Valuation principles and practices

Question 1

Valuation

Answer 1

Refers to the process of finding the fair-value of an asset. Also called the intrinsic or estimated value of an asset

Question 2

Par value / Face Value

Answer 2

Refers to the arbitrarily assigned value of an financial asset

The value at which an financial asset is originally issued in the primary market

Question 3

Market value

Answer 3

Determined by what buyers are prepared to offers and what sellers are willing to accept in the secondary markets

Question 4

Market value added

Answer 4

The amount by which the ordinary shares of a firm have increased in market value a certain period

Question 5

Market capitalization

Answer 5

The number of shares which have been issued by a firm multiplied by the market value per share

Question 6

Book value for fixed assets

Answer 6

Cost minus accumulated depreciation

Question 7

Book value for equities

Answer 7

Par value per share times the number of shares issued, plus cumulative retained earnings, plus capital contributed in excess of par

Question 8

Fair (intrinsic) value

Answer 8

The value of an asset is the present value of all future cashflows the asset is expected to generate

Question 9

Inputs required for a cashflow model

Answer 9

• Cash Flows
• Timings of cash flows
• Discount rate / required rate of return
• In some equity models a growth rate

Question 10

Bonds (vanilla bond)

Answer 10

• Long term debt financing
• Enable companies to borrow money from a diverse group of lenders for periods (maturities) ranging from 10 to 20 years
• Normally interest is paid semi-annually
• Normally the principal is only paid at the end of the term

Question 11

Yield to maturity

Answer 11

Refers to the rate of return investors earn if they buy a bond at a specific price and hold it till maturity

YTM of bond with current value equal to its par value will be equal to its coupon rate

Question 12

Required return vs coupon rate

Answer 12

if required return > coupon rate, then bond value will be less than its par value

if required return < coupon rate, then bond value will be greater than its par value

if required return == coupon rate, then bond value will be equal to its par value

Question 13

Preference share

Answer 13

In its simplest form a preference share pays a coupon for a unlimited period of time

Question 14

Limitations of the constant growth / Gordon growth / Dividend discount model

Assumptions of the model

Answer 14

• Relevant only to firms growing at a constant rate
• As the growth rate converges with the discount rate, the value goes to infinity
• If the growth rate is greater than the required rate of return then the share value cannot be determined

Question 15

The constant growth / Gordon growth / Dividend discount model is appropriate for a firm with the following features:

Answer 15

• Stable earnings growth rate at or below nominal growth rate in the economy
• Well established dividend payout policy that is likely to continue in the future
• A payout ratio consistent with with the assumption of stability
• Stable leverage and beta

Question 16

Two-stage dividend discount model

Answer 16

Makes provision for two stages of growth

• An initial phase of extraordinary growth
• A subsequent steady state of no growth or stable growth

Question 17

Limitations of the two-stage DDM

Answer 17

• Defining the length of the high growth period is problematic
• Unrealistic growth assumptions are made
• The value estimate is highly sensitive to assumptions about the stable growth rate

Question 18

Where is the two-stage DDM suited

Answer 18

Companies with high growth, but where the sources of growth are expected to disappear

Question 19

Price-earnings ratio

Answer 19

Indicates the Rand amount an investor can expect to invest in a company in order to receive one Rand of that company’s earnings