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Year 1: Introduction to Finance > Topic 6: Valuing Stocks > Flashcards

Topic 6: Valuing Stocks Flashcards

(45 cards)

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1
Q

What is a stock?

A

Equity investment that represents part ownership in a corporation and entitles you to part of that corporations earnings and assets

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2
Q

What is a common stock?

A

Usually entitles the owner to vote at shareholders’ meetings and to receive dividends

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3
Q

What is a Preferred stock?

A

Generally does not have voting rights, but has a higher claim on assets and earnings than the common sharers

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4
Q

Show the Dividend Discount Model: A one-year investor?

A
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5
Q

What happens if the current stock price were less than P0 in the Dividend Discount Model?

A

Expect investors to rush in and buy it, driving up the stock’s price

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6
Q

What if the stock price exceeded P0?

A

Selling it would cause the stock price to quickly fall

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7
Q

In The Dividend Discount Model: A One-Year Investor how would you solve for the total return?

A

Total Return = Dividend Yield + Capital Gain Rate

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8
Q

Important Rule for the Dividend Discount Model

A

The expected total return of the stock should equal the expected return of other investments available in the market with equivalent risk

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9
Q

Show The Dividend Discount Model: Two-Year Investor

A
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10
Q

Show the The Dividend Discount Model: Multi-Year Investor

A
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11
Q

What is the definition of the Dividend Discount Model?

A

The price of any stock is equal to the present value of the expected future dividends it will pay

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12
Q

Formula for Dividend Discount Model

A
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13
Q

Firms future dividends will grow at a ….

A

Constant Rate

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14
Q

For a firm to maximise its share price it would like …

A

To increase both Dividends and Growth

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15
Q

What are the trade-offs of a firm maximising its share price?

A
  • Retaining more earnings (less dividend) can fund investment, boosting future growth
  • Paying out more earnings (higher dividend) leaves less for reinvestment can reduce further growth
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16
Q

Payout Rate

A
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17
Q

Retention Rate

A
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18
Q

Earnings per share

A
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19
Q

The change in earnings is driven by…

Study These Flashcards
A

the new investment

20
Q

New investment =

Study These Flashcards
A

Earnings x Retention Rate

21
Q

Firm’s growth rate in earnings

Study These Flashcards
A

g = (1 - Payout Rate) x Return on New Investment

22
Q

The more a firm retains and the higher the return on new investments…

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A

The faster it can grow its earnings (and dividends)

23
Q

If a firm wants to increase its share price

Cut dividends and invest more?

vs.

Cut investment and pay more dividend?

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A

The answer will depend on the profitability of the firm’s investments

Cutting the firm’s dividend to increase investment will raise the stock price if, and only, if the new investments have a positive NPV.

Retaining earnings is worthwhile only if the return on those retained earnings is high enough to compensate shareholders for the lower dividends.

24
Q

Dividend-Discount Model with Changing Growth Rates

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A

We cannot use the constant dividend growth model to value a stock if the growth rate is not constant

Young firms often have very high initial earning growth rates

During this period of high growth, these firms often retain 100% of their earnings to exploit profitable investment opportunities

As they mature, their growth slows

At some point, their earnings exceed their investment needs, and they begin to pay dividends

25
Formula for Dividend-Discount Model with Changing Growth Rates
26
Limitations of the Dividend-Discount Model
- Uncertainty associated with forecasting a firm's dividend growth rate and future dividends - Small changes in the assumed dividend growth rate can lead to large changes in the estimated stock price
27
What are Share Repurchases
When the firm uses excess cash to buy back its own stocks
28
What are the implications for the Dividend-Discount Model
- The more cash the firm uses to repurchase shares, the less it has available to pay dividends - By repurchasing, the firm decreases the number of shares outstanding, which increases its earnings and dividends per share
29
What is the Total Payout Model
The value of all the firm equity per share - You discount total dividends and share repurchases - Use the growth rate of earnings (rather than earnings per share) when forecasting the growth of the firm's total payouts
30
Total Payout Model Formula
31
What is Free cash flow?
Cash flow available to pay both debt holders and equity holders
32
What is Enterprise Value?
Value of the firm to all investors (equity and debt holders)
33
Enterprise value Formula
V0 = Market Value of Equity + Debt - Cash
34
What is the Method of Comparables?
Estimate the Value of other comparable firms or investments that we expect will generate very similar cash flows in the future
35
What is the Valuation Multiple?
A ratio of firm's value to some measure of the firm's scale or cash flow
36
What is Price-Earnings Ratio?
Share Price divided by EPS (Firms with higher growth rates should have high P / E multiples)
37
What are other multiples?
- Multiple of Sales - Price to book value of equity per share - Enterprise value per subscriber
38
What are the limitations of Multiples?
- When valuing a firm using multiples, there is no guidance about how to adjust for differences in expected future growth rates or risk - Comparables only provide information regarding the value of a firm relative to other firms in the comparison set - Using multiples will not help us determine if an entire industry is overvalued -> They can incorporate specific information about the firm's cost of capital or future growth
39
Why can't a single stock valuation technique provide a final answer?
All approaches require assumptions or forecasts that are too uncertain to provide a definitive assessment of the firm's value Most real-world practitioners use a combination of these approaches and gain confidence if the results are consistent across a variety of methods
40
What does a valuation model do?
Can link three variables e.g. Share value, Future Cash flows and cost of Capital Is useful when given 2 variables, as the model allows us to make inference about the third variable
41
Information in Publicity traded firms?
Its current stock price should already provide very accurate information, aggregated from a multitude of investors, regarding the true value of its shares
42
What is the Efficient Markets Hypothesis?
Securities will be fairly priced, based on their future cash flows, given all information that is available to investors - Public, Easily Interpretable Information (news reports, financial statements, etc.) - All investors can determine the effect of this information on the firm's value - The stock price will react instantaneously to such news
43
Private or Difficult to interpret information?
- A small number of investors may be able to profit by trading on their private information - The efficient market hypothesis will not hold. But, as these informed traders begin to trade, they will tend to move prices, so over time prices will begin to reflect their information as well - If the profit opportunities from having private information are large, others will devote the resources needed to acquire
44
Consequences for investors
- If stocks are fairly priced, then investors who buy stocks can expect to receive future cash flows that fairly compensate them fir the risk of their investment - In such cases the average investor can invest with confidence, even if he is not fully informed
45
Implications for Corporate Managers
- Focus on NPV and free cash flow - Avoid accounting illusions and focus on free cash flows - Use financial transactions to support investment

Year 1: Introduction to Finance (10 decks)

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