Week 10 - Equity Evaluation Model

Question 1

What is Fundamental Analysis?

Answer 1

Models company value via assessing current and future probability

PURPOSE: Identify Mispriced Stocks

Question 2

What is Valuation by comparables?

Answer 2

Compare valuation ratios of firm to industry avg

Question 3

What are the some of the ways to value firms?

Answer 3

Ratios like price/sales are useful for valuing start-ups that have yet to generate positive earnings.

Book Values based on historical cost, not actual mkt values

Question 4

What is the ‘Floor’?

Answer 4

Liquidation value per share

-> Book value can be floor

Question 5

What is the Tobin’s q?

Answer 5

Ratio of market price to

replacement cost.

Question 6

How do you calculate Expected HPR (Holding Period Return)?

Answer 6

Expected HPR = E(r) = E(D1)+ [E(P1) − P0]/ P0

Question 7

What is the required return?

Answer 7

If priced correctly K = Equal Expected Return -> It is the mkt cap rate

k = rf + β(E(rM ) − rf )

Question 8

What is the Intrinsic Value (V0) (IV)

Answer 8

V0 = E(D1) + E (P1) / 1 + K

Question 9

What is the Mkt Value (MV)?

Answer 9

Consensus Value of all mkt participant

Question 10

What are the dif trading signals?

Answer 10

IV > MV Buy
IV < MV Sell or Short Sell
IV = MV Hold or Fairly Priced

Question 11

How do you calculate the dividend growth model?

Answer 11

V0 = D1/ 1+K + D2/ (1+K) squared + D3/(1+K) To the power of 3 etc.

Question 12

What does the DDM model state?

Answer 12

the stock price should equal the present value

of all expected future dividends into perpetuity

Question 13

If we assume constant growth how can we rewrite the DDM model?

Answer 13

V0 = D0(1 + g)/k − g = D1/k − g

EXAMPLE IN NOTES

Question 14

What does the Constant growth rate DDM miply?

Answer 14

1. The larger its expected dividend per share.
2. The lower the market capitalization rate, k.
3. The higher the expected growth rate of dividends

The stock price is expected to grow at the same rate as dividends

Question 15

How is g is determined?

Answer 15

g = ROE x b

Where:
g = Growth rate in dividends
ROE = Return on Equity
b = Plowback or retention percentage rate

Question 16

What do we see in the event of high reinvestment compared to low reinvestment

Answer 16

We see a higher dividend per share with high reinvestment policies compared to low reinvestment policies

Question 17

How do we calculate the value of a firm?

Answer 17

equals the value of the assets already in
place, the no-growth value of the firm,
Plus the NPV of its future investments (Called PVGO)

Question 18

How do we calculate the price of a firm?

Answer 18

Price = No-growth value per share + PVGO

P0 =
E1/k + PVGO

SEE EXAMPLE IN NOTES

Question 19

How do life cycles affect investment opportunities?

Answer 19

New companies higher return while Mature Companies see lower return
i.e . Utilities 6.5% return compared to Computer Software 16.% avg

Mature companies more constant earning growth rate, new companies extreme growth rate (Unstable)

Question 20

How can you use the Multi-Stage model to calculate price of steady growth and changing growth firms?

Answer 20

Split stock into steady state and non steady state and calculate from there

SEE EXAMPLE IN NOTES

Question 21

What is the ratio of PVGO to E/k?

Answer 21

the ratio of firm value due to
growth opportunities to value due to assets already in place
(i.e., the no-growth value of the firm, E/k).

Question 22

How do you calculate the

Price to Earnings Ratio?

Answer 22

P0/E1=1/k (1 +PVGO/ E/k)

Question 23

What happens to the Price to Earning ratio in dif situations?

Answer 23

->When PVGO=0, P0 = E1/k. The stock is valued like a
nongrowing perpetuity.
P/E rises dramatically with PVGO.
->High P/E indicates that the firm has ample growth
opportunities.
->P/E increases:
As ROE increases
As plowback increases, as long as ROE > k
P0/E1 = 1 − b/k − ROE × b

Question 24

What is the general rule of thumb with P/E

Answer 24

The growth rate is roughly equal to the P/E ratio.

“If the P/E ratio of Coca Cola is 15, you’d expect the
company to be growing at about 15% per year, etc. But if the P/E ratio is less than the growth rate, you may have found yourself a bargain.

Question 25

What are the pitfalls in P/E Analysis?

Answer 25

1. Use of accounting earnings
   a) Earnings Management
   b) Choices on GAAP
2. Inflation
3. Reported earnings fluctuate around the business cycle