Week 7 Flashcards
What is intrinsic valuation? How is it typically done?
In intrinsic valuation the value of an asset is a function of its fundamentals, its cash flows, growth and risk. In general this is done with discounted cash flow models.
What is relative valuation? How do we do this typically?
In relative valuation the value of an asset is estimated based upon what investors are paying for similar assets. This takes the form of value or price multiples and comparing firms within the same business.
What is contingent claim valuation?
Contingent claim valuation is when the cash flows on an asset are contingent on an external event, with the value estimated using option pricing models.
When will intrinsic value and relative value converge and when will they diverge?
The intrinsic value and relative value will converge in efficient markets and diverge in inefficient markets.
What is the value of equity?
the value of equity is the sum of present values of cash flows to equity, discounted at the cost of equity.
What is the dividend discount model? Is it a conservative or aggressive model?
The dividend discount model is a specialized case of equity valuation, and the value of a stock is the present value of expected future dividends. This can occur because there are two expected cash flows for investors, the dividends from the holding period and the expected price at the end of the holding period. The expected price at the end of the holding period is based on the dividends paid out. It is a conservative measure because it only counts cash flows actually paid out.
How do we attain the value of a firm?
The value of the firm is obtained by discounted expected cashflows to the firm, this means the residual cash flows after meeting all operating expenses and taxes, but prior to debt payments, at the weighted average cost of capital. So value of firm equals the sum of discounted cash flows to the firm, discounted at the WACC.
What must be true of a firms other measures of performance if a firm is expected to have its cash flows grow at a stable rate?
If a firm’s cash flows are expected to grow at a stable rate, then the firm’s other measures of performance, such as revenue, earnings, and reinvestment are expected to grow at the same rate. This is because if dividends grow higher than these eventually they will become too large to sustain. If the earnings grow faster than dividends the payout ratio will eventually become 0, which isn’t steady.
What is a good rule on the cap of a stable growth rate? Why is this important?
A firm cannot reasonably expect to grow at a rate significantly higher than the growth rate in the economy, as this would mean the firm would become larger than the economy, however a growth rate below the economy growth rate is possible. A good rule is that the cap on the stable growth rate should be less than or equal to the risk free rate. This is because the risk free rate should be equal to the expected inflation plus the expected real interest rates. Hence the risk free rate is a proxy for the real growth in the economy
What is true about the discount rate used and the risk of an investment?
The discount rate used should be consistent with both the riskiness and the type of cashflow being discounted.
What is the net capital expenditure?
Net capital expenditure = capital expenditure - depreciation.
How can we work out a firm’s reinvestment rate? How does this change over the life of the firm?
A firm’s reinvestment rate can be estimated using past history on reinvestment, or the average reinvestment rate (which is better when reinvestment rate tends to vary), as firms grow and mature however the reinvestment rate of firms tens to decline, making the historical reinvestment rate greater than the expected reinvestment rate, in this case we should use the industry average reinvestment rate.
What will the EPS growth rate of two firms with different debt levels but the same return on equity be?
Two firms with the same return on equity but different debt levels should have the same growth rate in earnings per share assuming they have the same dividend payout ratio, this is because earnings per share growth is given by return on equity * retention rate.
What is the maximum reasonable length of the high growth period
10 years
What are some ways to increase firm value?
Increase the cashflows from existing assets by managing them better, increase the growth from new investments by investing optimally for future growth, increase the efficiency growth, by introducing scope for more efficient utilization of existing assets, increase the length of the high growth period by building on competitive advantages, lower the cost of capital by using the right amount and kind of debt for the firm.
