Flashcards in Section 103 Unit 9 Deck (14):

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## Instrinsic Value of Stock Four Approaches

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The constant growth dividend discount model;

The multistage (variable) growth dividend discount model; and

The no-growth (perpetuity) dividend discount model.

The discounted free cash flow model.

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## Constant Growth Dividend Discount Model

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This model is used to determine the intrinsic value of a stock when dividends are growing at a constant rate.

Intrinsic Value = Dividend Paid (D1) / Investor's required rate of return (r) - growth rate (g)

**If information is provided regarding the current year dividend (or end of period 0), the formula [D0 × (1 + g)] may be used in substitution of D1 in the model.

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## Expected Return of a Stock

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Rather than using the required rate of return we can replace it with the expected rate of return by doing

Dividends ( (D1) / Current Price (P) ) + Growth rate (g)

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##
Multistage (Variable) Growth Dividend Discount Model

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The multistage (variable) growth dividend discount model assumes that the growth rate of the stock’s dividend is not constant, but rather changes (either up or down). To determine the intrinsic value of a stock using this model, you must follow a three-step process.

Compute the value each future dividend until the growth rate stabilizes.

Use the constant growth dividend discount model to compute the remaining intrinsic value of the stock at the beginning of the year when the dividend growth rate stabilizes.

Use the uneven cash flow method to solve for the net present (intrinsic) value of the stock.

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## No-Growth (Perpetuity) Dividend Discount Model

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The same formula as the Constant Growth Dividend Discound Model except the growth rate will be ZERO since there is no growth.

Intrinsic Value = Dividend Paid (D1) / Investor's required rate of return (r) - growth rate (g)

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## Discounted Free Cash Flow Model

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When a company does not pay dividends.

FCFE = Free cash flow to equity

R = Required rate of return

G = Growth rate

FCFE/ (r - g)

7

## Discounted Earnings Model/Capitalized Earnings

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Used to discount earnings instead of cash flows as in the dividend growth models. This model is a simplistic method for valuing a corporation and, by extension, its outstanding stock.

E = Earnings for the company

Rd = Discount rate

E/ Rd = company worth

Company worth / outstanding shares = worth per share

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## Price-to-Earnings (P/E) Ratio

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P/E ratio = Dividend payout ratio / r -g

V = EPS × P/E ratio

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## Price-to-Earnings Divided by Growth (PEG) Ratio

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PEG = P/E / g

We would then compare the PEG ratio of Acme stock to its peers to determine whether the stock is a good buy. Proponents of the PEG ratio generally believe that companies with a low PEG ratio (for example, lower than 1.00) will have higher future rates of return and are good value stocks.

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## Price-to-Free-Cash-Flow (P/FCF) Ratio

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Another relative measure of stock valuation is that of how effectively the issuing company uses its free cash flow to generate earnings growth.

(1+g)/(r-g) = (P/FCF)

Then, as with the other ratios, we would compare this P/FCF ratio to Acme stock’s peers to determine if a purchase is warranted. For example, if the ratio is lower than that of the stock’s peers, we may wish to purchase the stock.

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## Price-to-Sales (P/S) Ratio

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P/S = Profit margin x dividend payout ratio x (1+g)/ r-g

As with all the other ratios discussed, the P/S ratio of Acme stock is then compared to its industry peers to determine whether the stock appears to be undervalued or overvalued. Similar to the price-to-free-cash-flow ratio, a ratio lower than that of its peers indicates a value buy.

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## Valuation Methods

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Intrinsic Value Methods

Constant Growth Dividend Discount Method

Multistage (Variable) Growth Dividend Discount Model

No-Growth/Perpetuity Dividend Discount Model

Discounted Free Cash Flow Model

Relative Value Methods

Price-to-Earnings (P/E) Ratio

Price-to-Earnings Divided by Growth (PEG) Ratio

Price-to-Free Cash Flow (P/FCF) Ratio

Price-to-Sales (P/S) Ratio

13

## Book Value

### The book value of a company refers to the amount of equity available to its shareholders—that is, the amount that the shareholders have invested in the company. The value is determined by subtracting company liabilities from company assets and is the equivalent of net worth as determined on an individual’s statement of personal financial position.

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