A brief refresh from Level 1:
Equity valuation can be using DCF, Relative Value, Asset Based valuation.
Discounted Cash Flow (DCF) – PV of future cash flows. This DCF includes DDM, FCFF, FCFE.
DDM – Assumptions – Return on Equity is constant, Dividend ratio is constant, Growth rate will remain constant, Cost of Equity > growth rate. Value of stock = D1/(k-g) when dividend is not the same every year. K = cost of equity.
Relative Value can be based on P/E, P/S, P/CF, P/EBITA etc. How should the price be relative to competitor as well as to sales , earning etc.
Asset Based Valuation would be (Assets – Liabilities) / # of shares.
Now lets get to Level 2 study as below
HPR vs RR
If Req Return (RR) > HPR , then stock overvalued.
If RR < HPR then stock undervalued.
Equity Risk Premium for a given stock can be calculated using
ERP = Historical Return – RFR
Forward looking ERP can be calculated using
- GGM ::: where ERP = D1/P0 + g – RFR where D1 = next period’s dividend, P0= current stock price, g = consensus growth rate , RFR = Risk free rate or benchmark rate.
2. Ibbotson and Chen Model ::: ERP = ((1+Expected Inflation) * (1+Expected real EPS growth rate ) *(1+