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Valuation Drivers Flashcards

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1
Q

What is the core goal of valuation?

A

To estimate the economic (intrinsic) value of a firm as the discounted sum of its expected future cash flows.

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2
Q

Is economic value always equal to market value?

A

Not necessarily; valuation aims to determine whether market prices align with intrinsic value.

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3
Q

Why isn’t book value a good estimate of firm value?

A

Because book value is backward-looking and often doesn’t reflect future profitability, growth, or risk.

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4
Q

What are the three key valuation drivers?

A

Profitability (ROE), investment growth (g), and risk (r)

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5
Q

What does the ROE - r spread measure?

A

Whether the firm is creating value (ROE > r) or destroying it (ROE < r)

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6
Q

What is the cost of equity (r)?

A

The return required by investors for bearing equity risk; the firm’s “hurdle rate”.

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7
Q

What does a positive ROE - r mean?

A

The firm is generating returns above investor expectations = creating value.

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8
Q

What are the three steps of equity valuation taught in the course?

A

Understanding the past
Forecasting the future
Performing valuation

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9
Q

What are the components of understanding the past?

A

Business model analysis, accounting analysis, and ratio analysis.

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10
Q

Why is financial statement analysis important?

A

It helps uncover the firm’s true performance by interpreting accounting data.

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11
Q

What is the Dividend Discount Model (DDM)?

A

A valuation model based on the present value of expected future dividends.

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12
Q

Why is the DDM often not used?

A

Many firms don’t pay dividends, and dividends are discretionary.

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13
Q

What is the NPV formula used for?

A

To compute the present value of future cash flows discounted at a risk-adjusted rate.

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14
Q

What are value drivers in a firm’s context?

A

Elements that determine value: profitability, investment intensity, and risk.

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15
Q

What is “clean surplus” relation?

A

A condition where all changes in equity come from net income and dividends - no direct equity adjustments such as buybacks or other comprehensive income.

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16
Q

What is meant by “expected value” in valuation?

A

The average of possible future outcomes weighted by probability.

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17
Q

What is the purpose of using a structured approach to valuation?

A

To reduce errors and make forecasting and valuation more consistent and defensible.

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18
Q

What is the relationship between ROE and value creation?

A

If ROE exceeds the cost of equity, the firm adds value beyond its book equity.

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19
Q

Why is it important to understand a company’s business model before valuing it?

A

Because strategy, industry and operations drive performance and help interpret accounting numbers.

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20
Q

How does growth (g) affect firm value?

A

Higher growth leads to a larger capital base, which multiplies the effect of value creation if ROE > r.

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21
Q

What is the Residual Income Model (RIM)?

A

A valuation method based on the book value of equity plus the present value of residual income (abnormal earnings).

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22
Q

What is residual income?

A

The income left after subtracting the cost of equity from net income; RI = NI - (r * CE)

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23
Q

What is the main formula of RIM?

A

P = CE0 + Sigma( ( (ROE - R) * CEt-1) / (1 + r)^t )

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24
Q

What is ROE?

A

Return on Equity = Net Income / Book Value of Equity

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25
What does a negative residual income mean?
The firm is underperforming relative to investor expectations; destroying value.
26
What is the terminal value in RIM?
The value of the residual income beyond the forecast horizon, often modeled as a perpetuity.
27
What assumption allows for RIM simplification?
Constant ROE and constant growth (g) over time.
28
How does the simplified RIM formula look under constant assumptions?
P = CE0 + ((ROE - r) * CE0) / r - g
29
What are the key strengths of the residual income model?
Anchored in book equity, works when firms don't pay dividends or have negative cash flow, links directly to accounting performance.
30
What's a major drawback of RIM?
It heavily relies on clean accounting and accurate estimation of ROE and r.
31
When is RIM more useful than DDM or FCF?
When the firm doesn't pay dividends or has unreliable or negative cash flows, but earnings are stable and informative.
32
What type of firm is best suited for RIM?
Firms with reliable accounting, positive earnings, and no dividends.
33
What type of firm is poorly suited for RIM?
Firms with distorted accounting (write-downs, restatements etc.), or unpredictable income.
34
What is the role of cost of equity (r) in RIM?
It is used both as a hurdle rate for determining residual income and as the discount rate.
35
Is RIM sensitive to accounting manipulation?
Yes, since it depends on reported net income and book equity, aggressive accounting can distort results.
36
How does RIM relate to economic added value (EVA)?
They are conceptually similar - both focus on returns above the cost of capital.
37
How does RIM treat reinvested earnings?
RIM assumes reinvested earnings generate future residual income if ROE > r.
38
Can RIM produce the same valuation as FCF and DDM?
Yes - in theory, all consistent models should converge to the same value given consistent inputs.
39
What role does book equity play in RIM?
It's the starting point and the base on which abnormal returns are earned.
40
Why is RIM favored in accounting-based valuation courses?
Because it links directly to financial statements and shows how accounting performance drives value creation.
41
What does NPV represent in valuation?
The present value of all expected future cash flows discounted at a required rate of return.
42
Why do we discount future cash flows in valuation?
Because money today is worth more than money tomorrow due to time value and risk.
43
What is the 'clean surplus" relation?
An accounting assumption where all changes in equity (other than transactions with owners) flow through net income.
44
What is meant by "forecasting the future" in valuation?
Projecting a firm's future performance based on past trends and expected changes.
45
What is a "catalyst" in equity investing?
An event or signal that may trigger the market to recognize a mispriced security (new info, fraud exposure etc.)
46
Why might investors prefer earnings-based valuation over DDM or FCF?
Because it links value directly to accounting performance and doesn't require dividend payments or complex FCF estimates.
47
What is the "cost of equity capital"?
The return that equity investors require, considering the firm's risk profile.
48
What is pro-forma forecasting?
The construction of forward-looking financial statements based on assumptions.
49
What are financial ratios used for in FSA?
To evaluate a company's financial performance, efficiency, profitability, and risk.
50
What are some common financial ratios used in valuation?
ROE, ROA, profit margins, asset turnover, inventory turnover, and P/E ratio.
51
What is the difference between ROE and ROI?
ROE focuses on returns to equity holders; ROI can refer to returns on total investment, including debt.
52
What is the role of "information collection" in valuation?
Gathering context (industry, economy, firm strategy) to inform assumptions in forecasting.
53
What is accounting analysis in valuation?
Evaluating how well financial statements represent the firm's real economic situation.
54
Why is understanding the business model essential before doing valuation?
Because operations and strategy determine how financials are generated and interpreted.
55
What is the danger of relying purely on quantitative models in valuation?
They can miss qualitative factors (competitive edge, leadership, market sentiment) that affect value.
56
What is "value creation"?
Generating returns above the required cost of capital (ROE > r).
57
What is "value destruction"?
Earning a return below the cost of capital (ROE < r), eroding shareholder value.
58
What does "CE" stand for in the earnings-based model?
Common Equity, or book value of equity, at a point in time.
59
Why is book value used as the valuation anchor in the RIM model?
Because it reflects the cumulative reinvested earnings and capital contributions, forming the capital base for future value creation.
60
What is book value?
The accounting value of an asset or equity as recorded on the balance sheet; for equity, it's total assets minus total liabilities.
61
What is market value?
The current price at which an asset or equity can be bought or sold in the market.
62
What is Common Equity (CE)?
The residual interest in the assets of a firm after deducting liabilities; it represents shareholders' ownership.
63
What is Net Income (NI)?
A firm's total earnings or profit, calculated as revenues minus expenses, taxes, and interest.
64
What are retained earnings?
The portion of net income that is kept in the company instead of being distributed as dividends.
65
What is total equity?
The sum of common equity, preferred equity, and retained earnings.

Financial Statement Analysis & Valuation (7 decks)

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