Reading 50 LOS's

Question 1

LOS 50a: Evaluate whether a security, given its current market price and a value estimate, is overvalued, fairly value, or undervalued by the market

Answer 1

The aim of equity analysis is to identify mispriced securities. Securities are mispriced by the market when their market prices dont equal their intrinsic values.

• If the estimate for a security’s intrinsic value is lower than the market price, the security is overvalued
• IF the estimate for a security’s intrinsic valee is higher than the market price, the security is undevalued

In practice tho, the analysis is not so straightforward since intrinsic value is an estimate that is unique to each individual investor

Question 2

LOS 50c: Explain the rational for using present value of cash flow models to value equity and describe the dividend discount and free-cash-flow-to-equity models

LOS 50e: Calculate and interpret the intrinsic value of an equity security based on the Gordon(constant) growth dividend discount model or a two-stage dividend discount model, as appropriate

LOS 50f: Identify companies for which the constant growth of a multistage dividend discount model is appropriate

LOS 50k: Explain advantages and disadvantages of each category of valutaion model

Answer 2

The value of an investment must equal the present value of its expected future cash flows. The simplest present value model for equity valuation is the dividend discount model (DDM), which values a share of common stock as the present value of its expected future cash flows

• Value = Σ D_t / (1 + k_e)^t

Important:

• When an investor sells a share of common stock, the value that the purchaser will pay equals the present value of the future stream of cash flows. Therefore, the value of the stock at any point in time is still determined by its expected future dividends.
• If a company pays no dividends currently, it does not mean that its stock will be worthless. There is an expectation that after a certain period of time the firm will start making dividend payments. Currently the company is reinvesting all its earnings in its business with the expectation that its earnings and dividends will be larger and will grow faster in the future. If the company does not make positive earnings going forward, there will still be an expectation of a liquidating dividend.
• The required rate of return on equity (k_e) is usually estimated using the CAPM. Another approach for calculating required return on equity simply adds a risk premium to the before-tax cost of debt of the company

Examples of DDM in Valuing Common Stock

One-year holding period: If our holding period is just one year, the value that we will place on the stock today is the present value of dividends that we will receive over the year plus the present value of the price we expect to sell the stock for at the end of the holding period.

• Value = [Dividend to be received / (1+k_e)] + [year-end price/ (1+k_e)¹]

Multiple Year Holding Period DDM

We apply the same discounting principles for valuing common stock over multiple holding periods. In order to estimate the intrinsic value of the stock, we estimate all dividends that will be received and the price we expect to sell the security for after the holding period. We then discount these cash flows to get out present intrinsic value.

• V = D₁ / (1+k_e) + D₂ / (1+k_e)² + …… + D_n+P_n / (1 + k_e)ⁿ

Infinite Period DDM (Gordon Growth Model)

The infinite period DDM assumes that a company will continue to pay dividends for an infinite number of periods. It also assumes that the dividend stream will grow at a constant rate (g_c) over the infinite period. In this case the intrinsic value of the stock is calculated as:

• PV = D₁ / ( k_e- g_c)

The long-term (constant) growth rate is usually calculated as:

• g_c= RR x ROE

The Gordon growth model is highly appropriate for valuing dividend-paying stocks that are relatively immune to the business cycle and are relatively mature.

Applying the DDM is relatively difficult if the company is not currently paying out a dividend

Even though the Gordon growth model can be used for valuing such companies, the forecasts are generally quite uncertain. Therefore, analysts use one of the other valuation models to value such companies and use the DDM model as a supplement.

The relation between k_e and g_c is critical:

• As the difference between them increases, the intrinsic value of the stock falls
• As the difference narrows, the intrinsic value of the stock rises
• Small changes in either k or g can cause large changes in the value of the stock

For the infinite-period DDm model to wrok the following assumptions must hold:

• Dividends grow at a rate, g_c, which is not expected to change
• k_e must be greater than g_c, otherwise, the model breaks down because of the denominator being negative

Valuation of Common Stock with Temporary Supernormal Growth

Growth companies are firms that are able to earn returns on investments that are consistently above their required returns. In order to take advantage of such opportunities, they retain a high proportion of their investments. The assumptions of the infinite-period DDM do not hold for these growth companies because:

• They do not have constant dividend growth rates. The growth rate of dividends can be impressively high, but only for a temporary period. Eventually, competition catches up with these firms and their growth rate slows down
• During periods when they experience extremely high growth rates, their growth rate can exceed the cost of equity (k_e)

The correct valuation model to value such “supernormal growth” companies is the multistage dividend discount model that combines the multi-period and infinite-period dividend discount models

• Value = D₁ / (1 + k_e)¹ + D₂ / (1+k_e)² +… D_n / (1 +k_e)ⁿ + P_n / (1+ k_e)ⁿ

where:

• P_n = D_n+1 / (k_e-g_c)
• D_n= last dividend of the supernormal growth period
• D_n+1 = first dividend of the constant growth period

The following steps must be followed to value stocks of companies that experience temporary supernormal growth

• Estimate the amount and duration of dividends during the supernormal growth phase
• Forecase the normal, constant growth rate in dividends (g_c) that will occur once the supernormal growth period ends
• Project the first dividend after the commencement of normal growth
• Calculate the price of the stock at the end of the supernormal growth period using the infinite-period DDM. The first dividend after commencement of normal growth will be the numerator
• Determine the cost of equity, k_e
• calculate the present value of supernormal growth-period dividends and the terminal stock price

If a company has two or three stages of supernormal growth, we must calculate the dividend for each year during supernormal growth separately. Once the growth rate stabilizes below the required rate of return, we can compute the terminal value of the firm by using the constant growth DDM

The Free-Cash-Flow-to-equity (FCFE) Model

Many analysts assert that a company’s dividend-paying capacity should be reflected in its cash flow estimates instead of estimated future dividends. FCFE is a measure of dividend paying capacity and can also be used to value companies that currently do not make any dividend payments. FCFE can be calculated as:

• FCFE = CFO - FC Inv + Net borrowing

Analysts may calculate the intrinsic value of the company’s stock by discounting their projections of future FCFE at the required rate of return on equity

• V₀ = Σ FCFE_t / ( 1 +k_e)^t

Question 3

LOS 50d: Calculate the intrinsic value of a noncallable, nonconvertible preferred stock

Answer 3

When preferred stock is noncallable, nonconvertible, has no maturity date, and pays dividends at a fixed rate, the value of the preferred stock can be calculated using the perpetuity formula:

• V₀ = D₀ / r

For a noncallable, nonconvertible preferred stock with maturity at time, n, the value of the stock can be calculated using the following formula:

• V₀ = Σ D_t / (1+r)^t + F / (1+r)ⁿ

Where:

• V₀ = value of preferred stock today
• D_t = expected dividend in year t, assumed to be paid at the end of the year
• r = required rate of return on the stock
• F = par value of preferred stock

Preferred shares may also be callable or putable:

• A callable preferred stock grants the issuer right to call the stock at some point prior to maturity at a price determined at inception. Such call options tend to reduce the value of the issue for investors, as they favor the issuer
• A putable preferred stock grants the holder the right to sell the stock back to the issuer at some point prior to maturity at a price determined at inception. Put options increase the value of the issue for investors as they favor the holder

Question 4

LOS 50g: Explain the rational for using price multiples to value equity and distinguish between multiples based on comparable versus multiples based on fundamentals

Answer 4

Price multiples are ratios that compare the price of a stock to some sort of value. Price multiples allow an analyst to evaluate the relative worth of a company’s stock. Popular multiples used in relative valuation include price-to-earnings, price-to-sales, price-to-book, and price-to-cash flow

A common criticism of price multiples is that they do not consider the future in that their values are calculated from trailing or current values of the divisor. For example, the P/E ratio is calculated at the current price, but divided by a trailing earnings. To make up for this analysts estimate future earnings and derive P/E ratios from that.

Multiples Based on Fundamentals

a price multiple may be related to funadmentals throught a DDM such as the Gordon Growth. We can use this model to derive an expression for the justified P/E multiple for a stock

Gordon Growth DDM: P₀ = D₁ / (r-g)

Divide borth sides of the equation by next year’s earnings forecast E_1:

P₀ / E₁ = (D₁ / E₁) / (r-g)

D/E is known as the dividend payout ratio. It equals the proportion of its earnings that a company pays out as dividends

Analysis of justified forward P/Es:

• The P/E ratio is inversely related to the required rate of return
• The P/E ratio is psoitively related to the growth rate
• The P/E ratio appears to be positively related to the dividend payout ratio. However, this relationship may not always hold because a higher dividend payout ratio implies that the company’s earnings retention ratio is lower. A lower earnings retention ratio translates into a lower growth rate. This is known as the “dividend displacement” of earnings

Justified forward P/E estimates are very sensitive to small changes in the assumption used to compute them. Since the growth rate is calculated as ROE time the retention ratio, any changes in the dividend payout ratio also has an impact on the growth rate.

Multiples Based On Comparables

This method compares relative values estimated using multiples to determine whether an asset is undervalued, overvalued, or fairly valued. The benchmark multiple can be any of:

• A multiple of closely matched individual stock
• The average or median multiple of a peer group of the firm’s industry
• The average multiple derived from trend or time-series analysis

Question 5

LOS 50h: Calculate and interpret the following multiples: price to earnings, price to an estimate of operating cash flow, price to sales, and price to book value

Answer 5

Price to Earnings ratio

advantages:

• Earnings are key drivers of stock value
• The ratio is simple to calculate and widely used in the industry
• According to empirical research, differences in P/E ratios are significantly related to long-term stock returns

Disadvantages:

• Companies that make losses have negative EPS and P/Es. Negative P/E ratios are useless as far as relative valuation is concerned
• Earnings of some companies are very volatile, which makes the task of determining a fundamental stock value very challenging
• Management can use different accounting assumptions to prepare their financial statements. This reduces the comparability of P/E ratios across companies

Price to Cash Flow

Advantages:

• Cash flows are less prone to management manipulation than earnings
• Price to cash flow is more stable than the P/E ratio
• Using the price to cash flow ratio gets around the problem related to differences in accounting methods used by companies
• Differences in price to cash flow ratio over time are related to differences in long term average returns on stocks

Disadvantages:

• When “EPS plus noncash charges” is used as the definition for cash flow, noncash revenue and changes in working capital items are ignored
• Free cash flow is more appropriate for valuing a company than cash flow. However FCFE has the following drawbacks:
  
  • for many businesses, it is more volatile than CF
  • it is more frequently negative than CF

Price to cash flow ratio = Market price of share / Cash flow per share

Price To Sales

Advantages

• sales are less prone to manipulation by management than earnings and book values
• Sales are positive even when EPS is negative
• The P/S ratio is usually more stable than the P/E ratio
• Price to sales is considered an appropriate measure for valuing mature, cyclical, and loss-making companies
• Studies have shown that differences in price to sales ratios are related to differences in long-term average returns on stocks

Disadvantages

• using sales reveals no information about the operating profitability of a company. Ultimately, a company derives its value from its ability to generate profits
• Using the P/E ratio does not reflect the differences in cost structure and operating efficiency between companies
• Revenue recognition practices may allow management to distort revenue figues

Price to sales ratio = Market price per share / net sales per share

Price to sales ratio = market value of equity / total net sale

Price to Book Value

Advantages:

• Book value usually remains positive even when the company reports negative earnings
• Book value is typically more stable over time compared to reported earnings
• For financial sector companies that have significant holdings of liquid assets, P/BV is more meaningful, as book values reflect recent market values
• P/BV is useful in valuing a company that is expected to go out of business
• Studies suggest that differences in P/BV ratios over time are related to differences in long term average returns on stocks

Disadvantages:

• Book values ignore nonphysical assets such as the quantity of a company’s human capital and brand image
• P/BV can lead to misleading valutaions if significantly different levels of assets are being used by the companies being studied
• Accounting differences can impaid the comparability of P/BV ratios across companies. In most cases, boko values of assets are based on historical cost adjusted for accumulated depreciation. However, over time, inflation and changes in technology may result in significant differences between accounting book values and actual values of a company’s assets

P/BV = Current market price of share / Book value per share

P/BV = Market value of common shareholders’ equity / book value of common shareholders equity

where book value of common shareholders’ equity = (total assets - total liabilities) - preferred stock

Question 6

LOS 50i: Explain the use of enterprise value multiples in equity valuation and demonstrate the use of enterprise value multiples to estimate equity value

Answer 6

EV is calculated as the market value of the company’s common stock plus the market value of outstanding preferred stock if any, plus the market value of debt, less cash and short term investments. It can be thought of as the cost of taking over a company.

The most widely used EV multiple is EV/EBITDA. EBITDA is used as a proxy for operating cash flows, as it excludes noncash depreciation and amortization expenses. However, it may include other noncash expenses and revenues. EBITDA measures a company’s income before payments to any providers of capital are made

• The EV/EBITDA multiple is often used when comparing two companies with different capital structures
• Loss-making companies usuallly have a positive EBITDA, which allows analysts to use the EV/EBITDA multiple to value them

Enterprise value may be difficult to calculate for companies whose debt is not publicily traded. Analysts may then use market prices of similar debt issued that are publicly traded as a proxy for the market value of the company’s debt.

Question 7

LOS 50j: Explain asset-based valuation models and demonstrate the use of asset-based models to calculate equity value

Answer 7

Asset-based valuation uses market values of a company’s assets and liabilities to determine the value of the company as a whole

Asset-based valuation works well for :

• Companies that do not have a significant number of intangible or “off-the-book” assets and have a higer proportion of current assets and liabilities
• Private companies, especially if applied together with multiplier models
• Financial companies, natural resource companies, and companies that are being liquidated

Asset-based valuation may not be appropriate when:

• Market values of assets and liabilities cannot be easily determined
• The company has a significant amount of intangible assets
• Asset values are difficult to determine
• Market values of assets and liabilities significantly differ from their carrying values