Tax Profit Margin
OR
(Total Assets / Equity) * (Sales / Total Assets) * (EAT / Sales)
Price/Earnings Growth (PEG)
The PEG ratio helps quantify this idea. PEG stands for price/earnings growth and is calculated by dividing the P/E by the projected earnings growth rate. So if a company has a P/E of 15, and analysts expect its earnings will grow 10% annually over the next few years, its PEG = 1.5. The best use of the PEG ratio is on a comparative basis. Once calculated, the PEG should be compared to the industry peers or other investments under consideration. Historically, many investors have relied on the view that a PEG under 1 is good and over 1 is not as good. This view is not as useful as comparative analysis.
If a company has a P/E of 20 times its earnings, but its peers have a P/E of 10 times, it may appear that the company is expensive relative to its peers. However, if the company’s growth rate is at 25% while its competitors are averaging 8%, then the company’s PEG is .80 while its competitors are at 1.25. This will lead to the conclusion that the company’s expected growth rate makes it more attractive than its competitors even though it had a higher P/E.
Book Value
The book value of company stock is equal to assets less liabilities, divided by the number of shares of common stock of a company.
Common stock market price
Common stock market price is shaped by the market’s assessment of its earning power.
