L11 - DDM Flashcards
1
Q
What is Fundamental analysis?
A
- Fundamental analysis models a company’s value by assessing its current and future profitability.
- The purpose of fundamental analysis is to identify mispriced stocks relative to some measure of “true” value derived from financial data.
2
Q
What are the four models of equity valuation?
A
- Balance Sheet models
- Dividend Discount Models (DDM)
- Price/Earnings Ratios
- Free cash Flow Models
3
Q
How can we use comparables to value a company?
A
- Compare valuation ratios of firm to industry averages.
- Ratios like price/sales are useful for valuing start-ups that have yet to generate positive earnings.
- Book values are based on historical costs, not actual market values.
- Are we considering intangible assets across companies or just tangible
- It is possible, but uncommon, for market value to be less than book value.
- “Floor” or minimum value is the liquidation value per share.
-
Tobin’s q is the ratio of market price to replacement cost.
- In the long run price should reflect the replacement cost of capital
- In the long run Tobin’s q tends towards 1
4
Q
What is Holding Period Return and intrinsic value?
A
- HPR can also separate the expected future dividend payment from the equation in the following way (E(D1)/P0) + (E(P1) - P0)/P0
- This gives us the E(r) = Dividend Yield + Capital Gain
- CAPM give required return k –> risk-adjusted return (firm return)
- Also called market capitalisation rate
- Under CAPM k = E(R) if it fairly prices
- If E(r) < k –> overpriced
- If E(r) > k –> underpriced (the market is compensating more for risk than it should be
- Intrinsic value is the PV of the expected future price and dividend discounted by k
- Why k? –> making a risky investment so should use an interest rate than adjust to this risk (risk-adjusted interest rate)
5
Q
How do you derive the Dividend Discount Model?
A
- By the assumption that V1 = P1 (no deviation for intrinsic value in period 1 )the second equation holds
- Keep subbing for Px using the previous assumption to get the Dividend Discount Model
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6
Q
What is the Dividend Discount Model (DDM)?
A
- To derive the growth rate formula:
- Sub into DDM model D0 = (1+g)D0
- Do V0 *(1+k)/(1+g)) - V0 to give D1 / k -g
- Only true if g < k
- What happens if g > k
- the dividend is growing at a higher speed than the discount factor
- V0 would explode (growing over time) –> this never happens
- When V0 = P0
- HPR = k
7
Q
What are the implications of the DDM?
A
The constant-growth rate DDM implies that a stock’s value will be greater:
- 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. (shown in picture)
8
Q
How is g determined in the DDM?
A
- We can use the following equation to estimate the dividend growth rates:
- g = ROE × b
- Where g = growth rate in dividends, ROE = Return on Equity for the firm, and b = blowback or retention percentage rate (1- dividend payout percentage rate)
- Total equity = Total Assets - Total Liabilities
- Also called net book value
- total earnings/ book value –> gives total ROE
- ROE = EBIT/Book value
- Total equity = Total Assets - Total Liabilities
9
Q
What is an alternative way to derive the value k?
A
- Based on the assumption the stock is fairly priced (price = intrinsic value) so that we can derive the HPR = k
- What if P0 < V0 how long will it take to adjust back?
- The usual estimate is 5 years
10
Q
How is dividend growth affected by different reinvestment policies?
A
- If you reinvest into more projects, initially it will be lower, but once they start paying you back the Dividend per share increases significantly
11
Q
How do we handle the life-cycle of business in our DDM?
A
- multistage growth model
- More established companies that have exhausted all their profitable reinvestment opportunities may reach a steady state of growth where they focus on paying out higher dividend s
Step 1: use growth formula to calculate the present value from the point of steady-state growth
Step 2: calculate the present value of annual dividends for all years from now to the start of the steady-state growth
Step 3: Add both together
12
Q
What is the Price to Earnings ratio and how does it relate to PVGO?
A
- people are willing to pay more given future growth opportunities
- Also riskier firms tend to have higher required rates of return that is higher values of
13
Q
What is a rule of thumb relating growth and the P/E ratio?
A
- Also riskier firms tend to have higher required rates of return that is higher values of k, therefore the P/E multiplier will be lower
- For any expected earnings or dividend stream, the PV of the cashflows will be lower if the stream is perceived to be riskier
- What about for small, risky start up with very high P/E multiplies –> could be evidence that the market has high expectations for the growth rate of these companies
14
Q
Pitfalls of P/E Analysis?
A
WIDER READING
- Use of accounting earnings
- The denominator of the P/E ratio is affected by accounting earnings which are influenced by somewhat arbitrary accounting rules e.h. historical cost depreciation and investor valuation
- In times of high inflation, historic cost depreciation and investor costs will tend to underrepresent true economic values because replacement costs will rise to the general price levels
- P/E is general a worse measure in times of inflation
- Earnings Management is a practice of using flexibility in accounting rules to improve the apparent profitability of a firm
- 1990s used Pro format earnings measures –> could ignore certain expenses e.g. restructuring charges, stock option expenses, write-downs of assets from continuing operations
- Choice of GAAP
- Some extent allows firms considerable discretion to manage earnings
- In the late 1990s Kellogg took restructuring charges which are suppose to be one-time events, nine quarters in a row (were these really one time events or were they more appropriately treated as ordinary expenses)
- Some extent allows firms considerable discretion to manage earnings
- Earnings Management is a practice of using flexibility in accounting rules to improve the apparent profitability of a firm
- P/E is general a worse measure in times of inflation
- Reported earnings fluctuated around the business cycle
- DDM needs earning to be net of economic depreciation –> that is the max. flow of income that the firm could pay without depleting its productive capacity
- Dont need to do that for P/E ratio under GAAP –> reporter earnings can fluctuate dramatically around a trend line over the course of a business cycle
15
Q
What are other comparative valuation ratios we could use?
A
- Price -to-book ratio
- price-to-cash-flow ratio
- price to-sales ratio
