Final Exam Cards v4

P/E Ratio Calculation

Divide share price by EPS; tells you how much investors are paying per €1 of earnings.

P/B Ratio Calculation

Divide share price by book value per share; used to compare market value vs. accounting value.

Stock Return Formula

Return = (P1 + D – P0) / P0; includes capital gain and dividend.

Market Capitalization Formula

Share price × number of shares outstanding; gives total equity market value.

CAPM Formula

Re = Rf + β(Rm – Rf); calculates the required return on equity based on systematic risk.

Alpha vs Beta Investing

Alpha investors seek outperformance; beta investors passively track the market.

WACC Formula

WACC = E/V × Re + D/V × Rd × (1 – T); used to discount FCFF to determine firm value.

DDM Valuation Formula

P = D1 / (r – g); values a firm based on next year’s dividend and constant growth.

D0 vs D1 in DDM

D1 = D0 × (1 + g); always convert D0 to D1 before using DDM.

NPV of Cash Flows

PV = CF₁/(1+r) + CF₂/(1+r)² + ...; use for discounting future values in DCF questions.

Residual Income Formula

RI = EPS – (COE × Book Value); measures economic profit above equity cost.

Book Value Forecasting Formula

BVt = BV(t–1) + EPS – DPS; used in residual income projections.

DCF Terminal Value Formula

TV = FCFF_(t+1) / (WACC – g); continuing value in DCF model.

RIM Terminal Value Formula

TV = RI_(t+1) / (COE – g); continuing value in residual income model.

Multiples Valuation Steps

1. Identify peers; 2. Get P/E or P/B; 3. Apply multiple to target firm's EPS or BV.

Weakness of P/E Ratio

Distorted by accounting choices, cyclical earnings, or negative profits.

Ryanair Valuation Insight

Use DCF over DDM because Ryanair reinvests heavily and doesn’t pay stable dividends.

CRH Valuation Insight

Market price exceeded RIM model value because investors likely expected higher future ROCE or lower risk.

Q11 DCF Structure

Forecast FCFF → Discount → Add Terminal Value → Subtract net debt → Divide by shares.

Q12 RIM Structure

Forecast EPS & DPS → Update BV → Calculate RI → Add PV of RI and terminal RI to BV₀.

Q13 Answer Trigger: Why market > model

Market expects higher ROCE, lower COE, or sees value model doesn’t capture (e.g. intangibles, growth).

Q14 Comparison

DDM Inputs; D1, r, g; best for stable dividend firms; fails when dividends are inconsistent.

Q14 Comparison DCF Inputs

FCFF, WACC, g; best for firms with clean cash flow; sensitive to TV assumptions.

Q14 Comparison RIM Inputs

EPS, BV, COE, g; best when FCF and dividends are unreliable but earnings are stable.

Terminal Value Risk

Inflated by overestimating growth or underestimating discount rate; can skew valuation significantly.

When to Use CAPM

When you need to calculate cost of equity for DDM, FCFE, or RIM.

When to Use WACC

When you’re discounting FCFF in a DCF model; reflects blended cost of capital.

Enterprise Value Formula

EV = Market Cap + Net Debt; represents total firm value to all capital holders.

Equity Value per Share Formula

Equity Value / Number of Shares; final step in both DCF and RIM models.

FCFF Formula

FCFF = EBIT × (1 – tax rate) + Depreciation – CapEx – Change in Working Capital; used to calculate free cash flow to the firm in DCF.

Adjusted Beta Formula

Adjusted Beta = 2/3 × Raw Beta + 1/3 × 1.0; used to smooth beta estimates toward market average.

ROCE vs COE Logic

If Return on Common Equity (ROCE) > Cost of Equity (COE), the firm is generating positive residual income and creating value.

DCF Model Weakness

Highly sensitive to discount rate and terminal value assumptions; small changes can drastically affect valuation.

RIM Model Weakness

Relies on accurate accounting and book value forecasts; can be distorted by aggressive earnings or accounting noise.

Multiples Valuation Strengths

Fast and widely used; provides quick peer comparison when good comps exist.

Multiples Valuation Weaknesses

Can be distorted by accounting differences, not forward-looking, and fails with negative earnings.

Forecasting Book Value

Update book value each year by adding EPS and subtracting DPS: BV_t = BV_(t–1) + EPS – DPS.

Shiller’s Irrational Exuberance

Markets can become overvalued due to investor overconfidence and herd behavior, not fundamentals.

Keynes’ Beauty Contest

Investors try to anticipate what others will value, leading to prices disconnected from intrinsic value.

Efficient Market Hypothesis (EMH)

Theory that prices reflect all available information; weak, semi-strong, and strong forms affect investor strategy.

Free Cash Flow to Equity (FCFE)

Cash available to equity holders after operating expenses, capex, and debt repayments; used in equity-level DCF.

DDM Limitation (Conceptual)

Assumes dividends are the only way value is distributed to shareholders; fails when firms reinvest or use buybacks.

RIM vs DCF

RIM relies on clean accounting earnings and book value; DCF uses cash flows and is better when FCFs are stable.

EV vs Equity Value

EV includes debt and cash (total firm value); equity value is EV minus net debt.

FCFF vs FCFE

FCFF is cash flow to all capital providers (discount with WACC); FCFE is to shareholders only (discount with Re).

Terminal Value Dominance

In DCF and RIM, terminal value often represents over 70% of total firm value; be cautious with assumptions.

Book Value Forecasting Tip

Always start with BV₀ and roll forward using: BV_t = BVₜ₋₁ + EPS – DPS.

Residual Earnings vs Net Income

Residual earnings subtract the equity cost from net income; NI alone doesn’t account for capital cost.

When to Use DDM / DCF / RIM

DDM: stable dividends, DCF: stable FCF, RIM: clean earnings but no dividends or messy FCF