Term
what are some of the problems with valuation based on the balance sheet, such as using book value?
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Definition
book value: assets are recorded at historical cost. therefore, the amount that an asset cost may not reflect what they could fetch at the current market prices (think of real estate) |
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Term
what are some of the problems with valuation based on the balance sheet, such as using liquidation value?
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Definition
| liquidation value: at the same time, many assets require a small discount. the net realizable amount that could be generated by selling assets such as accounts receivable will require 15-25% off, while inventory may require 50-75% off. other assets may not be readily sold, and will be assigned a value of 0. **for going concerns, liquidation is irrelevant because you won't be liquidating the entity. |
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Term
what are some of the problems with valuation based on the balance sheet, such as using adjusted book value?
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Definition
adjusted book value: for going concerns, you can adjust all the book values in the balance sheet to reflect things such as inflation and appreciation to arrive at a more current measure of financial value. BUT even this may not be accurate because the balance sheet does not take into account goodwill, brand recognition, customer loyalty, etc.
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Term
| what are some of the problems with valuation based on the balance sheet, such as using reproduction of costs? |
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Definition
one would seek to determine what it would cost to duplicate the company, buy its properties, train its employees, develop intellectual property, and attract and retain customers.
however, there are many things that GAAP does not assess. for example, a new entrant might need to invest in R&D to replicate the target company. this exact value is difficult to estimate. |
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Term
| what are some of the problems with valuation based on the balance sheet, such as using book values of stocks/bonds? |
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Definition
whatever measure of book value is used, it can be refined further to specify that book value per share of common stock or preferred stock.
1. book value divided by total face amount of the bonds.
2. the amount of the bonds outstanding are subtracted from the calculation, then divdied by the number of preferred shares outstanding.
3. then both bonds and preferred are subtracted, and the result divided by the number of common shares outstanding.
however, taken alone, book value per share has limited meaning for most entities operating in the ordinary course, because at best it measures the amount of cash each share would be allocated in the event the entity were to be liquidated. it may be useful when comparing to other companies' book value per share. |
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Term
| what is Market/Book ratio? |
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Definition
M/B ratio = market price per share / book value per share
This relationship can be compared with that of other publicy traded entities in the same industry to give a measure of how investors regard the subject entity compared with other entities or the industry average.
the recent prices of trading company's stocks are not required by GAAP to be disclosed. |
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Term
| what does a high M/B ratio mean? |
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Definition
| high m/b ratios mean that investors regard the stock more favorably. |
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Term
| why must we also look at the income statement for the valuation determination? |
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Definition
| unless we are valuing an entity for the purposes of liquidating it, what we really want to know is what these assets, and the enterprise taken as a whole, can do for us. we are interested in know what it can generate in terms of returns over time. |
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Term
| what is a way to define "financial value" ? |
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Definition
| an estimate of present worth in light of past, present, and prospective financial performance of an investment. this sort of value can be measured in terms of the earnings the investment generates over time. |
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Term
| what is "capitalizaing earnings" ? |
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Definition
the method for assessing value in terms of the earnings the investment generates over time.
capitalizing earnings means dividing earnings by a specified rate of return, and requires an estimate of earning and the selection of an appropriate rate of return. |
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Term
| when making an assessment on earning that will be generated in the future, which prior year's earnings do we use? how do we go about making this estmate? |
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Definition
| a common practice in making an earnings estimate is to compute normalized earnings. it is taking an average of earnings over the past several years, usually 3 to 5. Also, if there is some reason to believe that the years are more or less representative they could be weighted accordingly. |
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Term
| what is a problem relating to reporting when employing accouting earnins in the valuation determination? |
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Definition
| in comparing a particular entity's earnings with those of other entities, care must be taken to ascertain any differences in accouting conventions (LIFO/FIFO, method of depreciation, allowance for bad debts) that have material affects on reported earnings. |
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Term
| what are pro rata financial figures? |
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Definition
these are pictures of performance based on making various assumptions other than those applied in preparing actual financial statements.
while useful for certain exercises (such as depicting how a newly-merged company would have looked if the merger had occurred some years earlier), they do not represent useful useful valuation resources in other contexts. |
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Term
| what is the next step when using valuation based on income statement after you have figured out the estimated earnings of the future? |
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Definition
the earnings must be discounted. to do so, a suitable capitalization rate (cap rate) must be chosen.
the cap rate is the rate of return that an investor would require in order to make the investment. |
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Term
| how do you determine which cap rate to use? |
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Definition
in general, the lower the risks involved in a particular type of business, the lower the cap rate.
the question the investor faces is what amount of money is she willing to pay for a specified return, compensated by the risk that that amount will not materialize.
e.g. high degree of certainty, 8-10%
moderate degree of risk, 15-25%
high risk, 30% or 40% up to 100%
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Term
| what is the formula to determine value of an entity based on income statement? |
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Definition
V = E / R
V: valuation based on earnings
E is the expected earnings (per share)
R: cap rate |
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Term
| what happens to the value of any given stock when the cap rate increases? |
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Definition
| the value of the stock decreases. cap rate reflects a measure of risk, and therefore higher risk that earnings will not be realized, and thus lower valuation. |
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Term
| what is the relationship between the cap rate and the p/e ratio? |
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Definition
the p/e ratio reflects perceived risk, so we can calculate the market's implied cap rate. it is the reciprocal of the p/e ratio.
however, we might agree or disagree with the market's collective judgment. (the average common stock listed in public captial markets in the US typically varies in price during a single year by as much as 50%)
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Term
| what is a limiation even if we use income-based valuation? |
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Definition
sometimes what is of interest in valuation is the future expected stream of payments, and therefore 2 conditions would need to be met:
(1) the p/e ratio must be calculated based on expected average future earnings
(2) all such earnings must be expected to be paid in dividencds to stockholders rather than reinvested in the business. |
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