Equity Valuation

Front 1

earnings multiplier

Back 1

(P0)/(E1) = (D1)/(E1) / (K-G)

Front 2

implications of a earnings multiplier

Back 2

*higher dividend payout ratio or faster growth rate = higher P/E ratio

Front 3

investors required rate of return is composed of

Back 3

*real risk free rate
*expected rate of inflation
*risk premium to compensate for uncertainty of the return of the investment

Front 4

following five factors are used to develop estimates of the risk premium appropriate for a specific country

Back 4

*business risk
*financial risk
*liquidity risk
*exchange rate risk
*specific country risk

Front 5

g (firm's growth rate)

Back 5

ROE * retention ratio

retention ratio = (1-dividend payout ratio)

Front 6

growth rate of dividends can be estimated from...

Back 6

*fundamentals (ROE nad retention rates)
*examination of historical growth rates and their trends and cycles relative to either time or economic conditions

Front 7

growth company

Back 7

one that consistently selects projects that earn higher returns than required for their level of risk

Front 8

growth stock

Back 8

*one that earns above-normal risk-adjusted returns
*usually does not pay a dividend
*high expected earnings growth
*high P/E ratio
*high price to book

Front 9

defensive company

Back 9

earnings are insensitive to economic recessions

Front 10

defensive stock

Back 10

one that declines less than the market when the overall market is declining (low beta stocks)

Front 11

cyclical company

Back 11

earnings that are sensitive to the business cycle

Front 12

cyclical stock

Back 12

returns that increase and decrease more than the overall market (high beta stock)

Front 13

speculative company

Back 13

assets with high risk and the potential to generate high earnings

Front 14

speculative stock

Back 14

large probability of low or negative returns and small probability of very high returns

Front 15

value stock

Back 15

*slower growth
*lower p/e ratio
*lower price to book
*high dividend yield

Front 16

EPS can be estimated off these three metrics

Back 16

*sales forecast
*estimate of profit margin
*number of shares outstanding

Front 17

P/E can be estimated by

Back 17

1) macroanalysis of the market
2) estimate company's dividend payout ratio, sustainable growth rate, and required rate of return

can then multiply estimated EPS and expected P/E ratio and see if stock is overvalued or undervalued

Front 18

advantages of using P/E ratios in valuation

Back 18

*earnings power is the primary determinant of investment value
*the P/E ratio is widely used in the investment community
*empirical research shows that P/E rankings are significantly related to long-run average stock returns

Front 19

disadvantages of using P/E ratios in valuation

Back 19

*earnings can be negative, which produces a useless P/E ratio
*the volatile, transitory portion of earnings makes the interpretation of P/E ratios difficult for analysts
*management discretion can distort earnings which distorts P/E

Front 20

advantages of P/BV

Back 20

*book value is a cumulative amnt that is usually positive can be used when EPS is negative
*book values are stable
*appropriate measure of net asset value for firms that primarily hold liquid assets, including finance, investment, insurance, and banking firms
*can be useful in valuing companies that are expected to go out of business
*empirical research shows that differences in P/BV ratios help explain differences in long-run average returns

Front 21

disadvantages of P/BV

Back 21

*do not recognize value of assets not shown on the balance sheet, such as human capital
*misleading when there are significant differences in the net balance sheet values of the assets used by the firms being compared
*different accounting conventions can obscure the true investment in the firm made by shareholders
*inflation and technological change can cause the book and market value of assets to differ significantly

Front 22

advantages of P/S ratios

Back 22

*meaningful even for distressed firms
*sales figures are not as easy to manipulate or distort as EPS and book value
*p/s are not as volatile as p/e multiples
*p/s ratios are particularly appropriate for valuing stocks in mature or cyclical industries, as well as start-up companies with no record of earnings

Front 23

disadvantages of P/S ratios

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*high sales do not necessarily indicate operating profits as measured by earnings and cash flows
*p/s ratios do not capture differences in cost structures across companies
*while less subject to distortion than earnings, sales figures are affected by revenue recognition methods

Front 24

advantages of P/CF

Back 24

*cash flow is harder for managers to manipulate than earnings
*price to cash flow is more stable than price to earnings
*using cash flow addresses the problem of differences in quality of earnings that arises when using P/Es
*differences in price to cash flow are significantly related to differences in long-run average stock returns

Front 25

disadvantages of P/CF

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*some items affecting actual cash flow from operations are ignored when the EPS plus noncash charges estimation method is used.. for example, noncash revenue and net changes in working capital are ignored
*some measure of free cash flow is theoretically preferred to operating cash flow. Free cash flow to equity can be used, but can negative and is generally more volatile than operating cash flow