Reading 50- Equity Valuation: Concepts & Basic Tools Questions And Answers Well Defined.

the larger the % difference between market prices & estimated values, - correct answer the more likely the investor is to take a position based on estimate of intrinsic (fundamental) value the more confident the investor is about the appropriateness of the valuation model, - correct answer the more likely investor is to take an investment position in an overvalued/ undervalued stock if analyst is more confident of his input values, - correct answer more likely to conclude that security is overvalued market price is more likely to be correct for a security when - correct answer many analysts follow security present value model (discounted cash flow model) - correct answer estimate intrinsic value of security as present value of future benefits -dividend discount model (DDM) -free cash flow to equity model (FCFE) (-) not used for companies that have only 1 year of data available multiplier model (market multiple model) - correct answer price multiples or enterprise value multiples P/E, P/S, P/B, EV (-) MV debt hard to obtain asset-based model - correct answer intrinsic value of common stock is estimated as total value of [assets- liabilities] & preferred stock book value (carrying value) dividend discount model (DDM) - correct answer intrinsic value of stock= PV of future dividends + expected selling price in one year V0=D1/(1+r) + P1/(1+r) one-year holding period (DDM) - correct answer value of stock= present value of any dividends during the year + present value of expected price of stock at end of year multiple-year holding period DDM - correct answer sum present value of dividends over holding period and the estimated terminal (ending) value free cash flow to equity (FCFE)= represents cash that could be paid out to common shareholders a measure of dividend-paying capacity - correct answer net income + depreciation - increase in working capital- fixed capital investment (FCInv)- debt principal repayments + new debt issues discount expected future FCFE by required rate of return on equity: V0= sum FCFE/(1+r)^t present value of a non-callable, non-convertible PERPETUAL preferred share - correct answer V0= D0/r present value of a non-callable, non-convertible preferred stock - correct answer V0=∑ D/(1+r) + F/(1+r) (similar to DDM but P1 is replaced by F) F= preferred stock's par value Gordon growth model (constant growth model) - correct answer annual growth rate of dividends, g, is constant. dividend D1= D0(1+g) dividend D2= D0(1+g)^2 dividend D3= D0/(1+g)^3... when should you use the Gordon growth model? (key words) - correct answer forever infinitely indefinitely just paid, recently paid, current dividend= last dividend D0 will pay, is expected to pay= D1 price multiple - correct answer ratio that compares share price with some monetary flow or value (-) doesn't consider the future P/E ratio - correct answer price to earnings per share a low P/E= buy P/S - correct answer price to sales per share 1. sales revenue/ number of shares 2. divide stock price by sales per share P/S P/B - correct answer price divided by book value of equity per share P/CF - correct answer price divided by cash flow per share cash flow= operating or free cash flow justified P/E - correct answer P/E based on fundamentals derived from Gordon growth model d/(r-g) P0/E1=p/(r-g), where p= payout ratio the justified P/E ratio is very sensitive to inputs (r and g) dividend displacement earnings:* An increase in the dividend payout ratio will (hint: g= (1- dividend payout ratio)*ROE justified forward P/E= p/(r-g) - correct answer reduce firm's growth rate net effect on firm value is ambiguous* (because have to take into account value of r in d/(r-g) P/E ratio is inversely related to r & directly related to g. payout ratio p is ambiguous "dividend displacement of earnings" higher P/E - correct answer higher dividend payout ratio higher growth in sales lower P/E - correct answer higher level of debt (bc higher risk and higher required return on equity k in the denominator) law of one price - correct answer 2 identical assets should sell at the same price (multiples based on comparables) (-) using price multiples based on comparables - correct answer stock may be overvalued by comparable method; undervalued by fundamental method different accounting methods price multiples greatly affected by economic conditions Enterprise Value (EV)= - correct answer MV equity + MV debt + MV preferred stock - Cash - Short-term Investments Therefore, Equity value (MV equity)= EV- Debt + Cash Calculate EV/EBITDA: - correct answer 1. short-term debt book value= book value of total debt- book value of long-term debt 2. market value of total debt= market value of long-term debt + short-term debt 3. market value of total equity= stock price * number of shares 4. enterprise value= sum of debt + equity- cash 5. EV/EBITDA= enterprise value/ (given in the problem) multiple 10 9= overvalued if competitor or industry average EV/EBITDA is ABOVE that of the firm, the firm is relatively - correct answer undervalued price multiples advantages - correct answer