Essay on Discounted Cash Flow

Submitted By jayd101201
Words: 3644
Pages: 15
Open Document
Valuentum Financial Advisor Insights

Brian Nelson, CFA

President, Equity Research brian@valuentum.com c - +1 (708) 653-7546

Thinking about the Price-to-Earnings
Ratio in a Different Light
The P/E Multiple Is Not as Basic as You Might Think
March 12, 2012

Executive Summary: We break down the key components of a price-toearnings multiple and highlight some of the pitfalls investors may encounter by using it incorrectly in the valuation process.
What is the purpose of such an article? The P/E ratio is so simple, right? It is just the price of the stock divided by the annual net diluted earnings per share of the firm. And the forward P/E is merely the price of the stock divided by next year’s annual net diluted earnings per share of the firm. The P/E is probably the most common measure to help investors compare how cheap or expensive a firm’s shares are, as stock prices for lack of a better term are arbitrary. For example, firms like Warren Buffett’s Berkshire Hathaway (BRKA), which has never split its stock, have traded as high as $140,000 per share, while other well-known companies like Sprint (S) can trade for just a few bucks per share. And Citigroup (C) was once a penny stock before its 10to-1 reverse split in 2011.
It’s only when investors compare a firm’s share price to its diluted earnings per share that they have any idea whether a company’s shares are expensive
(overvalued) or cheap (undervalued). The higher the P/E, the more expensive the company’s stock – and vice-versa. This seems way too simple, so why would we (or better yet, how could we) devote a whole paper to talking about such a basic financial concept. Well, the truth is that the P/E ratio is not as basic as you might think (and even some of the most seasoned investors don’t understand what this powerful multiple means).
To learn more about Valuentum and its equity research services, please visit us at www.valuentum.com or contact a sales representative at info@valuentum.com. As followers of Valuentum know, the second pillar of our Valuentum Buying
Index™ considers a company’s forward P/E ratio by comparing this measure to that of its industry peers to determine if the company is trading at a

© 2012 Valuentum Securities, Inc. All rights reserved.

comparatively attractive valuation. If the P/E is lower than its peer median, an investor is paying less per unit of earnings than the median of its peer group.
Investors are getting a good deal in this case, all else equal, right? Well, the

Valuentum Securities Inc.
From Value Through Momentum Investing

1

2 problem is that companies are never equal, and even comparisons among firms that are in the same industry can be misleading. It is also inappropriate for investors to apply a firm’s historical median (or average) price-to-earnings ratio to the same firm’s future earnings stream. But why not? It’s the same stock. Shouldn’t it be relevant and applicable? Well, yes and no. First, it’s great for investors to have an idea of what “multiple range” a company has traded at in the past – there’s lots of value to this, and most relevant for cyclical firms (mainly industrials) that may, from a fundamental standpoint, exhibit similar (but not identical) patters with respect to both earnings and their P/E through the course of each economy cycle: think Boeing (BA) and the commercial aerospace cycle; Ford (F) and consumer demand for auto sales; or United Continental (UAL) with respect to premium air travel demand. But for less-cyclical firms (and even for cyclicals where structural industry dynamics have altered over time), investors are wrongly assuming that the forward outlook of the past (which determined the historical multiple) will be the same as the forward outlook of the present (which determines the current multiple). This, unfortunately, is never true.
So what is an investor to do? We know that it’s imperfect to compare a firm’s current or forward price-to-earnings ratio to its peers or even to the median
Show More

Related Documents: Essay on Discounted Cash Flow

Discounted Cash Flow and Dividend Discount Model Essay

question is the free cash flow method. The underlying principles of the free cash flow method start with the dividend discount model and this can best be described when we look at the way investors buy shares in a publicly traded company when it is traded in a free market. By understanding these underlying principles we can then understand the transition to the free cash flow model and why it is the preferred method of many analsyts. The investor is expecting two types of cash flows from their investment…

Words 2053 - Pages 9

Discounted Cash Flow and Football Field Analysis Essay

restaurants • The new restaurants opened may not be profitable • The expansion into international markets is risky 10 DCF Analysis 11 Peer Group Analysis Peer Comparison Ratios Liquidity Ratio Financial Leverage Efficiency Ratio Profitablity Ratio Cash Asset current Asset/Equit Conversion Gross Turnove ratio y Margin Cycle r Chipotle Mexican Grill 2.93 McDonald's Corp. 1.45 Yum Brands Inc. 0.87 Panera Bread Company, Inc. 1.34 Operating Margin EBT Margin -4.39 1.77 27.11% 16.69% 16…

Words 826 - Pages 4

Angus Cartwright III Financial Analysis Essay

Breakdown of Returns (Cash Flow, Tax, Future Value) Allison Green IRR: 14.93% Cash Flow Before Tax Income Tax Consequences Futures Total Year Actual Discounted Actual Discounted Actual Discounted Actual Discounted 0 1 $434,307 $377,902 ($91,865) ($79,935) $0 $0 $342,441 $297,968 2 $460,413 $348,589 ($102,596) ($77,678) $0 $0 $357,816 $270,911 3 $487,302 $321,031 ($113,697) ($74,903) $0 $0 $373,605 $246,128 4 $514,998…

Words 1084 - Pages 5

Accounting for Planning and Control Essay

necessitates an understanding of the topic of capital budgeting. Capital budgeting is the process of determining and pursuing investments which cash flows are expected in the future period usually more than a year. It entails the decision on the acquisition of new assets or equipment that is to be utilized by the business to increase its future cash flows and profitability. Managers are, therefore, faced with the challenge of determining which project to invest in order to avert the adverse effect…

Words 912 - Pages 4

Capital Budgeting Essay

The firm’s capital budgeting process is very much same as those of individual’s investment decisions. There are some steps involved. First, estimate the cash flows such as interest and maturity value or dividends in the case of bonds and stocks, operating cash flows in the case of capital projects. Second is to assess the riskiness of the cash flows. Next, determine…

Words 1764 - Pages 8

Week 4 Essay

FINS1613_s2_2010_L4 1 Lecture 4: Learning Objectives What is capital budgeting?  Capital budgeting is the process of analysing long-term  Understand the importance of capital budgeting and the steps in the process investment projects that will generate cash flow and deciding:  Understand the types of projects a firm may wish to undertake – whether a particular project is acceptable, or  Understand the decision rules for the main methods of – which project to choose between a number of possible projects…

Words 2941 - Pages 12

Phuket Beach Hotel Essay

85 Initial Investment ROI 1,700,000.00 0.299498735 29.95% Method 4: NPV Alternative 2: Beach Karaoke Pub Year Cash Outflow Capital Investment Other Investment Total Initial Investment Cash Inflow Sales 25% Risk Factor F&B (25%) Other Operating (22%) Depreciation Net Income before Tax Tax (30%) Net Income after Tax Depreciation Annual Cash Flow PV Factor Discounted NPV 3,310,076.84 1,610,076.84 (800,000.00) (900,000.00) (1,700,000.00) 4,672,000.00 4,905,600.00 5,150,880.00 5,408,424.00…

Words 1968 - Pages 8

IPPTChap007 1 Essay examples

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 7-1 KEY CONCEPTS AND SKILLS • Ability to compute and interpret an investment’s payback and discounted payback • Competence in calculating and interpreting accounting rates of return • Facility in computation and interpretation of the internal rate of return and profitability index • Fluency in describing the advantages and disadvantages of each…

Words 1894 - Pages 8

Business Valuation Essay

because they have particular drivers to sell, such as personal reasons or the need to raise cash to make another investment. Prudent valuers will use two or more valuation methods to generate and understanding of the probable value of a business. There are four categories of business valuation, and different methods within these categories: • Asset valuation • Market valuation • Discounting future cash flows • Income or profit multiples 2. Asset Valuation This involves working out the net…

Words 1732 - Pages 7

Valuation of Airthread Connections Essay

wireless subscribers. In order to gain accuracy in the calculation of synergies, affect measurements, the discounted cash flow method (DCF Method) prefers to use. The Discounted cash flow method is based on the theory that the value of a company is the sum of future free cash flows discounted at the weighted average cost of capital. Based on the information showed in the Excel, the additional cash flow costs are saved 13.4 million, while the annual business revenue has increased by 704 million at end of…

Words 1075 - Pages 5