LM 8: Equity Valuation: Concepts & Basic Tools

Question 1

What is the difference between market value and intrinsic value?

Answer 1

market value determined by market quotes and transactions

intrinsic value objective true value investors would get if they had all relevant quantitative and qualitative information

Question 2

Will the intrinsic value be less than the market value or more than the market value for undervalued and overvalued securities?

Answer 2

undervalued = intrinsic value > market price

overvalued = intrinsic value < market price

fairly valued = intrinsic value = market price

Question 3

What are the 3 major categories of equity valuation models? PMA

Answer 3

1. Present Value Models (Discounted Cash Flow Models) (FCFE)
2. Multiplier Models (Market Multiple Models)
3. Asset-based Valuation Models

Question 4

What is the difference between present value models and asset based valuation models?

Answer 4

present value models = intrinsic value is the present value of future benefits from the security.

asset based valuation models = intrinsic value is estimated as the market value of assets minus the estimated value of liabilities and preferred stock.

Question 5

What are multiplier models?

Answer 5

Relative valuation of stock based on some fundamental multiplier of value like price to earnings, price to sales, etc.

Question 6

What is the formula for asset based valuation models?

Answer 6

ABV intrinsic value = estimated value of assets - estimated value of liabilities - preferred shares

Question 7

What is forward basis vs trailing basis?

Answer 7

forward basis = projected earnings per share next year

trailing basis = earnings per share for the past year

Question 8

What is enterprise value formula?

Answer 8

EV = total market value of a company - cash and short-term investments

Question 9

What is declaration date?

Answer 9

This is the day that the dividend’s authorization is announced.

Question 10

What is ex-dividend date?

Answer 10

Starting this day, new owners will not be eligible to receive the previously declared dividend.

Question 11

What is holder of record date?

Answer 11

On this day, the company records the list of owners who held shares at the close of trading on the day before the ex-dividend date.

Question 12

What is payment date for dividends?

Answer 12

This is when the dividend is actually paid

Question 13

What is extra special dividends vs liquidating dividend?

Answer 13

extra special = may be paid at any time outside the regular schedule, often when companies does well

liquidating dividend = paid to return capital to shareholders when a company goes out of business.

Question 14

What are stock dividends?

Answer 14

grant extra shares to investors rather than cash

Question 15

What is stock split vs reverse stock split?

Answer 15

Stock splits = increase the number of shares outstanding,

Reverse stock splits = reduce the number of shares outstanding

Question 16

What is share repurchase?

Answer 16

Management can choose to repurchase shares if they believe that they are trading below their intrinsic value.

Question 17

What is the basis of the dividend discount model?

Answer 17

intrinsic value of a share of stock = PV of expected future dividends

Question 18

What is the formula for the dividend discount model?

Answer 18

v0 = (Dt / (1+r)^t) + (Pn / (1+r)^n)

v0 = intrinsic value of 1 share of stock
Dt = expected dividend in year t
r = require rate of return
Pn = expected selling price at end of investment horizon

Question 19

How is free cash flow to equity valuation model different than dividend discount model?

Answer 19

FCFE = focuses on how much they can pay dividends

dividend discount model = focuses on expected dividends

Question 20

What is FCFE formula?

Answer 20

FCFE = CFO - FCInv + Net Borrowing

CFO = cash flows from operations
FCInv = fixed capital investments

Question 21

What is the intrinsic value of stock using the FCFE?

Answer 21

v0 = (FCFEt / (1+r)^t)

Question 22

What is one method investors use to estimate R?

Answer 22

using CAPM

Question 23

What is CAPM formula?

Answer 23

E (Ri) = Rf + Bi [E(Rm) - Rf)]

E (Ri) = expected return
Rf = risk free rate
Bi = beta, stock sensitivity to equity market
E(Rm) - Rf = market risk premium
E(Rm) = expected return of market

Question 24

What is the preferred stock valuation formula, and the preferred stock valuation formula with a known maturity date?

Answer 24

preferred stock valuation = V0 = D0 /r

preferred stock valuation formula with a known maturity date = V0 = (Dt / (1+r)^t) + (F / (1+r)^n)

D0 & Dt = dividend
r = required rate of return
F = preferred stocks par value

Question 25

What is a retraction option of preferred stock?

Answer 25

essentially a put option, allow investor to sell preferred stock back to issuer at a set price on a set date

Question 26

What is the gordon growth model?

Answer 26

Gordon constant growth model (GGM) estimates future dividend payments by assuming a constant dividend growth rate (g
) and the required return on equity.

Question 27

What is the formula for the gordon growth model, and the simplified formula?

Answer 27

v0 = D0 (1+g)^t / (1+r)^t

V0 = D0 (1+g)^t / (r-g)

D1 = dividend in next period
D0 = dividend now
r = required rate of return
g = growth rate

Question 28

What is sustainable growth rate, and formula, and how is it used in the gordon growth model?

Answer 28

the maximum rate of growth that a company or social enterprise can sustain without having to finance growth with additional equity or debt

G = b (earnings retention rate) * ROE

used as the growth rate for gordon growth model

Question 29

What is the formula for retention rate and return on equity for the gordon growth model?

Answer 29

retention rate = 1 - dividend payout ratio

ROE = net income / average total equity

Question 30

What are price multiples?

Answer 30

ratios of the share price to some other value related to the relative worth of the company’s stock. eg. Price-to-earnings (P/E),
Price-to-book (P/B)

Question 31

What is enterprise value formula?

Answer 31

EV=Market capitalization (common stock)+MV of preferred stock+MV of debt−(Cash+Short-term investments)

short term investments doesn’t include inventory or accounts receivable

Question 32

What is asset base valuation?

Answer 32

uses difference between estimates of a company’s market value (fair value) of current assets & current liabilities

Question 33

What is the law of one price and what equity model does it apply too?

Answer 33

states that identical assets should sell for the same price. In theory, a company trading at 14 times earnings is attractively priced compared to a similar company with a P/E ratio of 20.

applies to multiplier models or fundamental models

Question 34

What is formula for intrinsic value of preferred share given issue rate, par value, and required rate of return?

Answer 34

Issue rate * par value for = annual dividend

Annual dividend/ required rate of return = stock price intrinsic value

Question 35

What is EV/EBITDA?

Answer 35

enterprise value / EBITDA

used to determine fair market value of a company

Question 36

When is it most appropriate to use Gordon growth vs two stage dividend discount model vs three stage dividend discount model?

Answer 36

Gordon growth: suited for mature companies

Two stage: companies transitioning from growth to mature stage

Three stage: young companies entering the growth phase

Question 37

What is the ratio used to get P/E forward P/E from retention ratio, and growth rate?

Answer 37

D1/EPS / R-G

D1/EPS = payout ratio (1- earnings retention)
R = required rate of return
G = growth