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The rate that equates the discounted CFs to the current price - if
markets are efficient, then the IRR represents the required return.
- CF is harder to manipulate than earnings- Price to CF is more stable
than earnings- Reliance on CF rather than earnings handles the problem
of differences in the quality of reported earnings, which is a problem
for P/E- Empirical evidence indicates that differences in price to CF
are significantly related to differences in long-run average stock
returnsDisadvantages:- EPS plus noncash charges estimate ignores items
affecting actual CF from operations- FCFE is preferred but is more
volatile than operating
ERP is the return over the risk free rate that investors require for
holding equity securities. The historical estimate of the ERP consists
of the difference between the mean return on a broad-based, equity
market index and the mean return on the US T-bills over a given time
period.
D(p)/r(p)
A company with economies of scale will have lower costs and higher
operating margins as production volume increases, and should exhibit
positive correlation between sales volume and margins.
Increases in input costs will increase COGS unless the company has
hedged the risk of the input price increases with derivatives or
constructs for future delivery. Vertically integrated companies are
likely to be less affected by increasing input costs. The effect on
sales of increasing product prices to reflect higher COGS will depend on
the elasticity of demand for products, and on the timing and amount of
competitors' price increases.
Fama-French model + liquidity factor
V= [d(0) * (1+g)]/ (r-g)
Bottom up analysis starts with analysis of an individual company or
reportable segments of a company.Top down analysis begins with
expectations about a macroeconomic variable, often expected growth rate
of nominal GDP.Hybrid analysis incorporates elements of both top down
and bottom up analysis.
Enterprise Value is measured as the market value of debt, common
equity, and any preferred equity, minus the value of cash and
investments. EV/EBITDA is a commonly used measure of relative company
value.Advantages:- Useful for comparing firms with different degrees of
financial leverage.- Useful for valuing capital-intensive businesses
with high depreciation.-EBITDA is usually positive even when EPS is
not.Disadvantages of EV/EBITDA:- If working capital is growing, EBITDA
will overstate CFO.FCFF is more str
Dividends, sahre repurchases, and share issues have no effect on
either FCFF or FCFE. Changes in leverage have only minor effect on FCFE
and no effect on FCFF.For example, a decrease in leverage through a
repayment of debt will decrease FCFE in the current year and increase
forecasted FCFE in future years as interest expense is reduced.
P(0) = V(0) = D(1)/(r-g)g= r - (D(1)/P(0))
Similar to the risk premium approach, but, doesn't use betas to adjust
for exposure to a factor. The bond yield plus risk premium method is a
type of build-up method.
- Contributes to total investment return- Dividends are not as risky
as the capital appreciation component of total returnDisadvantages:-
Dividend yield is only one component of the return on a stock- All else
equal, higher dividends will lead to slower growth, which drives the
other component of returns, price appreciation
Leading: P(0)/E(1) = D1/E1/(r-g) = (1-b)/(r-g)Trailing: (1-b)(1+g)/(r-g)
Required return on stock J = Risk free return + Beta (market, J) +
Beta (SMB, J) (small cap risk premium) + B (HML, J) (value risk
premium)
Refers to the amount by which market price is lower than the sum of
the parts value - the apparent price reduction applied by the markets
that operate in multiple industries
The greater (less) than required return, the asset is undervalued
(overvalued) - can lead to a convergence of price to intrinsic value
The increase in the price of asset plus an CF received from the asset, divided by the initial price of the asset.
First method: Forecast the FCFF or FCFE at the point in time at which
CFs begin to grow at a constant rate. Use the single stage DDM.Second:
use valuation multiples.Terminal Value = (Trailing P/E) * (earnings in
Year N)Terminal Value = (Leading P/E) * (Forecasted earnings in year
N+1)
=(2/3regression beta) + (1/3 1.0)
Required return on stock J = current risk-free return + (equity risk premium) * (beta of stock J)
When forecasting revenue with "growth relative to GDP growth"
approach, the relationship between GDP and company sales is estimated,
and then company sales growth is forecast based on an estimate for
future GDP.The "market growth and market share" approach begins with an
estimate of industry sales (market growth) and then company sales are
estimated as a percentage "market share" of industry sales. Forecast
revenue then equals the forecasted market size multiplied by the
forecasted market share.
The required return averaged across all suppliers of capital (e.g.
debt and equity holders).(MV Debt/MV Debt+Equity)(Rate Debt)(1-T) + (MV
Equity/MV Debt+Equity)(Rate Equity)
Underlying earnings are earnings that exclude non-reoccuring
components. Normalized earnings are earnings adjusted for the business
cycles using either the method of historical EPS or the method of
average ROE.
NI is poor proxy for FCFE. Net income includes non cash charges
(depreciation) that have to be added back to arrive at FCFE. In
addition, it ignores cash flows that don't appear on the income
statement, such as investments in working capital and fixed assets as
well as net borrowings. EBITDA is a poor proxy for FCFF. EBITDA doesn't
reflect the cash taxes paid by the firm and it ignores the cash flow
effects of the investments in working capital and fixed capital.
- Earnings power, as measured by EPS is the primary determinant of the
investment value.- Popular multiple-Empirical research shows that long
term differences are significantly related to long-run average stock
returns.Disadvantages:- Earnings can be negative.- The volatile,
transitory portion of earnings makes interpretation difficult.-
Management discretion distorts reported earnings.
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