Valuation

Question 1

What are the two approaches to valuation?

Answer 1

1. Income Perspective
2. Asset Perspective

Question 2

Valuation in terms of the income perspective

Answer 2

Predict future earnings and cash flows based on the available information

Question 3

Valuation in terms of the asset perspecitve

Answer 3

Measure of the firm’s net assets
(Assets-Liabilities=BV of Common Equity aka SHE)

Question 4

Why are there differences in P/E ratios?

Answer 4

• Expected growth rates differ (different strategies, strengths, lines of business, managerial expertise)
• Risks of expected cash flows differ
• Earnings are computed differently (accounting policies: revenue recognition, depreciation, inventories) (accounting estimates: bad debts, warranties)
• Earnings contain transitory items

Question 5

What is the average PE ratio for the market?

Answer 5

30

Question 6

Price Earnings Ratio

Answer 6

Earnings per Share/Share Price

Basic net income per common share attributable to the company/Share Price

Question 7

What does share price indicate?

Answer 7

It is determined partially by the shares outstanding, by looking at the share price alone we can’t tell anything (instead look at price relative to earnings)

Question 8

What affect do stock splits have?

Answer 8

Increased number of shares, for an decreased share price

Question 9

In isolation, per-share stock prices reflect…

Answer 9

the number of shares the company chooses to issue

Question 10

What do companies believe about their stock when they issue a stock split?

Answer 10

They often believe that the stock will trade around the same as it was prior to the split

Question 11

Walmart’s EPS was $1.81 and its share price was $47.8 - what is the PE ratio?

Answer 11

26.4

Question 12

How do unusual and non-recurring items affect PE ratios?

Answer 12

PE ratios are based on reported income, investors use recuring income to value the firm’s assets and it’s stock price

Question 13

Why does the economy-wide PE ratio change over time?

Answer 13

World events
(ex: .com bubble, real estate crisis, COVID, inflation, war, energy and food crisis, supply chain snags, central bank tightening)

Question 14

What are the advantages of the PE approach?

Answer 14

• Quick screening tool
• Easily understood summary measure
• Widely used

Question 15

What are disadvantages of the PE approach?

Answer 15

• Based on one year’s earnings
• Ignores many causes of PE differnce (ex: growth)

Question 16

What is noncontrolling interest?

Answer 16

Equity owned by owners that aren’t common shareholders

Question 17

Book Value Ratio

Answer 17

(Shares outstanding*Price per share)/Shareholder’s Equity

Question 18

What does the price to book ratio represent?

Answer 18

• Market valuation of owners’ equity (net recorded assets) on the balance sheet
• “Net recorded assets”=Assets-Liabilities=BV of Owner’s Equity

Question 19

Why might PE and PB ratios diverge?

Answer 19

Nonrecurring items

Question 20

If the price-to-book ratio equals one what does that mean?

Answer 20

Accountants and investors perfectly agree on the value

Question 21

What might a PB ratio of 0.65 imply?

Answer 21

Overstated assets

Question 22

If the PB ratio is more than one..

Answer 22

it could imply conservative accounting or intangible assets

Question 23

If the PB ratio is less than one…

Question 24

Why is the PE ratio not meaningful when earnings are negative?

Answer 24

The PE ratio calculation assumes that current earnings are representative of future earnings and subject to expected growth and risk

Question 25

Why to PB ratios vary?

Answer 25

- Expected growth rates - Risk - BV computations differ: accounting policies and estimates - Some assets are not recorded (R&D assets and advertising are sometimes labeled as "goodwill")

Question 26

Why is the PB ratio ever less than one?

Answer 26

- Outdated book values overstate market value or liquidation value - Asset values may have fallen below historical cost (outdated and misleading accounting numbers) - Specialized assets with no ready markets - Liquidation is not immediate -> takeover target

Question 27

Why do some firms' PB ratios sharply exceed one?

Answer 27

- Unrecorded assets - Balance sheets focus on historical cost and miss "intangible assets" - For example: managerial expertise and technological advantages ->high expected growth->investors value the assets at more than the assets acquisition cost

Question 28

What are advantages of the price-to-book ratio?

Answer 28

- Summary measure focused on the balance sheet

Question 29

What are disadvantages of the price-to-book ratio?

Answer 29

- Ignores differences in growth and risk - Ignores accounting differences

Question 30

Dividend Discount Model

Answer 30

P0=D1/1+re + D2/(1+re)^2 +... DT/(1+re)^T + PT/(1+re)^T

Question 31

The dividend discounting model with predicted steady-state growth

Answer 31

- In steady state, earnings and book value grow at a constant rate - The firm's dividend payout is a constant percentage of earnings - The firm's return on equity is constant

Question 32

How realistic is the steady-state concept? Do firms experience long periods of above-normal growth?

Answer 32

- Growth is theoretically limited by the size and growth of the firm's market - Empirical evidence suggests that most firms only expeirence a few years of above-normal or below-normal growth

Question 33

Outstanding shares

Answer 33

the number of shares held by investors Shares Issued - Treasury Stock = Outstanding Shares

Question 34

Authorized shares

Answer 34

The maximum number of shares the company can issue

Question 35

Par Value

Answer 35

Historical fiction

Question 36

Capital Surplus

Answer 36

APIC

Question 37

Reinvested earnings

Answer 37

Retained earnings

Question 38

Treasury stock

Answer 38

Stock bought back by the company from the shareholders

Question 39

What do you do to find dividends in the dividend discount model?

Answer 39

Include all payments to and from shareholders (Issuance of Common Stock, Purchases of Treasury Stock, Dividends)

Question 40

The dividend and earnings predictions are fundamentally different

Answer 40

Dividends: The board of directors could adopt whatever dividend policy they choose Earnings: Economic performance achieved given its strengths and competitors' actions

Question 41

Clean Surplus

Answer 41

The only changes in SHE are from earnings and payments to and from shareholders

Question 42

Dirty Surplus Items

Answer 42

- Adoption of accounting standards - Other comprehensive loss - Foreign currency translation - Other activities

Question 43

Payments to/from shareholders

Answer 43

Dividends +Treasury Stock - Issuance of Stock - Proceeds from Stock Options

Question 44

If the discount rate falls or the growth rate increases what happens to the PV of all future dividends?

Answer 44

It increases

Question 45

Market value only exceeds book value if...

Answer 45

Residual income is positive, or if ROE exceeds the cost of capital

Question 46

Market-to-book value only exceeds 1 if...

Answer 46

ROE exceeds the cost of capital