Finance 321 - Chapter 13

technical analysts

largely use trend analysis to uncover trading opportunities

When there is a higher the payout ratio, there is a ________ growth rate?

lower

liquidation value

net amount that can be realized by selling the asset of a firm and paying off the debt A better measure of a floor for the stock price instead of book value

present value of growth opportunities

present value of growth opportunities or PVGO reflects the value of the firms that rise by the NPV reinvested in the firm

tobin's q

ratio of market value of the firm to replacement cost. over time, in the long run, this will head towards 1 but the ratio can differ significantly over long periods of time

shareholders are sometimes called?

residual claimants, meaning that the value of their stake is what is left over when the liabilities of the firm are subtracted from its assets

if intrinsic value is greater than stock price you should? if intrinsic value is less than stock price you should?

1) you should buy more 2)you should buy less

dividend discount model (DDM)

A formula for the intrinsic value of a firm equal to the present value of all expected future dividends as it stands is still not very useful in valuing a stock because it requires dividend forecasts for every year into the indefinite future.

book value

The net worth of common equity according to a firm's balance sheet.

book value

Can book value represent a "floor" for the stock's price, below which level the market price can never fall? Although Microsoft's book value per share is considerably less than its market price, other evidence disproves this notion. While it is not common, there are always some firms selling at a market price below book value. In early 2012, for example, such troubled firms included Sprint/Nextel, Citigroup, Mitsubishi, and AOL

two-stage DDM

Dividend discount model in which dividend growth is assumed to level off only at some future date.

Price-to-cash-flow ratio

Earnings as reported on the income statement can be affected by the company's choice of accounting practices and thus are commonly viewed as subject to some imprecision and even manipulation. In contrast, cash flow—which tracks cash actually flowing into or out of the firm—is less affected by accounting decisions. As a result, some analysts prefer to use the ratio of price to cash flow per share rather than price to earn- ings per share. Some analysts use operating cash flow when calculating this ratio; others prefer free cash flow, that is, operating cash flow net of new investment.

Pitfalls in P/E Analysis

Earnings management - The practice of using flexibility in accounting rules to manipulate the apparent profitability of the firm. Pro forma earning or Operational earnings- no established guidelines, loose interpretations

intrinsic value

The present value of a firm's expected future net cash flows discounted by the required rate of return. including dividends as well as the proceeds from the ultimate sale of the stock, discounted at the appropriate risk-adjusted interest rate, k.

How to increase share price with PVGO (the g value)

If the firm's projects yield only what investors can earn on their own, then NPV is zero, and shareholders cannot be made better off by a high reinvestment rate policy. This demonstrates that "growth" is not the same as growth opportunities. To justify reinvestment, the firm must engage in projects with better prospective returns than those shareholders can find elsewhere.

free cash flow vs. ddm

In principle, the free cash flow approach is fully consistent with the dividend discount model and should provide the same estimate of intrinsic value if one can extrapolate to a period in which the firm begins to pay dividends growing at a constant rate. However, in practice, you will find that values from these models may differ, sometimes substantially. This is due to the fact that in practice, analysts are always forced to make simplifying assumptions.

Price-to-sales ratio

Many start-up firms have no earnings. As a result, the P/E ratio for these firms is meaningless. The price-to-sales ratio (the ratio of stock price to the annual sales per share) is sometimes taken as a valuation benchmark for these firms. Of course, price- to-sales ratios can vary markedly across industries, since profit margins vary widely.

free cash flow for the firm (FCFF)

One approach is to discount the free cash flow for the firm (FCFF) at the weighted-average cost of capital to obtain the value of the firm and then subtract the then-existing value of debt to find the value of equity. This is the cash flow that accrues from the firm's operations, net of investments in capital and net working capital. It includes cash flows available to both debt- and equityholders.7

dividend payout ratio

Percentage of earnings paid out as dividends.

other valuation ratios

Price-to-book ratio Price-to-cash-flow ratio Price-to-sales ratio

PEG ratio

Ratio of P/E multiple to earnings growth rate.

discounted cash flow (DCF) formula.

The D1/P0 1 + g for- mula provides a means to infer that required return.` Dividends/intrinsic value + growth rate

PE ratio and growth rate

The P/E ratio of any company that's fairly priced will equal its growth rate. I'm talking here about growth rate of earnings. . . . If the P/E ratio of Coca-Cola is 15, you'd expect the company to be growing at about 15% per year, etc. But if the P/E ratio is less than the growth rate, you may have found yourself a bargain.

price-earnings multiple

The ratio of a stock's price to its earnings per share. This procedure seems simple, but its apparent simplicity is decep- tive. First, forecasting earnings is challenging. As we saw in the previous chapter, earnings will depend on international, macroeconomic, and industry as well as firm-specific factors, many of which are highly unpredictable. Second, forecasting the P/E multiple is even more difficult. P/E ratios vary across industries and over time. Nevertheless, our discussion of stock valuation provides some insight into the factors that ought to determine a firm's P/E ratio.

What is the most conservative estimate?

The two-stage dividend discount model

Price-to-book ratio

This is the ratio of price per share divided by book value per share. As we noted earlier in this chapter, some analysts view book value as a useful measure of fundamental value and therefore treat the ratio of price to book value as an indicator of how aggressively the market values the firm.

The Constant-Growth DDM or the Gordon Model

To make the DDM practical, we need to introduce some simplifying assumptions. A useful and common first pass at the problem is to assume that dividends are trending upward at a stable growth rate that we will call g.

higher plowback ratios mean....

We conclude that the higher the plowback ratio, the higher the growth rate, but a higher plowback ratio does not necessarily mean a higher P/E ratio. Higher plowback increases P/E only if investments undertaken by the firm offer an expected rate of return higher than the market capitalization rate. Otherwise, increasing plowback hurts investors because more money is sunk into prospects with inadequate rates of return. Growth rate should roughly be equal to the P/E ratio

plowback ratio

aka the earnings retention ratio The proportion of the firm's earnings that is reinvested in the business (and not paid out as dividends).

limitations of book values

based on original costs that are historical and might include some depreciate but do not reflect the current market price

replacement cost

cost to replace a firm's assets. which equals replacement cost of assets less the liabilities market value won't fall above the replacement costs for long because competitive pressures would drive down the market value

free cash flow to equityholders (FCFE)

discounting those directly at the cost of equity to obtain the market value of equity. Alternatively, we can focus on cash flow available to equityholders. This will differ from free cash flow to the firm by after-tax interest expenditures, as well as by cash flow associated with net issuance or repurchase of debt (i.e., principal repayments minus proceeds from issu- ance of new debt). The free cash flow to the firm approach discounts year-by-year cash flows plus some esti- mate of terminal value, PT . In Equation 13.11,we use the constant-growth model to estimate terminal value. The appropriate discount rate is the weighted-average cost of capital.

DDM assumes what?

stock value is higher when the dividend is higher, when there's a lower market cap rate, when there's a higher growth rate SO higher growth rate and dividends and lower market cap rate

what does the constant growth rate DDM imply about stock value?

stock's value will be higher: 1. The larger its expected dividend per share. 2. The lower the market capitalization rate, k. 3. The higher the expected growth rate of dividends.

the higher the plowback ratio, the higher the...?

the higher the plowback ratio, the higher the growth rate, but a higher plowback ratio does not necessarily mean a higher P/E ratio.

market capitalization rate

the market-consensus estimate of the appropriate discount rate for a firm's cash flows is also know as the required rate of return, k

earnings management

the practice of using flexibility in accounting rules to manipulate the apparent profitability of the firm Pro forma earning or Operational earnings- no established guidelines, loose interpretations

What does DDM infer about stock price and dividends?

they grow at the same rate

when is the const DDM only valid?

when g is less than k

Problems with DCF

you must recognize that DCF valuation estimates are almost always going to be imprecise.