Financial Valuation Methods

Question 1

What is an annuity?

Answer 1

• a series of equal cash flows to be received over a number of periods
• annuity present value formula- divides FCF by a rate of return in order to determine the value of the annuity in today’s dollars

Question 2

What is a perpetuity/perpetual annuity?

Answer 2

• when the periodic cash flows paid by an annuity last forever
• when a co. is expected to pay the same dividend each period, the formula can be used to determine the value of the company’s stock
• the method used to value preferred stock

P= D/R
where P= stock price
D= dividend
R= required return

Question 3

What is the Constant (Gordon) Growth Dividend Discount Model (DDM)?

Answer 3

• assumes that dividend payments are the CFs of an equity security and that the intrinsic value of the company’s stock is the PV of the expected future dividends
• if dividends grow at a constant rate, this model can be used to determine the value of the co’s stock
• stock price will grow at the same rate as dividends

Question 4

What is the price-earnings (P/E) ratio?

Answer 4

• measures the amount that investors are willing to pay for each dollar of earnings per share
  Po/E1
  where Po= stock price or value today
  E1= EPS expected in one year (next four quarters)

Question 5

What is the PEG ratio?

Answer 5

• shows the effect of earnings growth on a company’s P/E, assuming a linear relationship between P/E and growth

PEG= (Po/E1)/G
where Po= stock price or value today
E1= expected EPS
G= growth rate

Question 6

What is the price-to-sales ratio?

Answer 6

• can be used to estimate the current stock price

Po/S1
where Po= stock price or value today
S1= expected sales in one year

Question 7

What is the price-to-cash-flow ratio?

Answer 7

• may be used to calculate the current stock price

Po/CF1
where Po= stock price or value today
CF1= expected CF in one year

Question 8

What is the price-to-book ratio?

Answer 8

• focuses on the balance sheet rather than the I/S or statement on CF
• a firm’s book value of common equity is more stable than earnings per share, esp when a firm’s EPS is extremely high or low for a given period

Po/Bo
where Po= stock price or value today
Bo= book value of common equity

Question 9

What is an option?

Answer 9

• a contract that entitles the owner (holder) to buy (call option) or sell (put option) a stock at a given price within a stated period of time
• american style options can be exercised at any time prior to their expiration
• euro style options can be exercised only at the expiration or maturity date of the option

Question 10

What are the 4 methods for valuing tangible assets?

Answer 10

Cost method- value of the assets is based on the original cost paid to acquire the asset

Market value method- similar assets be available in the marketplace in order to find a comparable value

Appraisal method- a professional appraiser determined the value of the asset, assuming that the company can find an appraiser with knowledge and experience with the asset

Liquidation value- represents the amount that the company would get upon sale assuming that there is an active market for the asset

Question 11

What are the 3 methods for valuing intangible assets?

Answer 11

Market approach- actual arm’s length transactions in similar markets be used as a reference for the asset to be valued

Income approach- future expected CFs over the estimated useful life of the asset are discounted to present value using discount rates reflecting the level of risk associated with the income stream

Cost approach- can be used when there are no similar assets or transactions involving similar assets and no reasonable estimates of future income

Question 12

What must management consider when preparing accounting estimates?

Answer 12

Historical information- GAAP requires that the ADA be estimated using historical info regarding the collectibility of a company’s receivables from its customers

Market information- info on the current value of inventory should be used to determine the lower of cost or market and lower of cost or NRV and also used to determine whether inventory should be written down or written off due to obsolescence

Expected usage- depreciation methods may be based on expected patterns of fixed-asset usage

Estimates from experts- attorneys are often used to provide estimates of probable futre losses on pending or threatened litigation