Equity Valuation Flashcards
(42 cards)
What are the three main phases of equity valuation?
Understanding the past
Forecasting the future
Valuation
What are the three fundamental valuation approaches and what do they focus on?
Market approach - uses prices of comparable firms.
Income approach - values based on future income/cash flows.
Asset approach - based on replacement or net asset value.
What is the central idea behind equity valuation?
To estimate the present value of all expected future benefits (usually cash flows or income) attributable to equity holders of the firm.
How does the “Trading Comparables (Comps)” method work?
Identify peer companies, derive valuation multiples (like P/E or P/S), and apply average or median multiples to the target firm’s metrics to estimate its value.
Give examples of commonly used valuation multiples.
Price-to-earnings (P/E)
Price-to-sales (P/S)
Price-to-book (P/B))
EV/EBITDA
What are the core assumptions and risks behind the comparables approach?
Assumes that comparable firms are correctly priced by the market, which may not be true. Choosing the wrong comparables can mislead the valuation.
Which implementation issues might arise in the comparables method?
Difficult finding truly comparable firms.
Different multiples can lead to varying valuations.
Negative earnings can distort ratios like P/E.
What is the core equation of the Dividend Discount Model (DDM)?
P0 = DIV / (1 + r)^t
Why is DDM often not used in practice?
Many firms do not pay stable dividends or reinvest earnings aggressively, making it hard to use dividends as a proxy for value distribution.
What does Free Cash Flow to Equity (FCFe) represent?
The cash available to equity shareholders after covering all operating costs, taxes, reinvestments, and debt repayments.
How do you calculate FCFE using the accrual-based method?
Net income - Change in Common Equity +/- Clean Surplus Adjustments
How is FCFE derived from the cash flow statement?
Start with operating cash flow, adjust for investing cash flows, changes in financing, and correct for preferred/minority interest.
What is the FCFE-based valuation formula?
P0 = FCFE / (1 + r)^t
What problem does the residual income model solve?
It values firms even when dividends or cash flows are hard to forecast by focusing on how much income exceeds the cost of capital.
Define residual income and give the formula.
Residual Income = Net Income - (Cost of Equity * Beginning Book Equity)
What is the conceptual focus of residual income compared to DCF?
DCF measures value distribution (how much value is paid out), while RIM measures value creation (how much is earned above the required return)
What’s the benefit of using RIM from an analyst’s perspective?
It uses familiar metrics like ROE and Net Income, and aligns better with how financial performance is evaluated in practice.
Are DCF and RIM truly different models?
No, if the inputs are internally consistent, they give the same valuation algebraically.
Why might results differ between DCF and RIM in practice?
Because of inconsistent assumptions, input errors, or differing time horizons in forecasts.
What is the Abnormal Earnings Growth model (AEG)?
An earnings-based model that doesn’t rely on book value. It uses expected earnings and the growth in earnings to determine firm value.
Why is AEG useful for certain types of firms?
It’s particularly suitable for low-capital or intangible-heavy firms, like tech companies, where book equity is not informative.
What’s the relationship between RIM and AEG?
They are theoretically equivalent, with AEG modeling the changes in residual income over time instead of levels.
What is the core idea behind entity valuation?
You value the entire firm (operations), and then subtract the value of non-equity claims (debt, preferred, minority) to get the equity value.
What does Free Cash Flow to the Firm (FCFF) measure?
Cash available to all capital providers (debt + equity) before debt service and interest.
