Week 11 Flashcards
What is a company’s book value, market value, liquidation value, and replacement cost?
Book value is the net worth of a company’s common equity, market value is the market value of assets minus currenct market value of liabilities. Liquidation value is the net amount that can be realized by selling the assets of a firm and paying off the debt. Replacement cost is the cost to replace a firm’s assets less its liabilities.
Can a firm becom valued above its replacement cost?
Not easily, as if the replacement cost is too low the competitors will enter the market.
What is the intrinsic value of a security? When will it be equal to the market price?
It is the “true” value of a security, according to a model.
The market price is the consensus value of all traders, under equilibrium the current market price will equal the intrinsic value. If the intrinsic value is greater than the market price the stock is underpriced and we should buy. If the intrinsic value is equal to market price we can hold. If the intrinsic value is less than the market price the stock is overpriced and we should sell.
What does the dividend discount model state?
It states that the value of the stock is equal to the present value of all future dividends(based on constant dividend and required rate of return), it is the sum of all discounted dividends.
How does the constant growth dividend discount model work?
The constant growth dividend discount model assumes the dividends will grow, there will be a formula for this.
When is the discounted cash flow model used? How does it work?
When the market price is equal to the intrinsic value, it allows us to calculate the expected holding period return. It states that the expected return equals the dividend yield + the capital gains yield. When market price = intrinsic value this will be given by the dividend yield + the growth rate.
How is the dividend growth rate estimated?
Return on equity of the firm * the plowback rate (its earning retention ratio, given by 1- the dividend payout rate.
When does high reinvestment of earnings instead of dividends increase stock price?
When the return on equity is higher than the company’s capitalization rate.
What is a firm’s value given by?
The value of assets already in place plus the net present value of its future investments(present value of growth opportunities, PVGO). This means the price at year 0 equals (year 1’s earnings divided by the capitalization rate) + PVGO.
Do investors desire growth by itself? What does this mean for company value in growing companies?
No, growth will only increase company value if it is achieved by investing in attractive projects (return on investment greater than capitalization rate/PVGO will be above 0.
This means when profitable investments are ample, management should set low payout ratios. When profitable projects are hard to find, money should be returned to shareholders instead.
What does it mean for a company if its present value of growth opportunities are negative?
The company will be vulnerable to takeover, as shares should be cheap, and by not reinvesting earnings the firm’s value will increase.
What is a two-stage growth dividend discount model good for?
How is it done?
It assumes a firm’s growth is high initially and then it settles down to a steady growth phase.
To do this we take the sum of some known expected dividends at the high growth rate, discount and sum them and then use the constant growth model, discounting the result based on how many years until the constant growth phase starts.
What is the price to earnings ratio? How does it relate to PVGO?
A function of two factors, the required rate of return and the expected growth in dividends.
When PVGO is 0 the PE ratio should be 1/required rate of return(market capitalization rate). As PVGO increases the PE ratio increases.
How does PE ratio relate to the return on equity?
The PE ratio increase as the return on equity increases, and plowback increases. If the return on equity is greater than the capitalization rate. Plowback decreases if return on equity is less than the capitalization rate, or the market capitalization rate decreases.
What are the two methods of equity valuation for free cash flow valuation? When is this useful?
This is useful if the company pays no dividend to discount.
- We can obtain the total value of a company by discounting its free cash flows for the firm at its weighted average cost of capital. Next we subtract the then-existing value of debt to get the value of equity.
- We can discount the free cash flows to equity holders at the cost of equity.
