06. Equity Valuation

Question 1

What is intrinsic value?

Answer 1

Intrinsic value is the value of an asset or security estimated by someone who has complete understanding of the characteristics of the asset or issuing firm.

To the extent that market prices are not perfectly (informationally) efficient, they may diverge from intrinsic value.

Question 2

What is the going concern assumption?

Answer 2

The assumption that a company will continue to operate as a business as opposed to going out of business.

Question 3

What is liquidation value?

Answer 3

The estimate of what the assets of the firm would bring if sold separately, net of the company’s liabilities.

Question 4

What is the difference between FMV and investment value?

Answer 4

• FMV is the price at which a hypothetical willing, informed, and able seller would trade an asset to a willing, informed and able buyer.
• Investment value is the value to a specific buyer after including any additional value attributable to synergies. Investment value is an appropriate measure for strategic buyers pursuing acquisitions.

Question 5

Porter’s Five Forces:

Answer 5

1. Threat of new entrants in the industry.
2. Threat of substitutes.
3. Bargaining power of buyers.
4. Bargaining power of suppliers.
5. Rivalry among existing competitors.

Question 6

What is the difference between an absolute valuation model and a relative valuation model?

Answer 6

• An absolute valuation model is one that estimates an asset’s intrinsic value (e.g., the discounted dividend approach).
• Relative valuation models estimate an asset’s investment characteristics compared to the value of other firms (e.g., comparing P/E ratios to those of other firms in the industry).

Question 7

What are the strengths and weaknesses of the CAPM model?

Answer 7

• Pro: Simple
• Con: Low explanatory power.

Question 8

What are the pros and cons of the multifactor model?

Answer 8

• Pro: More explanatory power
• Cons: More complex and costly.

Question 9

What are the pros & cons of build-up models?

Answer 9

• Pros: Simple and can apply to closely held companies
• Cons: Typically use historical values as estimates that may or may not be relevant to the current situation.

Question 10

What is mallebility?

Answer 10

The extent to which a company and its competitors can influence the industry.

Question 11

Describe an adaptive business environment(in terms of predictability & malleability) and give examples of types of industries that fit this model:

Answer 11

Environment: less predictable, less malleable

Ex: Specialty retail.

Office electronics.

Construction materials.

Question 12

Describe an classical business environment(in terms of predictability & malleability) and give examples of types of industries that fit this model:

Answer 12

Environment: more predictable, less malleable

**Ex: **Oil companies. Household products. Tobacco.

Question 13

Describe a shaping business environment(in terms of predictability & malleability) and give examples of types of industries that fit this model:

Answer 13

Environment: less predictable, more malleable

Ex: Internet software and services.

Construction and engineering.

Health care technology.

Question 14

Describe a** visionary** business environment(in terms of predictability & malleability) and give examples of types of industries that fit this model:

Answer 14

Environment: more predictable, more malleable

Ex: Food products.

Gas utilities.

Aerospace and defense.

Question 15

Describe bottom-up analysis:

Answer 15

Bottom-up analysis starts with analysis of an individual company or reportable segments of a company.

Question 16

Describe top-down analysis:

Answer 16

Top-down analysis begins with expectations about a macroeconomic variable, often the expected growth rate of nominal GDP.

Question 17

The development of sales-based pro forma financial statements includes what steps?

Answer 17

1. Estimate revenue growth and future expected revenue.
2. Estimate COGS.
3. Estimate SG&A.
4. Estimate financing costs.
5. Estimate income tax expense and cash taxes, taking into account changes in deferred tax items.
6. Model the balance sheet based on items that flow from the income statement and estimates for important working capital accounts.
7. Use historical depreciation and capital expenditures to estimate future capital expenditures and net PP&E for the balance sheet.
8. Use the completed pro forma income statement and balance sheet to construct a pro forma cash flow statement.

Question 18

When is it appropriate to use dividend to value a company?

Answer 18

• The company has a history of dividend payments.
• The dividend policy is clear and related to the earnings of the firm.
• The asset is being valued from the position of a minority shareholder.

Question 19

When are free cash flow models appropriate for valuation?

Answer 19

• The company does not have a dividend payment history or has a dividend payment history that is not related to earnings.
• The free cash flow corresponds with the firm’s profitability.
• The asset is being valued from the position of a controlling shareholder.

Question 20

When are residual income models appropriate for valuation?

Answer 20

• Do not have dividend payment histories.
• Have negative free cash flow for the foreseeable future.
• Have transparent financial reporting and high-quality earnings.

Question 21

what are the assumptions of the gordon growth model?

Answer 21

Dividends grow at a constant growth rate.

Dividend policy is related to earnings.

Required rate of return r is greater than the long-term constant growth rate g.