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71 Cards in this Set
- Front
- Back
Appeal of Residual Income |
Company's income statement includes a charge for the cost of debt financing in the form of interest expense, but it does not include any kind of charge for the cost of equity financing. |
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Economic Value Added (EVA) |
Stern Stewart & Company; until a business returns a profit that is greater than its cost of capital, it operates at a loss, pays taxes, returns less to the economy than it devours in resources. "Destroys well" |
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4 ways EVA can be increased |
1) Increase the ROIC generated by existing capital 2) Reduce the WACC on existing capital 3) Invest in new projects where ROIC exceeds the WACC 4) Discontinue existing projects where ROIC is below the WACC |
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Market Value Added |
MVA= market value of the company- total capital OR MVA/Total Capital |
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Tobin's q |
Developed by Tobin as the ratio of market value to replacement cost
=Market value of debt and equity/ replacement cost of assets |
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Equity q |
Popularized by Smithers and Wright in Valuing Wall Street
=market value of equity/ net worth at replacement cost
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Limitations in using Tobin's q and Equity q |
1) hard to estimate replacement costs 2) intangible assets add to firm value but that value isn't recorded in financial statements (value of tangible assets) |
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OECD Classification of Intangible Assets |
1) computerized information 2) innovative property (copyrights, trademarks) 3) economic competencies (brand equity, networks) |
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When to use residual income model |
-firm doesn't pay dividends or unpredictable dividends -firm has negative free cash flows for many years but will one day have positive cash flows -great deal of uncertainty in forecasting terminal values |
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Clean Surplus Relation |
assumes changes in the book value of equity derive solely from earnings and dividends (changes flow through the income statement)
Bt=Bt-1+Et-Dt => Dt=Et+Bt-1-Bt |
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Residual Income (RI) Model |
the value of a share of stock equals its book value per share plus the present value of expected future residual income per share |
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Single State (Constant Growth) Residual Income Model equation |
=B0+ROE-r ------------------ X B0 r-g |
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Key Determinants of Intrinsic Value According to the RI Model |
book value and the relationship between ROE and required return |
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Multistage Residual Income Model |
valuation model that can be used when residual income is forecast for finite time horizon with a terminal value included at the end of the time horizon to reflect continuing residual income after the forecast horizon |
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Remember this for exam |
Terminal value in the residual income model is not as large of a driver of intrinsic value as it is in other models because the RI Model tends to be front-end loaded due to its reliance on beginning book value. This can be an advantage since forecasting errors tend to magnify over time. |
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The RI Model is closely-related to what? |
The Price-to-Book Ratio positively correlated to ROE
Negatively correlated to r
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Residual Income Fades Over Time |
model has a persistence factor of w equal to between 0 and 1. 0 means that RI will not continue after T. higher persistence factor the greater the stream of RI.
The model assumes ROE regresses towards r and that RI fades to 0 |
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Limitations of RI Model |
-Model is based on accounting data that can be manipulated by management -Accounting data used for inputs may require significant adjustments -Model requires the clean surplus relation holds, analyst makes appropriate adjustment when the clean surplus relation does not hold. |
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Problems with Accounting Data: Reported EPS |
RI based on recurring items
-unusual items -extraordinary items -restructuring charges -discontinued operations -accounting changes |
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Problems with Accounting Data: Book Value |
balance sheet should be adjusted for significant off-balance sheet assets and liabilities -Inventory -Deferred tax assets and liabilities -Pension plan assets and Liabilities -operating leases -special purpose entities -reserves and allowances (bad debts) -intangible assets
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Problems with Accounting Data: Intangible Assets |
-important to include intangibles that can be separated from the entity (sold) in the book value of equity -goodwill is not usually recognized as an asset unless it results from an acquisition -research and development must be included
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Violations of Clean Surplus Relation |
happens when accounting standards permit changes directly to stockholders' equity, bypassing the income statement
-changes in the mrkt value of LT securities -foreign currency translation adjustments -certain pension adjustments -fair value chngs in come financial instruments |
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Absolute Valuation Models |
specify an asset's intrinsic value |
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Relative Valuation Models |
compare an asset's value on a cross-sectional or time series basis |
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Justified Price Multiple |
analyst's estimated fair value for that multiple |
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Determinants of P/E |
1) positively related to growth 2) negatively related to required return |
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Given g= b X ROE |
1) ROE>r, increases the retention rate increase P/E
2) ROE |
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Why is P/E ratio still the most closely-followed price multiple by equity analysts? |
commonly believed that equity markets price expectations about a firm's earnings growth |
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Limitations of Using P/E |
1) EPS can be negative for individual stocks, and the P/E ratio doesn'tmake sense with neg denom 2) Earnings often have volatile or transient components which makes comparisons hard 3) Mgmt has the discretion under GAAP to make various ACCT choices that can harm the comparability of P/E over time or across companies |
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Trailing/ Current P/E |
makes use of the most recent four quarters of EPS. (Trailing 12 months or TTM)
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Leading or forward P/E |
makes use of the next year's expected earnings |
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Underlying EPS or Ongoing EPS |
excludes anything from reported earnings that is considered an unusual or non-recurring item. identify the "true" earnings from a company's core operations |
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Pro forma EPS |
reflect earnings that have been adjusted from GAAP by the reporting company by excluding one or more costs to give what the company believes to be a truer picture of its underlying profitability |
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Adjustments to EPS |
1) transitory, nonrecurring components of earnings that are company specific 2) changes in the choice of accounting methods over time 3) transitory components of earnings due to the business cycle or the cyclicality of the industry the firm operates in 4) potential dilution of EPS if the option to purchase shares via employee/executive stock options, warrants, or convertibles is used
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Molodovsky Effect |
countercyclical property of P/E |
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normalized EPS or Normal EPS |
the level of EPS that the company could achieve currently under mid-cyclical conditions |
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Two Methods Used to Determine Normalized EPS |
1) method of historical avg EPS( doesn't account for changes in the size of business) 2) method of average ROE (PREFERRED METHOD) |
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method of average ROE |
Preferred method calculated as the average ROE from the most recent full cycle, multiplied by current book value per share. |
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Irrational Exuberance |
Robert Shiller adjusts the S&P 500 and EPS for CPI inflation and uses the avg of the last 10 years of monthly data for EPS to compute P/E |
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Basic Earnings Per Share |
reflect reported earnings divided by the weighted average number of shares actually outstanding during the period |
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Diluted eranings per share |
reflect division by the number of shares that would be outstanding if holders of the securities as executive stock options, equity warrants, and convertible bonds exercised their options to obtain common stock |
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Fed Model |
named by Ed Yardeni based on the result of the Hymphrey-Hawkins report to congress. Fed Model is misleading and is not endorsed by the federal reserve |
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Fed Model Predictions |
1) stocks are undervalued (overvalued) if the earnings yield on the S&P 500 is greater than (less than) the T-bond yield 2) stocks are undervalued (overvalued) if the P/E ratio for he S&P 500 is less than (greater than) the reciprocal of the T-bond yield. |
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Problems with the Fed Model |
1) completely ignores the equity risk premium 2) the relationship is far from constant over time 3) compares a real variable, the earnings yield, to a nominal variable, the T-bond yield 4) biased towards stocks- use forecasts for OI which is higher than NI |
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Rule of 20 |
valuations are fair when the sum of the market's price-earnings ratio and the rate of inflation is equal to 20
fair value P/E- 20.0 inflation rate |
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Price to book value (P/B) |
stock or level variable which appears on the balance sheet; represents the investment that common shareholders have made in the company |
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Common Shareholder's Equity (Book Value) |
=common stock+additional paid-in capital + retained earnings- treasury stock |
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additional paid-in capital |
difference between the market value and par value of common shares when they were issued |
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Limitations of P/B |
-best suited for liquid companies -doesn't reflect the benefit of human capital or other intangible assets -may not reflect the effects of inflation due to historic cost accounting conventions -capital insensitive firms usually have a higher book value making comparisons difficult |
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P/B relationship |
1) Positively related to ROE 2) Negatively related to required return |
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Price-to-sales (P/S) |
calculated as price per share divided by annual net sales per share (gross sales less returns and discounts) |
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Reasons to use P/S |
-sales as top line number on the income statement are not as easy to manipulate -not sensitive to the business cycle -doesn't suffer from the problem that EPS can be negative for some firms |
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Problems using P/S |
to create value for investors, a firm must generate earnings; revenues not equal to profits |
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P/S relationship |
positively related to profit margin and the dividend/ earnings growth rate
negatively related to its required return |
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Price-to-cash flow (P/CF) |
calculated as price per share divided by some per share measure of cash flow
=EPS+ per share non cash charges |
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FCFE : Free cash flow to equity |
=Net income + Ncc -FCInv - WCInv+ Net borrowing |
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EBITDA: earnings before interest, taxes, depreciation, and amortization |
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Why use P/CF |
-better measure because considerable non-cash expenses -less subject to accounting manipulation than earnings -typically more stable than earnings |
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Dividend Yield (D/P) |
calculated as the dividend per share divided by the price per share
high dividend yield is an indication of value! |
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why use the dividend yield? |
-component of total return -investors rely on income from investments to maintain current lifestyles -income from dividends is taxed the same as capital gains |
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Limitations of D/P |
raising the payout ratio implies a decrease in b and g. while a higher payout ratio results in a larger dividend, it also implies a slower rate of earnings growth and price appreciation known as dividend displacement of earnings |
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enterprise value multiples |
market value of common equity + market value of preferred stock + market value of debt - cash and short-term investments = enterprie value |
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Enterprise Value (VA) to EBITDA |
-most widely used enterprise value ratio -flow to both debt and equity so comparison is appropriate
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Enterprise value to sales (EV/sales) |
-alternative to P/S -some revenue is used to pay principal and interest on debt |
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Momentum Indicators |
-price ( technical indicators) -fundamental ( earnings) |
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Earnings Momentum |
occurs when a company continues to show accelerating earnings growth from quarter to quarter (LT sign)
-positive earnings trends -EPS estimate upgrades -positive earnings surprises |
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Good Value Investors |
operate in the bottom left quadrant of the cycle; need to be contrarian buyers |
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Good Growth Investors |
operate in the top left quadrant of the cycle; need to be contrarian sellers |
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Relative Strength or Price Momentum Indicators |
compare a stock's performance during the current period with : 1) its own past performance 2) performance of other stocks 3) performance of an industry or market index
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Relative Strength Index |
-developed by Wilder -momentum indicator that measures the speed and change of price movements -between 0-100 -overbought when about 70 -oversold when below 30 =average gain/ average loss |
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Moving Averages |
average share price over a certain number of days and shows the volatility of day to day and week to week movements to show general direction of price |