Lecture 4 - The Value Of Stocks Flashcards
1
Q
IPO
A
Initial public offering
2
Q
Underwriting
A
- Advise the issuing corporation on procedures and financial aspects such as appropriate price
- They buy the issue
- They resell to the public
3
Q
Secondary markets
A
Investors trade previously issued securities amongst themselves in the stock exchanges that are secondary markets
4
Q
Examples of secondary markets
A
- Exchanges
- Over the counter markets
5
Q
Exchanges
A
Buyers and sellers of securities meet in one central location to conduct trades (huge auction markets matching up orders from several investors)
6
Q
Over the counter (OTC) markets
A
Dealers at different locations who have an inventory of securities stand ready to buy and sell securities over the counter to investors who come to them and are willing to accept their prices e.g. foreign exchanges, gov bonds, most corporate bonds, NSDAQ
7
Q
Money markets
A
Deal in short term debt instruments (<1 year)
8
Q
Capital markets
A
Deal in longer term debt and equity instruments (>1 year)
9
Q
Market capitalisation
A
- Is the total value of a company’s outstanding shares of stock
- Calculated by multiplying the current stock price by the total number of outstanding shares
- Market cap reflects the market perception of a company’s worth
10
Q
Earnings per share (EPS)
A
- EPS is the amount of profit that has been earned for each ordinary share
- A key measure of company’s profitability/actual performance
- It is a measure of a firms ability to pay dividends and provide some retained earnings to plough back into the company
- EPS is calculated by taking the net profit after deducting tax, interest on borrowings and all operating expenses
- The denominator typically represents the weighted average number of shares outstanding during the reporting period
11
Q
Price/Earnings ratio (P/E)
A
- Market price of share incorporates all available info by investing public
- So relating this measure with earnings can show what investors believe about the company’s performance
- In practice P/E reflects the market’s view of the company’s growth potential and helps investors decide if a stock is overvalued, undervalued or fairly priced
12
Q
Historical vs Prospective P/E
A
- Historical (trailing) P/E ratio is using last years EPS and prospective (forward) P/E using an estimate of EPS for the current year
- For example if a company had 0 EPS last year e.g. breaking even, it’s historical P/E ratio would be undefined or not reported
- However based on expectations of profitability this year:
- If modest profitability is expected, the prospective P/E ratio might be 12
- If much higher profitability is anticipated, the prospective P/E ratio could drop to 6
- This highlights how P/E can vary significantly based on earnings expectations
13
Q
More on P/E ratio
A
- P/E of a company also depends on industry’s performance
- Stock market prices increase more than profits when business cycle swings up and fall more than profits in a downturn
- A HIGH historic P/E compared with the industry group suggests either that the company is a leader in its sector or the share is overvalued
- A LOW historic P/E compared with industry group suggests that either a poor performing company or an undervalued share
14
Q
Dividend yield
A
- This ratio measures the amount of current income (dividends) an investor receives per unit of investments (the share price)
- A relatively low dividend yield may mean that investors expect dividends to grow rapidly or the share is overvalued
15
Q
Book Value
A
- The book value is the net worth (total value of its assets minus its liabilities) of the firm according to the balance sheet
- It provides a measure of the company’s net worth based on historical cost rather than market value
- Book value per share is calculated by dividing the book value of the firm by the number of outstanding shares
- It serves as a fundamental indicator of a company’s health and can be compared to its market value to assess its relative valuation
16
Q
How is book value calculated
A
- The book value of a company’s equity is calculated based on the historical cost of its investments
- It reflects the company’s cumulative past investments, adjusted for depreciation and subtracts debt and other liabilities
17
Q
Price to book value
A
- The price to book value (P/B) compares a stock’s market price to its book value indicating how much investors are willing to pay for each pound of the company’s net worth
- Book values are useful as benchmark against which we can compare market prices
18
Q
Book value disadvantages
A
Book value is not a reliable measure of a company’s current value
19
Q
Book values do not incorporate inflation
A
- E.g. a real estate company may own properties recorded at their historical purchase price (book value) but those properties could have significantly appreciated in market value over time
- As a result the company’s market value might be much higher than its book value
20
Q
Book values typically exclude intangible assets such as trademarks and patents
A
- E.g. a tech company like Apple may have a relatively low book value (P/B) because most of its assets are intangible e.g. software, patents and brand reputation
- However its market value is significantly higher because investors value its potential for future earnings and market dominance
21
Q
Doesn’t capture the going concern value
A
Simply adding book values of assets does not capture the going concern value which is created when a collection of assets is organised into a healthy operating business
22
Q
Valuation by Comparables
A
Identifying similar firms as potential comparables and then examining how much investors in these comparables companies pay per dollar of earnings or book value
23
Q
Features of Valuation by Comparables
A
- Works best when firms are clustered together by industry or similar companies in the same industry
- The rationale is that in competitive and efficient markets, companies with similar characteristics will have similar values (similar P/E and P/B ratios etc)
- By comparing multiples across similar companies or industries, investors can gain insights into relative valuation, growth potential and market sentiment
- Identify a company’s peers in the industry
- Identify and calculate relevant valuation multiples (ratios used to compare a company’s value to a specific financial metric, such as earnings, revenue, or book value
- Common valuation multiples include the price-to-earnings (P/E) ratio, price-to-sales (P/S) ratio, price to cash flows, and price-to-book (P/B) ratio
- These multiples help investors assess a company’s valuation relative to its peers or the broader market
24
Q
Valuation by Comparables (not only intrinsic value)
A
- Compare with similar or comparable assets (stocks with similar risks)
- Corporate world bases a lot of its valuation on discounted cash flow (DCF) techniques
- However a DCF analysis about corporate value needs high quality forecasts (about growth rate, cost of capital etc)
- Comparing companies’ multiples improves the accuracy of these forecasts
25
Dean of Valuation
- Main inputs of the DCF valuation e.g. terminal value are estimated using a relative analysis of firms’ financial ratios
- Relative valuation is much more likely to reflect market perceptions + moods than DCF valuation e.g. during an IPO you have to sell a stock based on information you have on that day
- Relative valuation generally requires less info than DCF valuation for example, 4 ratios can give some indication
- Portfolio managers/ firms' performance is relative (to the market and other money managers/competitors)
- So, relative valuation is more tailored to their needs; cost of capital is an opportunity cost
26
The price of the common stock
- A fundamental principle: the value of any investment is calculated by computing the present value of all cash flows the investment will generate over its life
- E.g. the value of a flat reflects the present value of all net cash flows (rents minus expenses) over its useful life
- Similarly we value common stock as the value in today's money of all future cash flows
- The cash flows that a stockholder might earn from stock are dividends, the sales price or both
27
Cost of equity
The cost of equity equals shareholders' opportunity cost of capital defined as the expected rate of return on other securitites with the same risks (same risk class) as the company's stock
28
Intrinsic value of the stock
- The PV of all cash flows from holding this stock (that includes dividends and capital gains/losses from the sale of stock) discounted at the theoretically correct risk adjusted interest rate
- The market price will reflect the intrinsic value estimates of all market participants
29
Market capitalisation rate
A common term for the consensus value of the required rate of return is the market cap rate
30
What is a stock does not pay dividends
A high growth firm paying no dividends now can still be valued based upon dividends that it is expected to pay out when it becomes mature and the growth rate declines
31
Constant growth DDM (aka Gordon growth model)
Many firms try to increase their dividends at a constant rate each year which is denoted by g
32
Assumptions of the Gordon model:
1. Dividends are assumed to continue growing at a constant rate forever
- Actually, as long as the dividends are expected to grow at a constant rate for an extended period of time, the model should yield reasonable results
- This is because errors about distant cash flows become small when discounted to the present
2. The growth rate is assumed to be less than the required return on equity
- Myron Gordon, in his development of the model, demonstrated that this is a
reasonable assumption. In theory, if the growth rate were faster than the rate
demanded by holders of the firm’s equity, then in the long run the firm would grow impossibly large
- If 𝑘𝑒 = 𝑔, then 𝑃0 will be infinite
- If 𝑘𝑒< 𝑔, then 𝑃0 is negative
33
The constant growth DDM implies that a stock's value will be greater:
1. The larger its expected dividend per share
2. The lower the market capitalisation rate
3. The higher the expected growth rate of dividends
34
Payout Ratio
Measures the proportion of earnings paid out to shareholders in the form of dividends
35
How is payout ratio calculated?
- It is calculated by dividing the total dividends paid by the company by its net income or dividend by EPS
- The payout ratio provides insights into how much of a company's earnings are being distributed to shareholders rather than retained for reinvestment in the business
36
Plowback Ratio
Also known as the retention ratio/rate measures the proportion of a company's earnings that is retained or reinvested back into the business for growth opportunities
37
Return of Equity (ROE)
- Is a measure of a company's profitability and assesses how effectively a company generates profits from shareholders' equity
- Reflects the company's ability to generate earnings relative to the equity invested by shareholders
38
Reinvestment
- If all earning are paid out as dividends and no earnings are reinvested in firms capital stock and earnings capacity would remain unchanged
- If some earnings are reinvested then they will increase book equity by: plowback ratio x ROE
- A standard assumption is that earnings and dividends are forecasted to grow forever at the same rate which is g
- g = plowback ratio x ROE
