Difference between fcff and fcfe investopedia

Peer Review -Reserved For Erudite787

Investment Growth Analysis for Gloria - June 19, 2016

Kimberly Huh

Casey Wilkins

Kent Wright

Calculate the required rate of return using the Capital Asset Pricing Model (CAPM).

Capital Asset Pricing Model (CAPM)

* for calculation

risk free = 4.30%

Beta = *retrieved from assignment

expected market return = 11.9%

Require Rate of Return

1

9.2400%

2

21.7800%

3

18.6640%

4

13.4200%

5

14.5600%

6

12.2800%

7

17.8280%

8

11.5200%

9

11.2920%

10

15.7000%

11

10.7600%

12

7.1880%

13

9.6960%

14

13.4200%

15

9.8480%

Using the constant growth formula, calculate the value of each stock

P = D1/(r-g)

Where P is the value estimate, D0 is the current dividend amount, D1 is the estimated dividend in year 1, r is the cost of common stock (or the required return by the shareholders), and g is the constant growth rate

Constant growth value

Current Stock Price

Difference

1

$11.13

$12.05

-8.20%

2

$0.00

$28.02

3

$0.00

$17.75

4

$19.21

$92.43

-381.00%

5

$5.56

$63.79

-1047.00%

6

$0.00

$2.88

7

$0.00

$10.00

8

$6.36

$49.51

-678.00%

9

$46.00

$101.00

-119.00%

10

$0.00

$39.78

11

$24.03

$29.75

-23.00%

12

$0.00

$73.09

13

$142.04

$20.39

696.00%

14

$0.00

$18.25

15

$147.24

$7.00

2100.00%

Compare the values you calculated in questions 1 & 2. Do the values closely approximate the stocks market price? If not, why not? No

The calculated stock price does not reflect the current market prices. The current prices are quite higher than their intrinsic value which simply means stock value is overvalued. This difference could be because of high demand of stock which has increased stock price. These stocks maybe riding on economic growth. Economic conditions are the state of the economy in a country or region and are considered to be sound or positive when an economy is expanding, and are considered to be adverse or negative when an economy is contracting (www.investopedia.com). The differences in values (market price vs constant growth value) are pretty high. Mostly, this is from the lack of dividends and dividend growth produced by a majority of the stocks. When evaluating the performance of any investment, it's important to compare it against an appropriate benchmark (www.investopedia.com). Since the constant growth formula uses the current dividend and expected increase in dividends as variables, the lack of these two components really dampen the accuracy and/or legitimacy of the stock valuations making this valuation tool non-applicable. However the companies that are paying a dividend need to have a growth rate comparable if not exceeding in order to meet the required rate of return.

What do your results mean for Gloria?

Gloria should pursue and acquire stocks which are undervalued like stocks 13 and 15. As they are undervalued and their prices may increase in the future. Even the growth potential of these companies is higher. Gloria should also look at growth patterns and risk factor. Companies that are having a negative growth rate may not perform well in near future and higher beta means that more risk involved. As a risk averse investor she should focus on companies with a higher return and lower risk. Once again what this means is that according to these numbers alone, only two of the fifteen stocks are "undervalued" and that she should pursue alternate methods of research for these stocks as there are possibly other and more appropriate methods for valuation. (Alternatively, this could also mean Mr. Bill is a big fat liar and is bad at his job). Unscrupulous investment advice is something Gloria should look at as well (Hunter, 2006).

Are there other options Gloria might consider for valuing stocks?

The one constant growth model is not enough as some companies are not paying dividends. Dividend and growth are not the only measures which reflect intrinsic values. Gloria could also calculate stock price through:

* FCFF (Free Cash Flow from Firm)

* FCFE (Free Cash Flow to Equity)

* Residual Income model

*Discounted Cash Flow Model

* Excess returns model

* Adjusted Present Value

* Relative Valuation

* Standardized values and multiples model

Comparing company's in the same sector would allow her to create standardized multiples defined by:

Definitional Test- Even the simplest multiples are defined differently by different analysts. Consider, for instance, the price-earnings (P/E) ratio, the most widely used multiple in valuation. Analysts define it to be the market price divided by the earnings per share, but that is where the consensus ends.

Descriptional - When using a multiple, it is always useful to have a sense of what a high value, a low value, or a typical value for that multiple is in the market. In other words, knowing the distributional characteristics of a multiple is a key part of using that multiple to identify under- or overvalued firms.

Analytical- In discussing why analysts were so fond of using multiples, it is argued that relative valuations require fewer assumptions than discounted cash flow valuations. The difference is that the assumptions in a relative valuation are implicit and unstated, whereas those in discounted cash flow valuation are explicit and stated.

Application-When multiples are used, they tend to be used in conjunction with comparable firms to determine the value of a firm or its equity. In addition, no matter how carefully we choose comparable firms, differences will remain between the firm we are valuing and the comparable firms (Damodaran, 2006).

Essentially throwing darts at a board is what is happening now. Without comparison, we are not sure whether non dividend paying companies will be better choice or not.

How does your result affect the “market efficiency” theory?

Market efficiency theory says it is impossible to beat the market which makes us uncertain that our decision to invest in undervalued could result in Gloria's favour. As there will be a lot of other investors looking for undervalued stock. Such increase in demand could increase stock price, eliminate any gain and bring price equal to its intrinsic value. But it is not necessary so as everyone in the market does not possess entire available information and there is always a chance to gain a bit. Periods marked by high arbitrage flows are periods during which markets are more efficient. These periods are likely to see a correction of cross-sectional mispricing, resulting in lower returns for quantitative strategies in the future (Akbas, 2016). Plus an efficient market is subject to rational investors. Rational investors, we are told, have adequate information to make investment decisions and act on that information, rationally and in their own best interest. They also make lifestyle choices, generally preferring aggressive portfolios early in their lives, and gradually becoming more conservative as they near retirement (Basu, 2008).

References

Akbas, F., Armstrong, W. J., Sorescu, S., & Subrahmanyam, A. (2016). Capital Market Efficiency and Arbitrage Efficacy. Journal Of Financial & Quantitative Analysis, 51(2), 387-413. doi:10.1017/S0022109016000223

Basu, S., Raj, M., & Tchalian, H. (2008). A Comprehensive Study of Behavioral Finance. Journal Of Financial Service Professionals, 62(4), 51-62

Damodaran, Aswath. ( © 2006). Damodaran on valuation: security analysis for investment and corporate finance, second edition. [Books24x7 version] Available fromhttp://common.books24x7.com.ezproxy.umuc.edu/toc.aspx?bookid=16748.

Hunter, T. (2006). 'The sell sell sell crowd are back again' Unscrupulous financial advisers have been accused of choosing investments that pay them the biggest commissions rather than deliver the best returns for clients. Teresa Hunter reports.Sunday Telegraph (London, England).