Advanced Valuation Lecture 3 Flashcards
1 company does lots of acquisitions, the other not. Which one has a lower EBIT and why? How do you solve the issue at hand?
The company that does lots of acquisitions has lower EBIT. If you acquire and pay goodwill, you have to amortise it. If you grow organically, you’re not allowed to amortise the intangibles. So, the company that does lots of acquisitions has a higher amortisation charge which lowers EBIT.
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Solution: look at EBITA instead of EBIT
What implies when an item is kept off balance?
Management does not believe it will realise it. For example, a tax loss carry forwards could be kept off balance.
One company is asset heavy, the other is asset light. Which one has a higher multiple?
Asset heavy businesses typically have higher multiples than asset low businesses, due to the fact that asset heavy businesses own the real estate themselves, and asset low businesses lease the real estate. For example, supermarkets that own the real estate themselves versus supermarkets that lease the real estate.
Which stock has a lower beta? Highly liquid stock or low liquid stock? How do you account for this in the valuation?
Low liquidity stocks tend to have lower betas, as the share price will not respond to changes as quickly as highly liquid stocks. Therefore, beta is biased downwards.
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Solution: add a liquidity premium in the valuation
How do you calculate the CoE?
Use CAPM:
- calculate beta
- estimate risk-free rate
- estimate MRP
- estimate additional risk premia
What does the risk-free rate consist of? How do you proxy for it?
- real interest rate => compensation for deferring consumption
- inflation => compensation for lost purchasing power
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Return on an asset where we know the expected return with certainty matching the timing and currency of the cash flows discounted. This implies that risk free asset bears no liquidity, reinvestment, inflation and default risk.
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Use 20-30Y zero coupon gov’t bond as a proxy
What are the ways to estimate MRP?
- Historical method = average MRP over historical period based on arithmetic or geometric return > it’s backwards looking.
- Survey method > dependent on different time frames and horizons of participants.
- Implied method = estimate the implied MRP by calculating the IRR of the market using a DCF model for the market as a whole
What are the challenges in estimating the implied MRP?
- dependency on model used
- dependency on the growth assumption
- volatile MRPs as a consequence of stock market volatility may result in volatile CoE estimations
- does not correct for market wide under-/overvaluation
Estimating beta can be done in which 2 ways? When do you use one or the other?
- CAPM model > inputs excess returns
- Market model > inputs raw returns
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Use 1 if risk-free rate is correlated with market returns. Otherwise it does not matter.
What do each of the Hamada / Harris-Pringle formulas imply?
Hamada: debt is independent of firm value
Harris-Pringle: debt is a constant portion of firm value
What does the cost of debt consist of? And how do you calculate it?
TOP DOWN APPROACH
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For investment grade (>BBB), the expected yield can be approximated by the promised YTM matching the duration and rating of the debt: rD = risk-free rate + credit spread
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For below investment grade bonds, expected yield has to be estimated based on expected cash flows taking into account default probabilities and loss given default:
E(coupon) = (1-p) * coupon + p * (1-LGD) * coupon
E(redemption) = (1-p) * redemption + p * (1-LGD) * redemption
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p = probability of default
Notes on weightings in WACC:
Weightings in WACC should be based on market values, because these represent the true economic claims the investors have on the firm and want a return over
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The target debt level should take into account how excess cash will be used going forward (reinvested in the business, dividend payout and/or share buybacks and/or debt reduction).
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If current capital structure differs significantly from target capital structure you may take the migration of the capital structure into account, resulting in a time varying WACC
What is the bottom-up approach for the cost of debt?
If a firm has more than one debt instrument, the average cost of debt should theoretically be determined based on a bottom up approach:
– Determine the expected YTM for each individual instrument
– Use market values of each instrument to weight each instrument’s yield and produce an average
What are the drivers of asset beta and equity beta?
Industry risk = sensitivity of revenue to market environment +
Operating leverage = sensitivity of operating profit to market environment. In other words, the degree of fixed costs versus variable costs. If you have large fixed costs, risk increases and your asset beta increases. Variable costs decrease risk
= business risk (asset beta)
—> impact of financial leverage (D/E) transfers the business risk from debt holders to equity holders. Higher financial leverage means higher equity risk
–> this ultimately drives equity risk (equity beta)
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Industry risk + operational risk > business risk > financial leverage > equity risk
What should you do with the tax rate used in the WACC if not all interest is deductible?
If the blended statutory tax rate = 27.5%, but you cannot fully realise the interest tax shield due to too low profits, or regulation or whatever, you have to haircut the tax rate. If you only realise 80% of the ITS, you do: 80% * 27,5%, and use that tax rate in the WACC calculation
