Flashcards in Equity Valuation Deck (23):
why is it difficult to value shares?
- cash flows are uncertain
- life of investment uncertain
- difficult to measure the expected return the market expects
What happens to the price of a share if the required rate of returns increases?
It will decrease
What are the advantages of the constant growth model?
- useful for valuing stable-growth, dividend paying co.s
- useful for valuing broad-based equity indexes
- Model features simplicity and clarity (understanding relationship among value and growth, req. rate of return and Payout ratio.
- provides an approach to estimating the expected Rate of Return given efficient prices
what are the advantages of the non-constant growth model?
useful as many scenarios exist in which a company can achieve a super-normal growth rate for a few years after which it falls to a more sustainable level.
why might a company achieve super-normal profits and then a decline?
May be due to a patent, first mover advantage, or another reason that provides a temporary lead in the marketplace. The earnings growth must decline to a level that is more consistent with competition and growth in the overall economy.
What is the Dividend Growth Model?
A model that determines the current share price divided by the discount rate less the dividend growth rate
Why may the dividend growth rate change in the future?
- Competition from other companies
- Change in the dividend payout policy:
if total dividend increases as a proportion of its total earnings, growth will have to fall as less money is retained to invest in value-making projects
What are the components of the required rate of return?
Dividend yield + Capital gains yield
R = D1/Po + g
what is the Capital Gains Yield?`
The dividend growth rate
/the rate at which the value of an investment grows.
What is the price-earnings ratio and what is it used for?
hare price/ earnings per share
Used by analysts to compare equity values across an industry and used to complement other methods of equity valuation
Why do some industriy sectors have high P/E ratios?
because they are perceived to have high growth rates
What is the denominator effect?
That P/E ratios are exceptionally high because average earnings in the past year are low.
what is ordinary equity?
equity without priority for dividends or inevent of bankruptcy
what are preference shares?
equity with dividend priority over ordinary shares, normally with a fixed dividend rate, sometimes without voting rights.
What are primary markets?
market in which new securities are originally sold to investors
what are secondary markets
markets in which previously issued securities are traded among investors
What are the components of the Required Return?
Dividend Yield + Capital Gains Yield
R = D1/Po + g
What is ordinary equity?
equity without priority for dividends or in event of bankruptcy
What are preference shares?
equity with dividend priority over ordinary shares, normally with a fixed dividend rate sometime without voting rights
What is a 'stated value'?
Preference shares have a stated liquidating value (usually £100 per share), the cash dividend is described as a percentage of stated value.
What are cumulative dividends?
if cumulative preferred dividends are not paid in a particular year, they will be carried forward as an arrearage.
Why may preference shares be classed as equity?
- can be seen as an equity-bond: receive a stated dividend only, and upon liquidation get a stated value
- often callable and can be converted to ordinary shares
- often have obligatory sinking funds