Week 10 - Equity Evaluation Model Flashcards
What is Fundamental Analysis?
Models company value via assessing current and future probability
PURPOSE: Identify Mispriced Stocks
What is Valuation by comparables?
Compare valuation ratios of firm to industry avg
What are the some of the ways to value firms?
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
What is the ‘Floor’?
Liquidation value per share
-> Book value can be floor
What is the Tobin’s q?
Ratio of market price to
replacement cost.
How do you calculate Expected HPR (Holding Period Return)?
Expected HPR = E(r) = E(D1)+ [E(P1) − P0]/ P0
What is the required return?
If priced correctly K = Equal Expected Return -> It is the mkt cap rate
k = rf + β(E(rM ) − rf )
What is the Intrinsic Value (V0) (IV)
V0 = E(D1) + E (P1) / 1 + K
What is the Mkt Value (MV)?
Consensus Value of all mkt participant
What are the dif trading signals?
IV > MV Buy
IV < MV Sell or Short Sell
IV = MV Hold or Fairly Priced
How do you calculate the dividend growth model?
V0 = D1/ 1+K + D2/ (1+K) squared + D3/(1+K) To the power of 3 etc.
What does the DDM model state?
the stock price should equal the present value
of all expected future dividends into perpetuity
If we assume constant growth how can we rewrite the DDM model?
V0 = D0(1 + g)/k − g = D1/k − g
EXAMPLE IN NOTES
What does the Constant growth rate DDM miply?
- The larger its expected dividend per share.
- The lower the market capitalization rate, k.
- The higher the expected growth rate of dividends
The stock price is expected to grow at the same rate as dividends
How is g is determined?
g = ROE x b
Where:
g = Growth rate in dividends
ROE = Return on Equity
b = Plowback or retention percentage rate
What do we see in the event of high reinvestment compared to low reinvestment
We see a higher dividend per share with high reinvestment policies compared to low reinvestment policies
How do we calculate the value of a firm?
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)
How do we calculate the price of a firm?
Price = No-growth value per share + PVGO
P0 =
E1/k + PVGO
SEE EXAMPLE IN NOTES
How do life cycles affect investment opportunities?
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)
How can you use the Multi-Stage model to calculate price of steady growth and changing growth firms?
Split stock into steady state and non steady state and calculate from there
SEE EXAMPLE IN NOTES
What is the ratio of PVGO to E/k?
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).
How do you calculate the
Price to Earnings Ratio?
P0/E1=1/k (1 +PVGO/ E/k)
What happens to the Price to Earning ratio in dif situations?
->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
What is the general rule of thumb with P/E
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.
What are the pitfalls in P/E Analysis?
- Use of accounting earnings
a) Earnings Management
b) Choices on GAAP - Inflation
- Reported earnings fluctuate around the business cycle
