5.8 equity valuation: concepts and basic tools

Question 1

market value of a security

Answer 1

can be determined from market quotes and transactions

Question 2

intrinsic value of a security

Answer 2

the objective “true” value that investors would ascribe to it if they had all relevant quantitative and qualitative information.

Unfortunately, intrinsic value cannot be observed, only estimated. Furthermore, a security’s market value may not necessarily reflect its intrinsic value. If an analyst estimates a security’s intrinsic value to be greater than its market value, the security is undervalued. On the other hand, if the security is trading above its intrinsic value, it is overvalued.

Question 3

Present Value Models (Discounted Cash Flow Models)

Answer 3

The intrinsic value is the present value of future benefits from the security. Benefits could be viewed as dividends or free cash flows.

Question 4

Multiplier Models (Market Multiple Models)

Answer 4

Usually, these are based on share price multiples or enterprise value multiples.

Examples of share price multiples include price to earnings and price to sales. The fundamental variable can be on a forward or trailing basis. This is commonly used to compare relative values.

Enterprise values (EV) subtract the cash and short-term investments from the company’s total market value. The denominator could be earnings before interest, taxes, depreciation, and amortization (EBITDA) or total revenue.

Question 5

Asset-based Valuation Models

Answer 5

The intrinsic value is estimated as the market value of assets minus the estimated value of liabilities and preferred stock.

Question 6

Regular dividends

Answer 6

paid at known intervals, which tend to vary by region (e.g., quarterly in North America, semiannually in Europe, annually in China).

Directors may authorize an annual dividend that is paid in quarterly or semiannual installments

Question 7

There are four important milestones in the standard chronology of dividend payments:

Answer 7

Declaration date

Ex-dividend date

Holder-of-record date

Payment date

Question 8

Declaration date

Answer 8

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

For example, XYZ Corp. may announce on 1 April that the board has voted to pay a $5 per share dividend on 31 May with an ex-dividend date of 16 April.

Question 9

Ex-dividend date

Answer 9

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

To continue the XYZ Corp. example, if the company’s shares closed at $100 on 15 April, they will trade for $95 when the market opens on 16 April (the ex-dividend date) because the $5 dividend that was declared on 1 April will be paid to the seller, not the investor who purchases the stock on 16 April.

Question 10

Holder-of-record date

Answer 10

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. It is usually one or two days after the ex-dividend date to reflect the fact that trades are not settled immediately.

In the XYZ Corp. example, an investor who paid $100 for XYZ shares just before the market closed on 15 April is entitled to receive the $5 dividend that was declared on 1 April.

However, this trade may take 24 to 48 hours to settle, so XYZ Corp. will wait until after the market closes on 17 April to finalize its list of shareholders who will receive the dividend to be paid on 31 May.

Question 11

Extra (special) dividends

Answer 11

may be paid at any time outside the regular schedule.

Often, companies in cyclical industries choose to supplement their regular dividends with a special dividend

Question 12

A liquidating dividend

Answer 12

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

Question 13

Stock dividends

Answer 13

grant extra shares to investors rather than cash

no effect on a company’s valuation.

Question 14

Stock splits

Answer 14

increase the number of shares outstanding

no effect on a company’s valuation.

Question 15

reverse stock splits

Answer 15

reduce the number of shares outstanding

no effect on a company’s valuation.

Question 16

Share repurchases

Answer 16

can be used as an alternative to paying cash dividends.

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

Share repurchases also allow managers greater flexibility over the amount and timing of payments to shareholders and can be used to offset the diluting effect of stock options.

Finally, shareholders may prefer share repurchases if capital gains are taxed at a lower rate than dividends.

Question 17

The dividend discount model (DDM)

Answer 17

estimates a stock’s fair value based on forecasts of the dividends to be received and the terminal value

Question 18

free-cash-flow-to-equity (FCFE) valuation model

Answer 18

This model uses the dividend-paying capacity rather than expected dividends.

This model can also be used for non-dividend-paying stocks. FCFE is a measure of the cash flow that is available for distribution to common shareholders.

It is the cash flow from operations less cash needed for fixed capital investment plus net amount borrowed during the period:

Question 19

the capital asset pricing model (CAPM) model)

Answer 19

calculate the required rate of return.

The expected return for security is a function of the risk-free rate, market risk premium, and the stock’s sensitivity to equity market returns (beta).

Question 20

Preferred Stock Valuation

Answer 20

Unlike common stock, preferred stock shares pay fixed dividends, which makes these securities easier to value because there is far more certainty about future cash flows.

Assuming that preferred stock has no maturity date, it can be valued like a perpetuity:

Question 21

The Gordon constant growth model (GGM)

Answer 21

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

Question 22

Note the following about the GGM:

Answer 22

1. This is a forward-looking model because the stock’s value is determined by the next dividend to be paid (D1).
2. The assumption of constant dividend growth is more appropriate for stable, mature companies, but this model is less appropriate for companies that are growing rapidly and/or are not currently paying a dividend.
3. The dividend growth rate must be less than the required rate of return.
4. The sustainable rate of dividend growth can be estimated as the product of accounting return on equity (ROE) and the earnings retention rate (b), which is 1 minus the dividend payout ratio (g = b * ROE).

Question 23

Multistage Dividend Discount Models

Answer 23

As noted, the assumption of constant dividend growth is inappropriate for valuations of younger, rapidly growing companies. In such cases, analysts may use a multistage model that allows for two or more periods of different growth.

–> Many companies experience temporarily high short-term growth before transitioning to a long-term sustainable growth rate.

These models allow for two or more growth rates. A short-term period of high growth is assumed for a set number of years.

–> Some assume growth falls into three stages: growth, transition, and maturity. This leads to a three-stage model for young companies.

–> It is important to discount each expected future cash flow at the appropriate rate.

Question 24

Price multiples

Answer 24

ratios of the share price to some other value related to the relative worth of the company’s stock.

Question 25

Commonly used price multiples include:

Answer 25

Price-to-earnings (P/E)

Price-to-book (P/B)

Price-to-sales (P/S)

Price-to-cash-flow (P/CF)

Question 26

Method of Comparables

Answer 26

This popular method is based on the law of one price, which 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.

However, comparing companies is often challenging and analysts must look for rational explanations of any differences in ratios. For example, a company with a low price-to-sales ratio may appear to be a good investment. However, it could be on the brink of bankruptcy. Differences in size, product lines, accounting policies, and other factors should also be considered.

Question 27

Enterprise Value (EV)

Answer 27

calculated as the sum of the market values of all forms of capital (e.g., common stock, preferred stock, debt) net of cash and short-term investments

It represents the cost of a takeover, since the acquiring company assumes (repays) the target company’s debt and receives its cash.

Enterprise value is useful for comparing companies with different capital structures.

EV/EBITDA is a commonly used valuation metric, particularly in Europe. EBITDA can be used as a proxy for operating cash flows.

–> An advantage EV/EBITDA has over P/E is that EBITDA is typically positive even when earnings are negative.

Question 28

Asset-Based Valuation

Answer 28

This method values a company’s equity as the difference between the market values of its assets and liabilities.

This method is often used in conjunction with other models to value private companies.

Asset-based valuations may become more common for public companies as disclosure requirements move toward greater use of fair value reporting.

Financial firms, natural resource producers, and companies that are being liquidated are among the best fits for this method.

Question 29

Some important considerations for analysts include with Asset-Based Valuation:

Answer 29

Asset-based valuation is difficult for companies with large amounts of PP&E

This method is easier to use for companies that have a high proportion of current assets/liabilities

Estimates of value for intangible assets are highly subjective

Asset values are difficult to estimate in hyper-inflationary environments

Question 30

An analyst is attempting to calculate the intrinsic value of a company and has gathered the following company data: EBITDA, total market value, and market value of cash and short-term investments, liabilities, and preferred shares. The analyst is least likely to use:

a) a multiplier model.

b) a discounted cash flow model.

c) an asset-based valuation model.

Answer 30

b) a discounted cash flow model.

To use a discounted cash flow model, the analyst will require FCFE or dividend data. In addition, the analyst will need data to calculate an appropriate discount rate.

Question 31

An analyst who bases the calculation of intrinsic value on dividend-paying capacity rather than expected dividends will most likely use the:

a) dividend discount model.

b) free cash flow to equity model.

c) cash flow from operations model.

Answer 31

b) free cash flow to equity model.

Question 32

The Gordon growth model can be used to value dividend-paying companies that are:

a) expected to grow very fast.

b) in a mature phase of growth.

c) very sensitive to the business cycle.

Answer 32

b) in a mature phase of growth.

Question 33

The best model to use when valuing a young dividend-paying company that is just entering the growth phase is most likely the:

a) Gordon growth model.

b) two-stage dividend discount model.

c) three-stage dividend discount model.

Answer 33

c) three-stage dividend discount model.

Question 34

An equity analyst has been asked to estimate the intrinsic value of the common stock of Omega Corporation, a leading manufacturer of automobile seats. Omega is in a mature industry, and both its earnings and dividends are expected to grow at a rate of 3 percent annually. Which of the following is most likely to be the best model for determining the intrinsic value of an Omega share?

a) Gordon growth model.

b) Free cash flow to equity model.

c) Multistage dividend discount model.

Answer 34

a) Gordon growth model.

The company is a mature company with a steadily growing dividend rate. The two-stage (or multistage) model is unnecessary because the dividend growth rate is expected to remain stable. Although an FCFE model could be used, that model is more often chosen for companies that currently pay no dividends.

Question 35

A price earnings ratio that is derived from the Gordon growth model is inversely related to the:

a) growth rate.

b) dividend payout ratio.

c) required rate of return.

Answer 35

c) required rate of return.

Question 36

The primary difference between P/E multiples based on comparables and P/E multiples based on fundamentals is that fundamentals-based P/Es take into account:

a) future expectations.

b) the law of one price.

c) historical information.

Answer 36

a) future expectations.

Question 37

An analyst makes the following statement: “Use of P/E and other multiples for analysis is not effective because the multiples are based on historical data and because not all companies have positive accounting earnings.” The analyst’s statement is most likely:

a) inaccurate with respect to both historical data and earnings.

b) accurate with respect to historical data and inaccurate with respect to earnings.

c) inaccurate with respect to historical data and accurate with respect to earnings.

Answer 37

a) inaccurate with respect to both historical data and earnings.

the statement is inaccurate in both respects. Although multiples can be calculated from historical data, forecasted values can be used as well. For companies without accounting earnings, several other multiples can be used. These multiples are often specific to a company’s industry or sector and include price-to-sales and price-to-cash flow.

Question 38

Which of the following statements regarding the calculation of the enterprise value multiple is most likely correct?

a) Operating income may be used instead of EBITDA.

b) EBITDA may not be used if company earnings are negative.

c) Book value of debt may be used instead of market value of debt.

Answer 38

a) Operating income may be used instead of EBITDA.

Question 39

Asset-based valuation models are best suited to companies where the capital structure does not have a high proportion of:

a) debt.

b) intangible assets.

c) current assets and liabilities.