Valuing Stocks Flashcards
What are the two potential sources of casdh flows from owning a stock?
-Dividend payments
-Selling shares at a future date
When would an investor be willing to sell a stock?
P(0) >= (Div1+P1)/ 1+rE
When would an investor be willing to buy a stock?
P(0) <= (Div1+P1)/ 1+rE
Why must buying or selling shares be a 0-NPV investment opportunity?
-For every buyer there must be a seller
-Both equations must hold
-P(0)= (Div1+P1)/1+rE
What is the equation for return of a stock?
-rE= Div1/P(0) +(P1-P0)/P0
-Term on the left is the dividend yield
-Term on the right is the capital gain rate
What is the return of a stock equal to?
The equity cost of capital
What is the price of a stock with a 1 year investment horizon?
-P1=(Div1+P2)/ 1+rE
-P0= Div1/(1+rE) +(Div2+P2)/(1+rE)^2
What is the equation for the dividend discount model?
P0= Div1/(1+rE)+ Div2/ (1+rE)^2+DivN/(1+rE)^N+PN/(1+rE)^N
How does the dividend discount model change if there is constant dividend growth?
-P0=Div1/ (rE-g)
-rE=(Div1/P0) +g
-This shows that the growth rate is equal to the capital gain rate
How would a firm maximise share price?
-Increase the current dividend level
-Increase the expected growth rate
What is the trade off between dividends and growth?
Increasing growth requires investment which decreases current dividends
What is the simple model of growth?
-The dividend payout rate is a fraction of earnings a firm pays as dividends
-Div(t)= (Earnings(t)/ Shares Outstanding(t))* Dividend Payout Rate(t)
-Firm can pay earnings to investors or invest earnings to increase future earnings and dividends
-No investment = no growth
-All increases in future earnings result directly from investment
What is the sustainable growth rate under the simple model of growth?
-The growth rate that a firm can achieve using only retained earnings
-Change in Earnings = New Investment * Return on New Investment
-New Investment= Earnings * Retention Rate
-Earnings Growth Rate=Change in Earnings/ Earnings= Retention Rate * Return on New Investment
-g= Retention Rate * Return on New Investment
When will increased investment raise stock price?
Only when the investments have a positive NOV
What is the Dividend-Discount Model with constant long term growth?
-P0 = Div1/1+rE + Dov2(1+rE)^2+ [1/(1+rE)^N][DivN+1/rE-g]
-Most applicable to fledgling firms with high growth rates
-Often retain all earnings to exploit profitable investment opportunities
-Apply a terminal value multiplier at end
What are the limitations of the Dividend-Discount model?
-Large amount of uncertainty associated with forecasts
-Small changes in the assumed dividend growth rate can cause large changes in the estimated stock price
-It is difficult to know which is the most reliable estimate of dividend growth rate
What is the Total Payout Model?
-Ignores a firm’s choice between dividends and share repurchases
-P0= PV(Future Total Dividends and Repurchases)/ Shares Outstanding
-Constant growth rate modification can be applied
-Discount total dividends and share repurchases and use the growth rate of total earnings
What implications do share repurchases for the dividend-discount model?
-The more cash a firm uses to repurchase shares the less it has available to pay dividends
-Repurchasing shares decreases its share count which increases earnings and dividends per share
What is the Discounted Free Cashflow Model?
-Avoids estimating the impact of a firm’s leveraging on its earnings
-Enterprise Value = Market Value of Equity + Debt - Cash
What are the steps of valuing stocks using the DCF Method?
- Calculate the future free cash flows of the firm
- Free Cash Flow= EBIT(1- tax rate) + Depreciation- CAPEX- Increases in Net Working Capital
- Calculate the terminal value of the firm
- Vn= (FCF (N+1))/ (rWACC-gFCF) = [(1+gFCF)/(rWACC-gFCF)]*FCFN
- Sum with discounting for the weighted average cost of capital
- V0= FCF1/ (1+rWACC) + FCF2/ (1+rWACC)^2 + FCFN+VN/ (1+rWACC)^N
What are the Price-Earnings Ratio valuation multiples?
-Share Price/ EPS
-Forward P/E = P0/EPS1= [(Div1/EPS1)/rE-g]= Dividend Payout Rate / rE-g
What is the EV multiple?
-V0/EBITDA= [(FCF1/EBITDA1)/ rWACC- gFCF)]
What are the limitations of multiples?
-Does not take into account the important differences among firms
-Can only provide information regarding the value of the firm relative to other firms in the comparison set
What are the pros and cons of using multiples vs DCF?
-Multiples approach not based off forecasts
-DCF can incorporate firm-specific information
-DCF have the potential to be more insightful and accurate than a valuation multiple
What is the efficient market hypothesis?
Competition among investors works to eliminate all positive-NPV trading opportunities
