6. Equity Valuation Models

Question 1

Fundamental analysts

Answer 1

• Use information concerning current and prospective profitability of company to assess its fair market value
• Purpose: find stocks that are mispriced relative to measures of “true” value

Question 2

To determine true value of stock, compare with:

Answer 2

1. Book value/valuation by comparable
2. Liquidation value
3. Replacement costs

Question 3

Book value/valuation by comparables (accounting) examples

Answer 3

• Price/Earnings, Price/Book (market-to-book), Price/Sales, Price/CF, PEG
• PEG normalizes P/E ratio by growth rate. If ratios are below industry average, they might indicate that stock is underpriced. However, more mature companies have lower expected future growth rate

Question 4

Book value/valuation of comparables

Limitations of book value

Answer 4

Values of assets and liabilities in financial statements are based on historical values (original cost)

Question 5

Book value/valuation of comparables

Market value of shareholders’ equity

Answer 5

Current value of assets – current value of liabilities. Current values generally don’t match historical values

Question 6

Liquidation value

Answer 6

• Amount of money that could be realized by breaking up firm, selling assets, repaying debt, distributing remainder to shareholders
• Firm becomes attractive takeover target if market price < liquidation value

Question 7

Replacement costs

Answer 7

• Cost of replicating firm (important in innovative industries)
• Market value will drive down to replacement cost, because competitors are entering market

Question 8

Replacement costs

Tobins Q

Answer 8

• Market price / replacement value of firm’s assets should be 1, but evidence is that it can differ significantly from 1 for long periods
• 0 < Q < 1 : market value < replacement cost (undervalued)
• Q > 1 : market value > replacement cost (overvalued)

Question 9

Quantitative models to value common stock (one year holding period):

Answer 9

1. Investor stock expects return consisting of cash dividends and capital gains/losses: expected dividend yield + expected capital gain yield
2. Intrinsic value

Question 10

Quantitative models to value common stock (one year holding period):

Intrinsic value

Answer 10

PV all cash payments to investor in stock discounted at appropriate risk-adjusted interest rate: dividend, proceeds from sale of stock

a. Compare intrinsic value with market value to see whether stock is under- or overvalued. Undervalued stock -> positive-alpha stock.
b. Market capitalisation rate

Question 11

Quantitative models to value common stock (one year holding period):

Intrinsic value

Market capitalisation rate

Question 12

Three main methods to value a stock (main problem: get reliable predictions):

Answer 12

1. Dividend discount model
2. P/E ratios and growth opportunities
3. Discounting free cash flow of equity

Question 13

Trading rules

Question 14

Dividend discount model

Answer 14

a. Determine investment horizon
b. Predict future dividend payments (and future stock price)
c. Estimate discount rate
d. Set IV equal to discounted expected future dividends

Question 15

DDM implications

Question 16

P/E ratios and growth opportunities

Answer 16

a. Common claim
i.
ii.
b. P/E ratios
i.
ii.
iii.