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Equity Analysis Part 3 – Introduction

The equity part three topics will build the previous two sessions and discuss commonly used models for valuing stocks.  There are a number of formulas covered, but none of them are terribly complex and many candidates will have likely seen at least a few of them before either in an academic or professional capacity.  Flashcards

Sustainable Growth Rate

When referencing a company’s sustainable growth rate, an analyst is discussing the growth in earnings and dividends that can be maintained given a company’s ROE and its existing capital structure. gsustainable = b × ROE b = earnings retention rate = (1 – dividend payout rate) CFA may present candidates with a problem that requires

H-Model for Valuing Growth

The H-Model is a modification of the Two Stage DDM. Unlike other two-stage models where the growth rate is assumed to be a constant, the H-Model assumes that the growth starts at a higher rate, and then gradually declines till it becomes normal stable growth rate. “H” represents half-life of the high growth period. V0

Multi-Stage Dividend Discount Models

Unlike the Multiple Holding Period DDM previously described, the Multi-Stage Dividend Discount Model allows for multiple growth rates in calculating a stock value. The allowance of multiple growth rates is more realistic, companies commonly experience a growth phase, a transitional phase (as new competition enters the market driving down returns), and a mature phase. Naturally

GGM, Leading P/E Ratio, and Trailing P/E Ratio

The principles of GGM can be applied to derive Leading and Trailing price to earnings ratios. Leading P/E Model: Based on future earnings. P0/E1 = (Div1/Earning1)/(rce – g) = k/(rce – g) Where k is the dividend payout ratio and g assumes that earnings growth and dividend growth are equal rates. Trailing P/E Model: Slight

Present Value of Growth Opportunities (PVGO)

A stock’s valuation can be heavily influenced by future growth expectations. As a company generates positive earnings and retains these earnings, its book value of equity increases; however, in order for the positive retained earnings to create wealth for investors, the company’s return on equity must exceed its cost of equity. In theory, when a

Gordon Growth Model (GGM)

The GGM is a variation on the standard DDM that allows the analyst to assume that dividends will grow in perpetuity at a constant rate. V0 = Div1 /(rce – gdiv) Div1 = D0 * (1 + gdiv) = future period dividend payment rce = by now you should know this! In an exam problem

Dividend Discount Model (DDM)

If James Brown is the “Godfather of Soul”, then the dividend discount model could be considered the “Godfather of Equity Valuation”. Many of the approaches used today can trace their roots to DDM. The basic thesis of the DDM is that the value of a common stock to an investor is the present value of

Cash Flows: Dividends vs. Free Cash Flows vs. Residual Income

When calculating the present value of a company, an analyst can choose between dividends, free cash flows, and residual income to derive the stock’s intrinsic price.  Each of these cash flows has advantages and drawbacks. Dividends These direct cash payments are a key component of an investor’s returns. Dividend Advantages: Typically more stable than earnings;

Cost of Capital in Emerging Markets

Cost of Equity CAPM can be used to estimate the cost of equity capital for an emerging market. Note however, if the country is not very well integrated into the global capital market system, then CAPM may be an unsuitable technique, so be mindful of this qualifier when reading the item set. Start by creating