Fin406 Ex2 Outline - Review for Test 2 I Overview a Equity...

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Review for Test 2 I. Overview a. Equity Valuation Trading signals i. Estimate the equity value ii. Identify under/over-valued stocks b. General approaches to equity valuation: i. Fundamental analysis – The EmIC framework ii. Technical analysis iii. Quantitative analysis c. Two (2) standard approaches based on the fundamental analysis i. DCF ii. Relative valuation II. EmIC Framework a. E conomies – domestic + global i. Focusing on economic growth, employment, inflation, and interest rates ii. Implications for capital m arkets such as equity and bond mkts b. I ndustry analysis i. Industry life cycle ii. Defensive vs. Cyclical industries c. C ompany-specific analysis i. Focusing on the valuation (in Fin406) III. Big Picture of DCF a. The intrinsic value of an asset = PV of its future cash flows i. Dividend Discount Models (DDMs) ii. Free cash flow models b. It makes you analyze the fundamentals of the firm and understand its business i. Warren Buffet: Good investors buy businesses rather than stocks c. These inputs of a DCF model are difficult to estimate accurately d. Valuation can be very sensitive to inputs IV. DDM – More Formulas a. Earnings and Dividends i. Dividends + RE (retained earnings) = NI ii. Dividend payout ratio 1. = dividends/NI = DPS / EPS iii. Retention ratio b = 1 – (div payout ratio) iv. DPS = EPS (div payout ratio) b. Fundamental growth in earnings i. g = b * ROE 1. Where ROE = NI / book value of equity c. Discount rate k: given by the CAPM
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V. To Implement a DDM a. Choose the firm’s growth pattern i. 1/2/3-stage models b. Estimate (k) using the CAPM c. Estimate the cash flows i. 1-stage: D 0 (DPS 0 ) or D 1 , g ii. 2-stage: Cf’s in the HG stage and the TV d. Estimate the growth in earnings i. Fundamental growth: use Eq. (6) ii. Historical based: analysts estimate iii. Industry/economy growth or other reasonable estimates VI. FCFE Valuation Formulas a. (separate page) VII.DDM vs. FCFE a. In general, we should use FCFE valuation models not the DDM for equity valuation i. One exception: financial firms b. FCFE is a better measure of cash flows to equity than (actual) div’s c. FCFE models and the DDM have the same pricing formulas except that cash flows to equity are measured differently VIII. FCFF Formulas a.
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