Investment Analysis - Chapter 13 (Quiz 4)
constant-growth DDM
A form of the dividend discount model that assumes dividends will grow at a constant rate.
Price-to-cash-flow:
Cash flow less affected by accounting decisions than earnings
replacement cost
Cost to replace a firm's assets.
two-stage dividend discount model (DDM)
Dividend discount model in which dividend growth is assumed to level off to a steady, sustainable rate only at some future date.
Combining P/E Analysis and the DDM
Estimates stock price at horizon date
Constant-Growth DDM
Form of DDM that assumes dividends will grow at constant rate = D1 / K-G
Dividend Discount Model (DDM)
Formula for intrinsic value of firm equal to present value of all expected future dividends
dividend payout ratio
Fraction of earnings paid out as dividends.
Price-to-book:
Indicates how aggressively market values firm
Market Capitalization Rate
Market-consensus estimate of appropriatediscount rate for firm's cash flows
Liquidation value:
Net amount realized by selling assets of firm and paying off debt
liquidation value
Net amount that can be realized by selling the assets of a firm and paying off the debt.
present value of growth opportunities (PVGO)
Net present value of a firm's future investments.
Book Value
Net worth of common equity according to a firm's balance sheet
• Present value of growth opportunities (PVGO)
Price = No growth value per share + PVGO P0 = (E1 / K) + PVGO
• Plowback ratio/earnings retention ratio
Proportion of firm's earnings reinvested inbusiness
PEG ratio
Ratio of P/E multiple to earnings growth rate.
Tobin's q:
Ratio of firm's market value to replacement cost
Tobin's q
Ratio of market value of the firm to replacement cost.
Price-earnings multiple
Ratio of stock's price to earnings per share
The expected holding-period return is
The expected total return on an asset over a stated holding period; for stocks, the sum of the expected dividend yield and the expected price appreciation over the holding period. E(D1) plus the expected page 396 price appreciation, E(P1) − P0, all divided by the current price P0.
The constant growth rate DDM implies that a stock's value will be greater:
The larger its expected dividend per share. 2. The lower the market capitalization rate, k. 3. The higher the expected growth rate of dividends.
market capitalization rate
The market-consensus estimate of the appropriate discount rate for a firm's cash flows.
Intrinsic Value = V0 =
[E(D1) + E(P1)]/(1 + K)
The constant-growth version of the DDM is simplistic in its assumption of
a constant value of g. There are more sophisticated multistage versions of the model for more complex environments. When the constant-growth assumption is reasonably satisfied, however, the formula can be inverted to infer the market capitalization rate for the stock
dividend discount model (DDM)
a formula for the intrinsic value of a firm equal to the present value of all expected future dividends
Stock market analysts devote considerable attention to a
company's price-earnings ratio. The P/E ratio is a useful measure of the market's assessment of the firm's growth opportunities. Firms with no growth opportunities should have a P/E ratio that is just the reciprocal of the capitalization rate, k. As growth opportunities become a progressively more important component of the total value of the firm, the P/E ratio will increase.
The free cash flow approach is the one used most in
corporate finance. The analyst first estimates the value of the firm as the present value of expected future free cash flows to the entire firm and then subtracts the value of all claims other than equity. Alternatively, the free cash flows to equity can be discounted at a rate appropriate to the risk of the stock.
One approach to firm valuation is to focus on the
firm's book value, either as it appears on the balance sheet or adjusted to reflect the current replacement cost of assets or the liquidation value. Another approach is to focus on the present value of expected future dividends.
The purpose of fundamental analysis is to
identify stocks that are mispriced relative to some measure of "true" or intrinsic value that can be derived from observable financial data.
All else equal, riskier stocks have
lower P/E multiples, higher required rate of return, k
Many analysts form their estimates of a stock's value by
multiplying their forecast of next year's EPS by a predicted P/E multiple. Some analysts mix the P/E approach with the dividend discount model. They use an earnings multiplier to forecast the terminal value of shares at a future date and add the present value of that terminal value to the present value of all interim dividend payments.
The dividend discount model holds that the
price of a share of stock should equal the present value of all future dividends per share, discounted at an interest rate commensurate with the risk of the stock.
plowback ratio or earnings retention ratio
the proportion of the firm's earnings that is reinvested in the business (and not paid out as dividends)
Pitfalls in P/E Analysi
• Earnings Management • Practice of using flexibility in accounting rules to improve apparent profitability of firm • Large amount of discretion in managing earnings
Constant-Growth DDM Implies stock's value greater if:
• Larger dividend per share • Lower market capitalization rate, k • Higher expected growth rate of dividends
Shareholders in a firm are sometimes called
"residual claimants," which means that the value of their stake is what is left over when the liabilities of the firm are subtracted from its assets
Multistage Growth Models
Allow dividends per share to grow at several different rates as firm matures
Two-stage DDM
DDM in which dividend growth assumed to level off only at future date
Expected HPR = E (r) =
E(D1) = expected dividend per share P0 = current share price E (P1) = expected end-of-year price
Price-to-sales:
For start-ups with no earnings
Limitations of Book Value
Liquidation value: Net amount realized by selling assets of firm and paying off debt Replacement cost: Cost to replace firm's assets Tobin's q: Ratio of firm's market value to replacement cost
Intrinsic Value
Present value of firm's expected future net cash flows discounted by required rate of return.
The models presented in this chapter can be used to explain or to forecast the
behavior of the aggregate stock market. The key macroeconomic variables that determine the level of stock prices in the aggregate are interest rates and corporate profits.
Replacement cost:
cost to replace a firm's assets
The constant-growth version of the DDM asserts that
if dividends are expected to grow at a constant rate forever, then the intrinsic value of the stock is given by the formula
Dividend payout ratio
• Percentage of earnings paid as dividends
Other Comparative Valuation Ratios
• Price-to-book: Indicates how aggressively market values firm • Price-to-cash-flow: Cash flow less affected by accounting decisions than earnings • Price-to-sales: For start-ups with no earnings
PEG Ratio
• Ratio of P/E multiple to earnings growth rate • PEG ratio should be about 1.
The Constant Growth Model states that a stocks value will be greater
• The larger its expected dividend per share. • The lower the market capitalization rate, k • The higher the expected growth rate of dividends.
For stock with market price = intrinsic value, expected holding period return =
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑦𝑖𝑒𝑙𝑑 + 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑔𝑎𝑖𝑛𝑠 𝑦𝑖𝑒𝑙𝑑
book value
The net worth of common equity according to a firm's balance sheet.
earnings management
The practice of using flexibility in accounting rules to manipulate the apparent profitability of the firm.
intrinsic value
The present value of a firm's expected future net cash flows discounted by the required rate of return.
price-earnings multiple
The ratio of a stock's price to its earnings per share.
