Multiples and other remaining topics Flashcards
(10 cards)
When might an analyst choose to use a price to book ratio (P/B) rather than a price to earnings
(P/E)?
If a firm is losing money (negative earnings) then book value can be a useful figure to use
as it is more likely to be positive.
Book value – and P/B – can also be useful in certain sectors, such as real estate and
banking, where Book value is a widely used metric and due to IFRS rules, many of the
assets would be fair valued.
When might you choose EBITA as an input to a valuation multiple over EBIT?
EBITA removes the distortion caused by acquisitions.
If some companies have grown via acquisition they will recognise, and likely amortise, a
number of assets. This will reduce EBIT in comparison to those companies that have
grown organically.
Using EBITA removes this distortion.
Explain the treatment of the following items in an EV bridge going form a DCF calculated
EV to an estimate of equity value:
* Fair value of outstanding employee stock options
* Pension deficit post tax
* Fair value of non-core equity investments
* Surplus cash
Surplus cash – Should be added or deducted from net debt
* Fair value of outstanding employee stock options – Should be deducted as
represents value “owned” by the employees (option holders)
* Pension deficit post tax - Should be deducted as represents value “owned”
by the employees (pension holders)
* Fair value of non-core equity investments – Should be added as not
included in EV but is owned by equity investors.
When might it not be suitable to use the Dividend Discount Model (DDM)?
Although the DDM can essentially be used on any company it becomes more difficult
where:
* No dividend payments are currently being made and there is no prospect of
payouts starting
* Management use dividends to manipulate signals sent to the stock market about a
company’s prospects.
Explain why NOPAT is often used in the calculation of Return on Invested Capital (ROIC).
Although we often wish to exclude tax, as it is not under management control, if we are
making internal comparisons and tax rates vary, our ROIC should reflect this. Using
NOPAT enables tax differentials to be reflected.
What can you say about the value of a company if the cost of equity (re) is greater than the
Return on Equity (RoE)?
The firm should be valued above its Book Value.
This is based on the residual income model:
Price of stock = BV + Present Value of Residual Income
Note residual income can be defined as: RoE (%) less Cost of Equity (%)
If ROE > Cost of Equity then residual income is positive and hence in the above
formula the company would be expected to be valued above book value.
The Gordon Shapiro Growth Model is a constant growth perpetuity calculation. What does this
mean and what is the model’s main use in valuation models?
The Gordon Growth Model (a form of the dividend discount model) assumes that dividends
(or FCF if it is used in that form) grow at a constant rate indefinitely. This assumption makes
the model simple to use but limits its applicability to companies with stable and predictable
dividend growth. The model’s main use is to estimate terminal value in a present value model.
You have overheard an investor say the following: “The intrinsic value of a stock is always
equal to its market price.” Explain with reasons whether you agree with this statement.
Disagree. The intrinsic value of a stock is the value based on fundamental analysis, such as discounted
cash flows or other valuation models. The market price, on the other hand, reflects the price at
which the stock is currently trading, which can be influenced by market sentiment, speculation,
or short-term factors. These two values often differ.
A government official states that a high dividend yield always indicates that a stock is
undervalued. Do you agree with this statement?
Disagree. A high dividend yield can sometimes indicate that a stock is undervalued, but it can also signal
financial distress or an unsustainable dividend policy. Investors should analyse the company’s
fundamentals, such as earnings stability and pay-out ratio, before drawing conclusions.
Growth stocks are always a poor investment compared to value stocks as they trade on higher
multiples. Set out with reasons whether you support this statement.
Disagree. Growth stocks often trade at higher valuation multiples due to their potential for future earnings
growth, but this does not necessarily mean they are overvalued and a poor investment. The
valuation depends on whether the growth prospects justify the higher multiples.
