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FM2555 > Chap 4 > Flashcards

Chap 4 Flashcards

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1
Q

How does a company raise new capital?

A

by borrowing or by selling new shares to investors.

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2
Q

Sales of shares occur in which market?

A

Sales of shares to raise new capital are said to occur in the primary market.

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3
Q

Stock exchanges occur in which market?

A

Stock exchanges are really markets for secondhand shares, but they prefer to describe themselves as secondary markets

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4
Q

If shares are traded from one person to another in a secondary market, what part does the corporation play in this transaction?

A

The transaction merely transfers partial ownership of the firm from one investor to another. No new shares are created, and the corporation will neither care nor know that the trade has taken place.

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5
Q

If shares are traded from one person to another in a secondary market, what part does the corporation play in this transaction?

A

The transaction merely transfers partial ownership of the firm from one investor to another. No new shares are created, and the corporation will neither care nor know that the trade has taken place.

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6
Q

Person A: wants to sell stock
Person B: wants to buy stock

How does this process happen?

A 
- Their orders must go through a brokerage firm. Person A (selling) might give her broker a market order to sell stock at the best available price. 
Person B (buying) might state a price limit at which he is willing to buy stock.
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7
Q

What are some examples of auction markets?

A

Tokyo Stock Exchange, the London Stock Exchange, and the Deutsche Börse, NYSE

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8
Q

What is an auction market?

A

A market where the exchange’s designated market makers match up the orders of thousands of investors.

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9
Q

What is a dealer market?

Give an example

A

Nasdaq is not an auction market. All trades on Nasdaq take place between the investor and one of a group of professional dealers who are prepared to buy and sell stock.

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10
Q

What is market capitalization?

A

market cap = outstanding shares x current price

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11
Q

What is EPS? How is it calculated?

remember the triangle

A

Earnings per share

EPS = price / (P/E ratio)

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12
Q

What is the P/E ratio?

A
  • Price to earnings ratio

P/E = price / EPS

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13
Q

How is the price of a stock calculated given EPS & P/E?

A

Price = (EPS) x (P/E)

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14
Q

What is the dividend yield?

A

div yield = ratio of dividend to price

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15
Q

What are ETF’s?

A

Exchange-traded funds, which are portfolios of stocks that can be bought or sold in a single trade.

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16
Q

Are ETF’s actively managed?

A

No, many simply aim to track a well-known market index such as the Dow Jones Industrial Average or the S&P 500.

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17
Q

What are closed-end mutual funds?

Are these funds actively managed?

A

You can buy shares in a closed-end mutual fund that invest in portfolios of securities.

Unlike ETFs, most closed-end funds are actively managed and seek to “beat the market.”

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18
Q

How do you calculate the book value of a corporation?

A

book value =
assets (PPE, inventory, cash, etc.) - liabilities (money owed, taxes due)

Difference between assets and liabilities

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19
Q

What are some deficiencies to using book value as a market value?

A
  • Book values are historical costs that do not incorporate inflation.
  • Book values usually exclude intangible assets such as trademarks and patents
  • Does not capture the Going- Concern Value; created when a collection of assets is organized into a healthy operating business
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20
Q

What is book values are useful for …

A
  • a benchmark

- clues about liquidation value

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21
Q

What does it mean to Value by Comparables?

A

When financial analysts need to value a business, they often start by identifying a sample of similar firms as potential comparables.

They then examine how much investors in the comparable companies are prepared to pay per dollar of earnings or book assets. They see price–earnings and price-to-book- value ratios as well.

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22
Q

Why are P/E ratios almost always useless when valuing a new start-up company?

A

Because most of which do not have any earnings to compare

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23
Q

When is valuation by comparable useful?

A

When you don’t have a stock price

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24
Q

Do all companies pay dividends?

Study These Flashcards
A

Not all companies pay dividends. Rapidly growing companies typically reinvest earnings instead of paying out cash. But most mature, profitable companies do pay regular cash dividends.

25
What does the logic of the DCF suggest with the PV of a share of stock?
PV(share of stock) = PV(expected future dividends per share)
26
What are the two cash payoffs you get from a stock?
1. Cash dividends | 2. Capital gains or losses
27
How do you calculate the rate of return on a stock (using dividends and price)
numerator: DIV1 + (P1 - P0) denominator: P0 (P1 + P0) - this is the price appreciation per share this formula can be rearranged to solve for today's price, P0, as well
28
How do you calculate the rate of return on a stock (using dividends and price)
numerator: DIV1 + (P1 - P0) denominator: P0 (P1 + P0) - this is the price appreciation per share this formula can be rearranged to solve for today's price, P0, as well
29
What is the discount rate "r" in the price formula | P0 = (DIV1 + P1) / (1+r)
This is the market capitalization rate, (or cost of equity capital) But, these are all alternative names for the opportunity cost of capital. - defined as the expected return on other securities with the same risks as the corporation being evaluated shares.
30
What would happen if a stock were to be underpriced?
Investors would rush to buy the stock, and the priced would be forced up
31
What is a condition for equilibrium in well-functioning capital markets?
At each point in time all securities in an equivalent risk class are priced to offer the same expected return.
32
How can we relate today's price to the forecasted dividends and price forecasted in the future?
P0 = [DIV1 / (1+r)] + [(DIV2 + P2) / (1+r)^2] - this can go on and relate today's price to the forecasted dividends and price at some time in the future. (until the final period H)
33
What is the Horizon Period, H?
- The horizon period H could be infinitely distant. | - The final time value that the stock will have
34
What happens your horizon recedes (increases)?
The present value of the future price declines but the present value of the stream of dividends increases. The total present value (future price and dividends) remains the same.
35
What is the DCF (dividend discount model) of stock prices? What does this formula assume about the terminal price of the stock?
This is another PV formula, we discount the dividend stream by the return that can be earned in the capital market on securities of equivalent risk. P0 = SUM[DIVt / (1 + r)^t] - where t goes to infinity. - this formula assumes that the terminal price of the stock is 0, because we are evaluating at a horizon value that goes to infinity (because the lifetime of the stock is essentially immortal - minus corporate hazards)
36
Is it correct to say that the value of a share is equal to the sum of the discounted stream of earnings per share? Why or why not?
NO - Earnings are generally larger than dividends because part of those earnings is reinvested in new plant, equipment, and working capital. - Discounting earnings would recognize the rewards of that investment (higher future earnings and dividends) but not the sacrifice (a lower dividend today).
37
Why would a successful company decide not to pay cash dividends? (2 reasons)
First, a growing company may maximize value by investing all its earnings rather than paying out any. Second, a company may pay out cash, not as dividends but by repurchasing shares from stockholders.
38
Why is the dividend discount model logically incorrect for growth companies? What other methods can be used to value a stock in this case?
Because it is difficult to use when the dividends are far in the future. In this case, most analysts switch to valuation by comparables or to earnings-based formulas.
39
If the expected dividend is growing at a constant rate, how is the PV taken? (constant-growth DCF formula)
P0 = DIV1 / (r-g) This is an example of a growing perpetuity. (only can use this formula when the anticipated growth rate, g, is less than the discount rate)
40
By using one single discount rate in the DCF (dividend discount model) what is being assumed?
This implicitly assumes that the company is all equity-financed or that the fractions of debt and equity will stay constant.
41
What happens if a growth company (doesn't pay dividends) is taken over by another company? What happens to these awaited deferred dividends?
The deferred payout may come all at once if the company is taken over by another. The selling price per share is equivalent to a bumper dividend.
42
Why would corporations pay out cash for repurchases rather than cash dividends?
It reduces the number of shares outstanding and increases future earnings and dividends per share. The more shares repurchased, the faster the growth of earnings and dividends per shares. Thus repurchases benefit shareholders who do not sell as well as those who do sell.
43
How can the growing dividend formula can be re-arranged to find the expected rate of return on other securities of comparable risk, r? - What assumptions are being made about r and g?
r = dividend yield + the growth rate dividend yield = DIV1 / P0 We are assuming that earnings and dividends are forecasted to grow forever at the same rate g
44
The product of which two ratios will provide you with an estimate the long-run dividend growth rate, g?
g = plowback ratio x ROE ROE: Return on equity
45
What is the ROE? How is it calculated?
Return on Equity | = EPS / book equity per share
46
What is the plowback ratio? How is it calculated?
= 1 - payout ratio Payout ratio = DIV / EPS The plowback ratio is the amount of EPS that the company is plowing back into the business
47
Would it be appropriate to estimate r by the analysis of one stock only?
We have stressed the difficulty of estimating r by analysis of one stock only. Try to use a large sample of equivalent-risk securities
48
Why should the constant growth formulas not be used when evaluating a company that has a high current growth rate?
Such growth can rarely be sustained indefinitely, but the constant-growth DCF formula assumes it can. This erroneous assumption leads to an overestimate of r.
49
When would it be acceptable to use a DCF model with two stages of growth?
When the company had a high growth rate in the past. - the growth rate will decrease. PV = PV(first-stage dividends) + PV(second-stage dividends) Refer to page 89 to see the formula and an example
50
Why would a company's growth rate vary?
Sometimes growth is high in the short run not because the firm is unusually profitable, but because it is recovering from an episode of low profitability
51
Why do investors separate growth stocks from income stocks?
- They buy growth stocks primarily for the expectation of capital gains, and they are interested in the future growth of earnings rather than in next year’s dividends. - They buy income stocks primarily for the cash dividends.
52
When a company has 0 growth (produces a constant stream of dividends), how would we calculate the expected return, r?
Expected return = dividend yield = earnings-price ratio BC NO GROWTH (payout ratio = 1) r = DIV1 / P0 = EPS1 / P0
53
What needs to be accounted for when using the earnings-price ratio to determine the discount rate?
PVGO (NPV of growth opportunities) P0 = EPS1 / r + PVGO
54
When is a firm considered a growth stock?
When it's PVGO accounts for a large fraction of its price
55
How is DCF used to value a business?
Discounts the forecasted FCF's out to a valuation horizon (looking for the first year of stable growth) *go over this process in our old notes* = PV(FCF) + PV(horizon value)
56
What is FCF? How is it calculated?
Free cash flow is the amount of cash that a firm can pay out to investors after paying for all investments necessary for growth. = firms earnings - investment expenditures
57
What does it mean when FCF = 0?
The company is rapidly growing; investing all earnings back into the business
58
What does it mean when PVGO = 0
This means that the firm's competition has caught up to them, the market capitalization rate has increased. - PVGO is only positive when investments can be expected to earn more than the cost of capital.

FM2555 (14 decks)

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