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VALUATION MODELS
VALUATION MODELS
Lecturer:
Lecturer:
scope
o Residual income = economic profit
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Notice that there are two cash flows in the final period!
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undervalued!
Current market price $60 < intrinsic value $61.11, therefore a
buy decision
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oValue = PV two years of cash flows and the future sales price
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=
Current Price = $50; thus undervalued
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Very important!
Nah
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where:
D = dividend g = sustainable growth rate
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Model :
Po = E1/ r + PVGO
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+ PVGO
expensive
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Intuition: o 1/r = P/E1 ratio for a no growth company o PVGO/ E1 = P/E1 component related to growth
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Justified leading
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o H-Model, Three-Stage
o Spreadsheet modeling Growth can be expressed in three distinct phases
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Phases of Growth
1. Initial growth phase use 3-stage model
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o
o
o
o
o
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Terminal Value
o Terminal value = forecasted value at beginning of the final mature growth phase Also known as the future sales price Two estimation methods:
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Two-Stage DDM
Assume stages of growth: o First: Fixed period of supernormal growth o Then: Identify growth at normal level
o o
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Two-Stage DDM
Problem: GGM constant g assumption unrealistic Solution: Assume rapid growth for n years, then long-term sustainable growth 2-stage assumes a drop-off in growth
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Two approaches
1. Formula 2. Timeline
Suggestion: Use the timeline (or spreadsheet approach) it provides the flexibility to solve many types of problems
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Required return
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= $22.39
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2. High-growth phase + H-model pattern High followed by linearly declining followed by perpetual growth
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A. Discounted Dividend Valuation Solution: Three-Stage With H-Model D1 = $0.30 x 1.251 = $0.375 D2 = $0.30 x 1.252 = $0.469 D3 = $0.30 x 1.253 = $0.586
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Evaluation
If the current market price of the stock is $15.00, determine if the stock is fairly valued/overvalued or overvalued by the market?
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Weaknesses
Required high-quality inputs (GIGO) Value estimates sensitive to g and r
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Example: If expected dividends are $1.60 and the current price is $40 with expected growth of 9%
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= 11.7%
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Calculate SGR
Example: Compute SGR for Green, Inc.,: o Payout ratio = 25% o EPS = $1.00 o BVPS is $10.00 o ROE of 10% SGR = Retention rate (rr) x (ROE) SGR = (1 DIV/EPS) x Net Inc/Equity SGR = (1 0.25) x 10% = 7.5%
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Note: Always use beginning of year balance sheet numbers on exam (unless told otherwise) Point: SGR = retention x ROE o SGR = retention x NPM x Asset T/O x EQ mult
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higher ROE
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- FCInv
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+ Net borrowing
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Non-Cash Items Depreciation & amort. Gain on asset sale Loss on asset sale Restructuring exp./(inc.)
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Decrease FCF
Increase in assets or decrease in liabilities Inventory Accounts receivable
Increase FCF
Decrease in assets or increase in liabilities Inventory Accounts receivable
Accounts payable
Accrued taxes & expenses
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A/P
Acc Exp
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5
10
20
20
(15)
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- Depreciation
+ Assets purchased (solve) - Book value of assets sold Ending net PP&E
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a. 22 b. 37 c. 77
Balance Sheet ($M) Original Cost $40 Accum Depr. (30) Net Book Value $10
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repurchases
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3. Current Portion of LT Debt o o Incr. in short-term debt, add to FCFE Decr. in short-term debt, subtract from FCFE
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o NI = EBIT(1 t) Int(1 t)
o FCFF = EBIT(1 t) + Dep WCInv - FCInv
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Borrowings
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Reading 10c: Free Cash Flow Valuation FCFF Beginning with EBITDA
To get FCFF from EBITDA, (Earnings before Interest, Taxes, Depreciation, and Amortization), use the formula for FCFF:
FCFF = EBITDA(1 t) + Depr(t) WCInv FCInv We add back the NNC (depr) times the tax because we capture the tax benefit from deducting the depreciation; it represents the
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FCFF = NI + NNC + [Int (1 t)] WCInv FCInv FCFF = CFO + [Int (1 t)] FCInv FCFF = [EBIT(1 t)] + NNC WCInv FCInv FCFF = EBITDA(1 t ) + (NNC x t) WCInv FCInv Notice: No net borrowings!
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Accounts payable Long-time debt Common stock Retained earnings Total liab, and OE
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$ 70
$ 100
NBV of disposals
Depreciation Additions Closing NBV
(0)
(5) 25 90
Cost of disposals
Additions Closing cost
0
25 125
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WC20x7 = ($24 + $150) ($101) = $73 WC20x6= ($17 + $100) ($91) = $26
Effective tax rate = $25 / $68 37% Net borrowing = $40 - $20 = $20
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B. Free Cash Flow Valuation Soft Corp. FCFF from NI and CFO
FCFF = NI + NNC + [Int (1 t)] WCInv FCInv - 20.85 = 43 + 5 + 5(1 0.37) 47 25 FCFF = CFO + [Int (1 t)] FCInv - 20.85 = (43 + 5 47) + 5(1 0.37) 25
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B. Free Cash Flow Valuation Soft Corp. FCFE from NI and CFO
FCFE = (NI + NCC WCInv) FCInv + Net borrowing - 4 = (43 + 5 47) 25 + 20 FCFE = CFO FCInv + Net borrowings - 4 = (43 + 5 47) 25 + 20
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B. Free Cash Flow Valuation Soft Corp. FCFF and FCFE FCFE = FCFF [Int(1 t)] + Net borrowing -$4 = -$20.85 [$5(1 0.37)] + 20
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FCFF = EBITDA(1 t ) + NNC(t) WCInv FCInv - 20.85 = 78 (1 0.37) + 5(0.37) 47 25 Small differences due to tax effects in interest
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a. b. c.
Total assets
252.0
324.0
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11.0
14.0
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10.0
115.0 (40.0)
75.0
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WC2011 = 10 + 20 56 = - 26
WC2010 = 14 + 18 32 = 0 Wcinv = 26 0 = - 26 T = 40 / 115 35% Net borrowing = 70 60 = 10
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B. Free Cash Flow Valuation Recognizing of Value Between FCFE and DDM
The general valuation models are the same but the numerator is different The share of common stock is the present value of dividend or FCFE, where FCFE could be either greater or less than dividends based on the adjustments to arrive at FCFE
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Note: Share repurchase/issue is use of FCF; not determinant * e.g., if leverage increases, FCFE higher in current year (net borrowing) and lower in future years (interest expense)
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Problem: FCFF
Which of the following is most likely to affect Free Cash Flow to the Firm (FCFF)?
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Problem: EBITDA
Which of the following is least likely to be considered a reason that EBITDA is an ineffective proxy for Free Cash Flow to the Firm (FCFF)? EBITDA does not account for:
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= FCFF0 x (1 + g)
WACC g
WACC g
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Required returns
FCFE0 x (1 + g) rg =
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Multi-Stage Models
Four major variations:
1. FCFF or FCFE? 2. Two stages or three?
Base case: 2-stage, historical growth, FCFE with the GGM for terminal value
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Sensitivity Analysis
Apply sensitivity to each of the following variables:
o The base-year value for the FCFF or FCFE o Future growth rate o Risk factors beta, risk-free rate, and ERP
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Terminal Value
Terminal value = forecasted value at beginning of normal
growth phase Apply average trailing multiple (P/E) to forecasted EPS = P/E x
EPSn
Or, use single stage (Gordon Growth) model Terminal value is added to the last period cash flow and then
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Year 1
Cash flow from operations $400
Year 2
$500
Year 3
$600
WCInv
FCInv
$50
$200
$60
$250
$80
$300
Interest expense
a. b. c. $4,056 $3,502 $3,900
$15
$15
$20
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a. Apply average trailing multiple (P/E) to forecasted EPS = P/E x EPSn b. Use Gordon growth model = Dividendn / (r g)
c. Add terminal value to the last period cash flow and then discount along with the prior period FCFEs
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VALUATION MODELS
Lecturer:
One Price
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Leading P/E1 (forward or prospective): Uses forecasted earnings for coming year P0 / E1=
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specific
o Cyclicality components of earnings due to business or industry trends o Differences in accounting methods o Potential dilution of EPS
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Price Multiples
Underlying Earnings
Goal: Analysts want to remove nonrecurring items from earnings for forecasting purposes Non-recurring items to remove include: o Gains/losses on asset sales o Asset write-downs impairment o Loss provisions o Changes in accounting estimates Result : Persistent, continuing, and core earnings
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Price Multiples
Underlying Earnings
Example:
o 2008 EPS = $8
o Gain on asset sale = $1.40 o Gain from change in accounting estimate = $0.75 Underlying earnings o = $8.00 - $1.40 - $0.75 = $5.85
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Price Multiples
Normalized Earnings
Adjust EPS to remove cyclical component of earnings and capture mid-cycle or an average of earnings under normal market conditions
Two normalization methods o Method of historical average EPS o Method of average ROE
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Price Multiples
2005
$4.00
2006
$3.80
2007
$5.25
2008
$4.50
BVPS ROE
$25.00 15%
$26.00 15%
$26.00 21%
$28.00 16%
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Price Multiples
= $4.39
= 0.1675
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approaches are:
Average EPS = $4.39 P/E = $60 / $4.39 = 13.7x
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Price Multiples
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Price Multiples
Trailing EPS
$0.49 $(0.11) $(0.40) $(3.15)
E/P Ratio
1.9% - 0.6% - 4.7% - 39.0%
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Price Multiples
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Price Multiples
P0 =
D1 rg
Payout
justified leading Note: All derivations are just (1) substitution and (2) algebra. The relationships are exact
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Price Multiples
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Price Multiples
Justified P/E
Fundamental factors affecting justified P/E: P/E positively related to growth rate and payout, all else equal
o Assumes no interaction between g, payout, and ROE
P/E inversely related to required return, (real rate, inflation, and equity risk premium) all else equal
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Price Multiples
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Price Multiples
Leading P/E =
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Price Multiples
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Price Multiples
Price Multiples
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Price Multiples
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Price Multiples
Stock
Beta
Alaska Inc.
Buffalo Inc. Industry average
20.2
16.3 22.7
15.4%
19.6% 19.4%
1.20
1.20 1.20
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o Why?
Lower P/E than the industry Approximately same growth rate and risk Alaska: Cant determine o Why? Lower P/E than industry But, low P/E may result from lower growth forecast
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Price Multiples
PEG Ratio
PEG ratio is a stocks P/E divided by the expected long-term earnings growth rate g P/E g Calculates a stocks P/E per unit of expected growth PEG = Lower PEG more attractive valuation, higher PEG less attractive valuation
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Price Multiples
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Price Multiples
Conclusion: SGS Inc., is undervalued o SGS Inc., has a lower multiple per unit of expected growth
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Price Multiples
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Price Multiples
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Price Multiples
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Price Multiples
P/B0 Ratio
Rationale:
Usually positive (even when EPS < 0) Less volatile, more stable than EPS
Good for firms with mostly liquid assets (e.g., financial firms)
Useful for distressed firms, liquidation Differences in P/B ratios explain differences in long-run average returns
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Price Multiples
market value of equity book value of equity market price per = share book value per share
Market price = $80 Book value = $200 million Shares O/S = 4 million Compute P/B ratio
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Price Multiples
= $50
= 1.6
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Price Multiples
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Price Multiples
Justified P/B
Fundamental factor affecting P/B: o (ROE r) Larger spread = value creation = higher market value
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Price Multiples
Inverse Relationship o P/B increases as r decreases (falling risk, interest rates, inflation, and beta)
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Price Multiples
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Price Multiples
Stock A B Industry
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Price Multiples
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Price Multiples
average returns
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Price Multiples
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Price Multiples
P/S =
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Price Multiples
Required return = r
Sustainable growth rate = g
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Price Multiples
P0/S0 =
P0/S0 =
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Price Multiples
Growth decreases
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Price Multiples
Price Multiples
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Price Multiples
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Price Multiples
P/CF =
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Price Multiples
3. Adjusted CFO:
Adj. CFO = CFO + [interest x (1 t)] 4. EBITDA: (Also used for EV/EBITDA ratio) 5. FCFE: Theoretically superior (from this study session)
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Price Multiples
EBITDA is a pre-tax, pre-interest, pre-investment in working capital and pre-investment in fixed assets o Appropriate for firm value, not equity
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Price Multiples
Justified P/CF
Two step Process o Step 1: Calculate stock value using suitable DCF model
V0 =
FCFE0 (1 + g) r-g
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Price Multiples
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Price Multiples
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Price Multiples
P/EBITDA or EV/EBITDA?
EBITDA is a earnings flow to both debt and equity holders A multiple using total company value: Enterprise Value (EV) in the numerator is logically more appropriate than equity market price (P) Because the numerator is enterprise value, EV/EBITDA is a valuation indicator for the overall company rather than common
stock
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Price Multiples
EV / EBITDA Ratio
Enterprise Value (EV) or Firm Value
= MV of common stock + MV of debt + MV preferred cash and investments Divided by EBITDA = earnings before interest, taxes, depreciation, and
amortization
o Ratio provides an indication of company/firm value, not equity value
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Price Multiples
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Price Multiples
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Price Multiples
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Price Multiples
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Price Multiples
trailing D/P =
leading D/P = next 4 quarters forecasted DIVs market price per share For practical purposes, dividend yield, D/P is preferred over P/D (zero dividends are a problem)
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Price Multiples
D0 rg = P0 1+g
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Price Multiples
D0 = P0
rg 1+g
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Price Multiples
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Price Multiples
D/P 8% 5%
9% 6%
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Price Multiples
Problem: P/CF
The least accurate description of the advantages and disadvantages of using the price to cash flow ratio (P/CF) rather than the price to earnings ratio (P/E) is that the P/CF ratio has the:
a.
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Price Multiples
Problem: Price/Sales
The price/sales ratio is most likely to decrease as:
a.
b. inflation increases
c. risk decreases
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Price Multiples
Problem: PEG
Which of the following is least likely to be considered a disadvantage of using the P/E to growth (PEG) ratio?
a.
The PEG ratio does not account for differences in the duration of growth between firms
b. The relationship between P/E and growth is non-linear c. The PEG ratio does not account for differences in risk attributes
between firms
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Price Multiples
c. price decreases
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Price Multiples
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Price Multiples
Momentum Indicators
Momentum indicators based on price, such as the relative strength indicator, have also been referred to as technical indicators Unexpected earnings (also call earnings surprise) is the difference between reported earnings and expected earnings
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Price Multiples
Momentum Indicators
Another momentum indicator based on the relative change in earnings per share is called standardized unexpected earnings
SUEt =
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Price Multiples
Harmonic mean
o Less affected by large, more by small, outliers
Median
o Least affected by outliers
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Price Multiples
Weighting:
o Less weight on higher ratios o More weight on lower ratios Lower value than arithmetic mean (unless all observations are the same value) Used when marked weight information unavailable
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Price Multiples
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Price Multiples
Stock Screens
Applies set of criteria to narrow possible investments to those meeting criteria May be used with: o Fundamental and/or valuation criteria Multiples Momentum indicators o Individual securities, industries, economic sectors
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Price Multiples
Benefits/Limitations to Screening
Benefit: o Efficient means of narrowing investment universe Limitations: o Little control over calculation of inputs in most commercial screening software o Lack of qualitative factors
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Price Multiples
Method of comparables vs. forecasted fundamentals Valuation multiples formulas: P/E, P/B, P/S, P/CF Advantages/disadvantages of different multiples
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Price Multiples
Selection of valuation multiple (when to use P/E, etc.) PEG ratio P/E to estimate terminal value in the DDM two-stage framework
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