M6 Financial Valuation Methods: Part 1

Question 1

What do you use to find the required rate of return if not given?

Answer 1

CAPM

RF rate + [ beta * (mkt return - RF) ]

Question 2

trailing vs. forward concept

Answer 2

Numerator (price) is readily available. However this is not the case for the denominator.
Trailing = E0 (PAST four quarters)
Forward = E1 (EXPECTED earnings so E0*(1+g)

Question 3

when the periodic cash flows paid by an annuity lasts forever; company is expected to pay the same dividend each period

Answer 3

Perpetuities (ZERO growth stock)

Question 4

stock value per share formula when there is ZERO growth (perpetuity)

Answer 4

“constant annual dividend”
P = D/R

P = stock price
D = dividend
R = required return

Question 5

Constant (Gordon) Growth Dividend Discount Model (DDM)

“Calculate the amount Able will pay for Baker’s stock 3 years from today”

-Example of a simple dividend discount model

Answer 5

GROWING
Pt = D(t) (1+G)
————–
(R-G)

Pt = current price (price at period “t”)
Dt = dividend current or one year after (Dt1)
R = Required Return (USE CAPM)
G = growth rate

Question 6

Use the value of comparable stocks to determine the value of similar stocks (price multiples useful for investors to determine if a stock is undervalued, fairly valued or overvalued)

Answer 6

Relative Valuation models
1.) Price-Earnings (P/E) Ratio
2.) PEG ratio
3.) Price to Sales (P/S)
4.) Price to Cash Flow (P/CF)
5.) Price to Book (P/B)

Question 7

Relative Valuation Models: Price-Earnings Ratio (trailing vs. forward)

Answer 7

P/E = P0/E0 (trailing) or E1 (forward)

P = current stock price value
E0 = current EPS or E1 = expected EPS

EPS = NI - Preferred Dividends / WACSO or #CSO
E1 = E0 * (1+g)
g = growth rate

Question 8

Relative Valuation Models: PEG Ratio

Answer 8

*measure that shows the effect of earnings growth on a company’s P/E; generally stocks with lower PEG ratios are MORE attractive to investors than stocks that have higher PEGs

PEG = (P0/E1) / G

P = Stock price today
E = expected/current (E0) EPS
G = Growth rate = 100*expected growth rate

Question 9

Use PEG ratio to figure out the Price

Answer 9

P0 = PEG * E1 * G

Question 10

Relative Valuation Models: Price to Sales Ratio
Formula and rationale

Answer 10

Rationale: Sales are less subject to manipulation than earnings or book values (sales always positive so can use when EPS is negative)
P0/S1

S1 = Expected sales in one year
S0 = sales/#CSO * (1+g)

Question 11

Use price to sales ratio to figure out Price

Answer 11

P0 = (P0/S1) * S1

Question 12

Relative Valuation Models: Price to Cash Flows Ratio
Formula and rationale

Answer 12

Rationale: cash flow is harder for companies to manipulate than earnings (more stable measure)

P0/CF1

CF1 = CF0/#CSO * (1+G)

Question 13

Use price to cash flow ratio to figure out Price

Answer 13

P0 = (P0/CF1) * CF1

Question 14

Relative Valuation Models: Price to Book Ratio
Formula and rationale

Answer 14

Rationale: focuses on BS rather than IS or CFS; firm’s BV of Common equity (A-L-PS) is more stable than EPS (can be used when firm’s EPS is negative or 0)

P/B ratio = P0/B0

B0 = BV of COMMON equity CE/#CSO

Question 15

Use price to book ratio to figure out Price

Answer 15

P0 = (P0/B0) * B0

Question 16

Use PEG to figure out Growth Rate

Answer 16

PEG = (P0/E0) / G*100