Definitions of Cash Flow
There are various proxies for cash flow that may be used when calculating cash flow multiples. EPS Plus Non-Cash Charges It is calculated as: $$ \begin{align*} \text{EPS Plus Non-Cash Charges} & = \text{EPS}+\text{Depreciation} \\ & +\text{Amortization}+\text{Depletion} \end{align*} $$ A…
Arbitrage Pricing Theory (APT), Its Assumptions and Relation to Multifactor Models
Arbitrage Pricing Theory (APT) Arbitrage pricing theory (APT) is a theory of asset pricing. It asserts that the expected return of an asset can be expressed as a linear function of multiple systematic risk factors priced by the market. APT…
Using P/Es to Obtain Terminal Value in Multistage Dividend Discount Models
When estimating the terminal value, analysts use price multiples such as P/Es and P/Bs to estimate terminal values. There are two significant approaches to computing terminal values based on multiples: I. Terminal Price Multiples based on Fundamentals The terminal…
P/E to Growth Ratio (PEG)
The PEG ratio considers the impact of earning growth on the P/E ratio. It is calculated as P/E divided by the expected earnings growth rate in percentage. Stocks with lower PEG ratios are more attractive than those with higher…
Valuation with Comparables
Valuation based on Comparables The P/E valuation method is used to estimate a company’s stock value by applying a benchmark multiple to the company’s actual or forecasted earnings. An equivalent approach is to compare a stock’s actual price multiple…
Calculating and Interpreting a Predicted P/E
A predicted P/E is estimated from the cross-sectional regressions of P/E on the fundamentals that are considered to determine investment value, e.g., the growth rate of earnings and payout ratio. Example: Calculating a Predicted P/E Consider a firm with…
Price Multiples Based on Forecasted Fundamentals
Justified Leading P/E Multiple based on Fundamentals $$\text{Justified leading}\ \frac{\text{P}_{0}}{\text{E}_1} =\frac{\text{D}_{1}⁄\text{E}_1}{\text{r}-\text{g}}=\frac{1-\text{b}}{\text{r}-\text{g}}$$ Where: \(1-\text{b}=\) Payout Ratio $$\begin{align*}\text{Justified leading}\ \frac{\text{P}_{0}}{\text{E}_0} &=\frac{\frac{\text{D}_{0}(1+\text{g})}{\text{E}_0}}{\text{r}-\text{g}}=\frac{(1-\text{b})(1+\text{g})}{\text{r}-\text{g}}=\bigg(\frac{1-\text{b}}{\text{r}-\text{g}}\bigg)(1+\text{g})\\ \text{Justified trailing}&=\text{Justified leading}\ \frac{\text{P}}{\text{E}}\times(1+\text{g})\end{align*}$$ If earnings are expected to grow by \(g\), next year’s earnings will be greater than last…
Mortgages and Mortgage-Backed Securities
After completing this reading, you should be able to: Describe the various types of residential mortgage products. Calculate fixed-rate mortgage payment and its principal and interest components. Describe the mortgage prepayment option and the factors that influence prepayments. Summarize the…
Fundamental Factors that Affect Alternative Price Multiples and Dividend Yield
Justified P/E Multiple Based on Fundamentals DCF valuation models can be used to estimate the justified P/E for a stock and to gain insight into the sources of valuation differences when the method of comparables is used. Connecting P/Es…
Earnings Yield
Using the P/E ratio in-stock selection involves ranking stocks from highest value to the lowest. However, ranking zero and negative P/Es would rank them below the lowest positive P/E when they are actually the most costly. A solution for…
