Corporate Finance (Chapter 9)
Whate are the implications of the efficient market hypothesis for corporate managers?
- Focus on NPV and free cash flow - Avoid accounting illusions - Use financial transaction to support investment In an efficient market, to riase the stock price corporate managers should focus on maximizing the PV(Free cash flow), rather than accounting consequences or financial policy.
Give the step-by-step plan of estimating the value stock with the discounted free cash flow model
1. Calculate the FCF 2. Compute a terminal enterprise value to estime the constant long-run growth rate gFCF for free cash flows beyond year N (assume: free cashflows growth at constant rate) Vn=FCFn+1/rwacc-gfcf = (1+gfcf)/(rwacc-gfcf)*FCFn 3. Calculate current enterprise value V₀ 4. Determine stock price: P₀=V₀+Cash₀-Debt₀/Shares Outstanding₀
Give the difference in the cashflows by buying a stock or short-selling a stock.
Cash flows from buying a stock: *Date 0 = -P₀ *Date t = +Divt *Date 1 = +P₁ Cash flows from shortselling a stock: *Date 0 = +P₀ *Date t = -Divt *Date 1 = -P₁
How can it change the earnings?
Change in Earnings = New Investment * return on new investment new investment = earnings * retention rate (fraction current earnings that the firm retains) Earnings growth rate = Change in earnings/Earnings = retention rate*return on new investment = g
What are the two types of degree of competition?
Competition between investors tends to eliminate positive-NPV trading opportunities. Competition will be strongest when information is public and easy to interpret. Privately informed traders may be able to profit from their information, which is reflected in prices only gradually. 1. Public, easily interpretable information 2. Private or difficult-to-interpret information
In what three ways can a firm increase its future dividend per share?
Div t = (Earnings t/Shares Outstanding t)*Dividend payout rate t = EPS* Dividend payout rate t 1. It can increase its earnings (net income) 2. It can increase its dividend payout rate 3. It can decrease it shares outstanding
Give the definition of the stock's dividend yield and capital gain rate.
Dividend yield = the percentage return the investor expects to earn from the dividend paid by the stock. Capital gain rate = difference between the expected sale price and purchase price divided by current stock price.
How do we determine the stock price in the dividend-discount model and the total payout model?
Dividend-discount model: P₀=PV(Future Dividends per Share) To determine the stock price, we divide the eequity value by the initial number of shares outstanding of the firm = Total Payout model: P₀=PV(Future Total Dividends and Repurchases)/Shares Outstanding₀
What is the enterprise value of the firm?
Enterprise Value = market Value of Equity + Debt - Cash The enterprise value is the value of the firm's underlying business, unencumbered by debt and separate from any cash or marketable securities.
Provides the formula for the firm's forward P/E.
Forward P/E = P₀/EPS₁ = Div₁/EPS₁/(rE-g) = Dividend Payout Rate/(re-g) with forward earnings (expected earnings next twelve months) We can also compute a firm's trailing P/E ratio using trailing earnings (earnings over the prior 12 months)
How does the growth rate used in the total payout model differ from the growth rate used in the dividend-discount model?
If the firm undertakes share repurchases, it is more reliable to use the total payout model to value the firm. In this model, the value of equity equals the present value of future total dividends and repurchases.
How can we estimate the firm's future free cash flows in the discounted free cash flow model?
In this model, we can estimate the firm's future free cash flows as: * Free Cash Flow = EBIT*(1-tc)-Net Investment - Increases in Net Working Capital Net Investment = Firm's Capital Expenditures - Depreciation
What is the dividend-discount model with constant long-term growth
P₀=Div₁/(1+rE)+Div₂/(1+rE)²+...+Divn/(1+rE)ⁿ+(1/(1+rE)ⁿ)*(DivN+1/rE-g) If the firm has a long-term growth rate of g after the periode N+1, then we can apply the dividend-discount model and use the constant dividend growth formula to estimate the terminal stock value Pn
Give the constant dividend growth model.
P₀=Div₁/(rE-g) rE = (Div₁/P₀)+g
What information gives the stock prices.
Stock prices aggregate the information of many investors. Therefore, if our valuation disagress with teh stock's market price, it is most likely an indication that our assumptions about the firm's cash flows are wrong.
What discount rate do you use to discount the future cash flows of a stock?
The Law of One Price states that hte value of a stock is equal to the present value of the dividends and future sale price the investor will receive. Because these cash flows are risky, they must be discounted at the equity cost of capital, which is the expected return of other securities available in the market with equivalent risk to the firm's equity.
What are the flaws of the dividend-discount model?
The dividend-discount model is sensitive to the dividend growth rate, which is difficult to estimate accurantely.
State the efficient market hypothesis
The efficient market hypothesis states that competition eliminates all positive-NPV trades, which is equivalent to stating that securities with equivalent risk have the same expected returns.
Give the definition of share repurchase
The firm uses excess cash to buy back its own stock.
How can we estimate the firm's enterprise value in the discounted free cash flow model?
The firm's enterpirse value (the market value of equity plus debt, les excess cash) equals the present value of the firm's future free cash flow: V₀=PV(Future Free Cash Flow of Firm)
What is the sustainable growth rate?
The rate at which it can grow using only retained earnings If the dividend payout rate and the number of shares outstanding is constant, and if earnigns change only as a result of new investment from retained earnings, then the growth rate of the firm's earnings, dividend, and share price is calculated as follows: g = Retention rate * Return on New Investment
How do you calculate the total return of a stock?
The total return of a stock is equial to the dividend yield plus the capital gain rate. The expected total return of a stock should equal its equity cost of capital: P₀=(Div₁+P₁)/(1+rE) rE = (Div₁+P₁)/P₀-1 = Div₁/P₀ (Dividend yield) + (P₁-P₀)/P₀ (Capital Gain Rate)
Under what circumstances can a firm increase its share price by cuttings its dividend and investing more?
Thus, cutting the firm's dividend to increase investment will raise the stock price if, and only if, the new investments have a positive NPV. Return on new investment must exceeds the firm's equity cost of capital.
What implicit assumptions are made when valuing a firm using multiples based on comparable firms?
Using multiples assumes that comparable firms have the same risk and future growth as the firm being valued.
Give the enterprise value multiples.
V₀/EBITDA₁=FCF₁/EBITDA₁/rwacc-gfcf
What are some common valuation multiples?
We can also value stocks by using valuation multiples based on comparable firms. Multiples commonly used for this purpose include the P/E ratio and the ratio of enterprise value to EBITDA.
Give the definition of weighted average cost of capital.
We discount cash flows using the weighted average cost of capital, which is the expected return the firm must pay to investors to compensate them for the risk of holding the firm's debt and equity together. Note: debt is less risky than equity rwacc<re and if there's no debt rwacc=re
How can you estimate a firm's stock price based on its projected free cash flows?
When a firm has leverage, it is more reliable to use the discounted free cash flow model.
Why will a short-term and long-term investor with the same beliefs be willing to pay the same price for a stock?
When investors have the same beliefs, the dividend-discount model states that, for any horizon N, the stock price satisfies the following equation: P₀=Div₁/(1+rE)+Div₂/(1+rE)²+...+Divn/(1+rE)ⁿ+Pn/(1+rE)ⁿ or if N go to infinity The price of the stock is equal to the present value of the expected future dividends it will pay. ∑n=1∞ Divn/(1+rE)ⁿ
Where is the growth rate of the firm's total payout governed by?
the growth rate of earnings, not earnings per share