EQUITY MODULE 46

Question 1

46.1 What does security valuation have to be to be profitable?

Answer 1

the convergence must happen!

Question 2

46.1 What are the three types of equity valuation models?

Answer 2

• Discounted cash flows
• multiplier models
• asset-based models

Question 3

46.1 What does a DCF do? And how does the approach differ on size of investor?

Answer 3

Question 4

46.1 What do multiplier models or ‘relative value’ models do?

Answer 4

compare something about the company’s fundamentals to the market price

Ones with ‘p’ are focused more on the equity value, whereas enterprise value involves more

Question 5

46.1 What are asset-based models?

Answer 5

look at assets, and whats left is left for the shareholders

Question 6

46.1 What are the different types of dividends?

What do three of these types have in common?

Answer 6

Question 7

46.1 What is a share repurchase as an alternative to a dividend?

Answer 7

Question 8

46.1 Describe the dividend chronology:

Answer 8

Question 9

46.1 What information is disclosed at the declaration date?

Answer 9

• what the dividend is going to be
• when its going to paid
• when you need to be ‘on the books’ as a shareholder in order to receive the dividend
  (which is usually at the holder of record date)

Question 10

46.1 What day do you need to buy the share to receive a dividend?

Answer 10

The day before the ex-div date!

because on the ex-div date you are too late! It is the first dat the stock trades without a dividend, therefore the price will be down by the dividend

Question 11

46.1 How does a DDM work? What are the ways the DDM could calculate?

Answer 11

Two stage growth - higher growth in starting years

Question 12

46.1 How would we calculate the PV of a share for a one year holding period?

+ how do we expand this for more years?

Answer 12

Question 13

46.1 How do we do a valuation for preferred stock?

Answer 13

We do this as a perpetuity because the dividend is fixed.

Usually assume that there is no end date

Question 14

46.1 You have valued a preferred share to be worth $63.

Would the value be higher or lower of the share was callable?

Answer 14

Question 15

46.1 What is the Gordon (constant) growth model formula? what does it do?

What is important to remember here!

Answer 15

It finds the PV of a perpetuity

NOTE: the dividend in the formula is actually the time 1 dividend - we will often have to work this out

Question 16

46.1 If a company has just paid a dividend - what do we label that dividend?

Answer 16

D0

Question 17

46.1 If we want to know how much of the value calculated int he GGM, how do we do this?

Answer 17

just do P0 = D1/k

Question 18

46.1 How do we estimate g? (growth)

Answer 18

g = b x ROE

b = earnings retention rate WHIHC IS THE SAME AS (1-dividend payout)

Question 19

46.1 How can you locate the information needed to estimate g in company data?

Answer 19

Question 20

46.1 Using data from company info - describe two methods of calculating g

Answer 20

Question 21

46.1 What is the historical growth rate and what is the sustainable growth rate?

Answer 21

historical = average of what has happened in future

sustainable = using ROE x (1 - dividend payout ratio)

Question 22

46.1 How would we tackle this?

Answer 22

Question 23

46.1 Especially on multi stage - how can we speed up?

Answer 23

AOS version on calc

Question 24

46.1 What do Free cash flow models do?

Answer 24

Question 25

46.1 What are the advantages and disadvantages of present value models?

Answer 25

Question 26

46.1 Name some price multiples:

Answer 26

price/book price/sales price/cash flow cash flow is less subject to accounting manipulation than profit, for example

Question 27

46.1 What are the advantages and disadvantages of using price multiples for valuation?

Answer 27

BUT inputs can be distorted by accounting choices

Question 28

46.1 How do we calculate forward P/E based on fundamentals?

Answer 28

Po is the price today! E1 is the analysts earnings estimate D1 and E1 dividend and earnings from same period 1

Question 29

46.1 Other things equal, the fundamental P/E ratio is higher if firm has:

Answer 29

Question 30

46.1 name some other price multiples:

Answer 30

Question 31

46.1 What is the law of one price?

Answer 31

Question 32

46.1 What is enterprise value?

Answer 32

the value of all of the sources of long term finance

Question 33

46.1 What is EV/EBITDA?

Answer 33

compares the value of the whole entity to the profit making ability of the whole company

Question 34

46.1 How would you tackle this?

Answer 34

1. compute EV (market value of equity (stock price x shares outstanding), debt, and subtract cash) 2. compute EBITDA (operating profit, but add back depreciation and amortisation) 3. do x/y 4. Compare to industry average

Question 35

46.1 What are asset-based valuations? (what are downsides)

Answer 35

look at the accounts, and this what are the net assets of the company?

Question 36

46.1 What considerations do we have when choosing a valuation method?

Answer 36

Question 37

46.1 A company is evaluating the likely effects on its share price of declaring a 50% stock dividend or a 3-for-2 stock split. Other things equal, which of these will result in a lower share price?

Answer 37

both should have the same effect Both a 50% stock dividend and a 3-for-2 stock split will increase the number of shares by 50%, while neither will affect value of the company. Therefore, the decrease in the share price should be the same in either case.

Question 38

46.1 For the constant growth model, the constant growth rate (g) must be ____ than the required rate of return

Answer 38

LESS

Question 39

46.1 How would you do this? An analyst estimates that a stock will pay a $2 dividend next year and that it will sell for $40 at year-end. If the required rate of return is 15%, what is the value of the stock?

Answer 39

($40 + $2) / 1.15 = $36.52

Question 40

46.1 How would you do this? What is the intrinsic value of a company's stock if dividends are expected to grow at 5%, the most recent dividend was $1, and investors' required rate of return for this stock is 10%?

Answer 40

Using the constant growth model, $1(1.05) / (0.10 − 0.05) = $21.00. REMEMBER - Vo = D1 / !!!

Question 41

46.1 Talk me through how you would do this: Assume that a stock is expected to pay dividends at the end of Year 1 and Year 2 of $1.25 and $1.56, respectively. Dividends are expected to grow at a 5% rate thereafter. Assuming that ke is 11%, the value of the stock is closest to:

Answer 41

Discount normally (so +1!!) to begin with. Then do GGM Chat GPT explains this better: Just find D1, D2 and D3 (in order to find the value of the stock at time 2) Then discount back D1, D2, and V2. and add them together. (no GGM, just normal discounting)

Question 42

46.1 How do you do this? A firm has an expected dividend payout ratio of 60% and an expected future growth rate of 7%. What should the firm's fundamental price-to-earnings (P/E) ratio be if the required rate of return on stocks of this type is 15%?

Answer 42

Using the earnings multiplier model, 0.6 / (0.15 − 0.07) = 7.5×

Question 43

46.1 Which type of valuation model is viewed as having the disadvantage of producing results that may not be comparable across firms?

Answer 43

price multiple models

Question 44

46.1 What is the earnings multiplier model?

Answer 44

Question 45

46.1 What is the Dupont formula?

Answer 45

ROE=(Profit Margin)×(Asset Turnover)×(Equity Multiplier)

Question 46

46.1 How do you calculate price to book ratio?

Answer 46

Question 47

46.1 All else equal, the price-to-earnings (P/E) ratio of a stable firm will increase if the:

Answer 47

ROE is increased. The increase in growth rate will increase the P/E ratio of a stable firm and growth rate can be calculated by the formula g = ROE × retention ratio. All else being equal an increase in ROE will therefore increase the P/E ratio. Note that decreasing the dividend payout ratio and decreasing the long term growth rate will both serve to decrease the P/E ratio. USE THE FORWARD PE RATIO EQUATION

Question 48

46.1 Beth Knight, CFA, and David Royal, CFA, are independently analyzing the value of Bishop, Inc., stock. Bishop paid a dividend of $1 last year. Knight expects the dividend to grow by 10% in each of the next three years, after which it will grow at a constant rate of 4% per year. Royal also expects a temporary growth rate of 10% followed by a constant growth rate of 4%, but he expects the supernormal growth to last for only two years. Knight estimates that the required return on Bishop stock is 9%, but Royal believes the required return is 10%. Is Royal's valuation of Bishop stock is approximately $5 less, more, or equal to Knights valuation?

Answer 48

You can select the correct answer without calculating the share values. Royal is using a shorter period of supernormal growth and a higher required rate of return on the stock. Both of these factors will contribute to a lower value using the multistage DDM.

Question 49

46.1 How would you approach this? Assume that a stock paid a dividend of $1.50 last year. Next year, an investor believes that the dividend will be 20% higher and that the stock will be selling for $50 at year-end. Assume a beta of 2.0, a risk-free rate of 6%, and an expected market return of 15%. What is the value of the stock?

Answer 49

As soon as you see beta - think CAPM Take the dividend last year, multiplied by growth rate for one this year. Then add the stock value at year end to numerator. Then discount by 1+cost of equity find cost of equity using CAPM

Question 50

46.1 How would you calculate P/E, P/B and P/S from the following:

Answer 50