Valuation Models Tested on the CPA Exam
The BEC section of the CPA Exam will test a candidates knowledge on a variety of valuation models. There are two types of valuation types that you need to be familiar with for the CPA exam. Underneath each type of valuation model, there are different methods or ratios that we need to understand for the CPA exam:
Absolute Valuation Models:
Absolute value focuses on intrinsic value which uses projected cash flows and other internal financial information to determine business valuation. With absolute models, we focus only on the characteristics of the company, and we will not compare against other peers or competitors in the industry.
1) Zero growth model:
Perpetuities are often referred to as “zero growth stocks” and will exist when periodic cash flows that have been distributed from an annuity will last indefinitely. This essentially will occur when a company pays out the same dividend in each period and will be applied when an organization is attempting to determine its stock valuation and more specifically, its preferred stock. Perpetuities must specify dividends involved as well as its required return. Perpetuities per share valuation can be computed as follows:
Below is an example of how to calculate the valuation using the zero growth model:
2) Gordon Growth Model (constant growth):
This Gordon model is commonly tested on the CPA exam. The basic premise of this model assumes that dividend payments are also the cash flows that come from equity securities. Additionally, the intrinsic value of the company’s stock is considered the present value of the expected future dividends.
When applying constant growth models, it should always be assumed that the dividends will be accounted for as one year subsequent to the year in which you are determining the price. Additionally, the formulas will presume that the required rate of return is greater than the dividend growth rate.
Below is an example of how to calculate the valuation using the Gordon growth model:
3) Discounted cash flow (DCF) method:
The discounted cash flow method can be used to calculate the intrinsic value of a stock. The DCF method calculates the present value of future cash flows for a specific period of time using a discount rate. As you can see in the visual below, we would take the business valuation from the DCF model and divide by shares outstanding to calculate the intrinsic value per share. This can be compared to the market price per share to determine if the stock is overvalued or undervalued.
Below is an example of how to calculate the valuation using the DCF method:
Relative Valuation and the Use of Price Multiples:
Models that use the value of comparable stocks for determining the value of similar stocks are called relative valuation models. These valuation multiples are typically compared to another company to determine valuation.
1) Price-Earnings Ratio (P/E):
The P/E ratio is most commonly used for the valuation of equity securities. The rationale for this is that earnings are the key driver of the investments value. The number is the market price or the stock price. The denominator uses the company’s earnings per share (EPS), which can be based on the trailing 12 months or forward looking 12 months.
P/E ratio comparison: This comparison illustrates that even though the tech firm has a higher market price per share, the P/E ratio for the tech firm of 20x indicates the stock is more expensive when compared to the grocery store’s P/E ratio of 10x. However, this ratio doesn’t factor in future growth like the PEG ratio below does.
2) Price-to-Earnings Growth (PEG) Ratio:
The PEG ratio measures the effect of earnings growth on a company’s price-to-equity. Stocks that contain higher PEG ratios are generally more attractive than stocks that contain lower PEG ratios.
PEG ratio comparison: The market price and EPS for both companies are the same as the P/E ratio example, however, we also can factor in the growth rate. When looking at the P/E ratio, the Tech firm looks more expensive at 20x earnings vs only 10x for the grocery store. However, the after factoring in the growth rate of 20% of the tech firm, the PEG ratio is now 100x vs 250x for the grocery store. This just shows that factoring in growth rate is key when assessing valuation. Investors want the PEG ratio to be as low as possible.
3) Price-to-Sales (P/S) Ratio:
The price-to-sales ratio can be used to forecast the current stock price. This rationale indicates that sales are less subjective to potential manipulation than book values or earnings.
P/S ratio comparison: In the example below, we can see how the P/S ratio for the grocery store is 2x while it is 5x for the tech firm. This implies that the tech firm is more expensive as it costs more for each $1 of revenue generated by the company. In general, investors want the P/S ratio to be as low as possible as it indicates the stock is cheaper.
4) Price-to-Cash-Flow (P/CF) Ratio:
The idea behind the price-to-cash-flow (P/CF) ratio is that cash flow will be harder for companies to manipulate than earnings. Generally, this is a more stable metric than price-to-earnings. Remember, cash flow adds back non-cash expenses like depreciation and amortization to net income (Cash flow doesn’t necessarily equal net income or profit).
P/CF ratio comparison: In the example below, we switch to calculating in total and not on a per share basis. The result ends up being the same. Even though the tech company has a higher market value, they appear more expensive with a P/CF ratio of 2.5 as compared to 0.8 for the grocery store.
5) Price-to-Book (P/B) Ratio:
The price-to-book ratio is calculated by dividing a company’s stock price by its book value per share, which is defined as the net assets of the company. This is another indicator for determining if a company is either over or under valued. The price-to-book ratio will vary by industry and should only be compared against the price-to-book ratio for comparable companies.
P/B ratio comparison: In the example below, we switch to calculating in total and not on a per share basis. The result ends up being the same. The tech company has a higher ratio at 9.0x as compared to the grocery store which is at 1.5x.
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