Ch. 1 Equity Valuation Flashcards
Intrinsic value
Value of asset given a hypothetically complete understanding
Of assets investment characteristics
Going concern assumption
Assumption company will continue its business activities into the foreseeable future
Fundamentals
Characteristics of a company related to profitability, financial strength or risk
Divestiture
Company sells some major component of its business
Spin off
Company separates one component of its business and transfers ownership of separate business to its shareholders
Leveraged buyout
Acquisition involving significant debt, which is collateralized by assets of company being acquired
5 steps in valuation process
1 understanding the business 2 forecasting company performance 3 selecting appropriate valuation method 4 converting forecasts to valuation 5 applying valuation conclusions
Industry and competitive analysis, together with an analysis of financial statements and other company disclosures provides a basis for…
Forecasting company performance
Forecasts of sales, earnings, dividends and financial position (pro forma analysis) provide the…
Inputs for most valuation models
Estimating value involves…
Judgement
Sensitivity analysis
Analysis to determine how changes in an assumed input would affect outcome of an analysis
Porter’s 5 forces characterizing industry structure
1 intro industry rivalry 2 new entrants 3 substitutes 4 supplier power 5 buyer power
Intraindustry rivalry, what enhances profitability?
Lower rivalry
New entrants, what equates to profitability?
Barriers to entry and less entrants
Substitutes, when few potential substitutes exist or cost to switch to substitute is high, industry participants are…
Less constrained in raising prices, generating higher profits
When many suppliers needed by industry exist, suppliers have…
Limited power to raise prices
When many customers for an industries product exist, customers have…
Limited power to negotiate lower prices
The level and trend of a company’s market share, indicate its…
Relative competitive position within an industry
Porter’s 3 corporate strategies for achieving above average performance
1 cost leadership
2 differentiation
3 focus
Cost leadership 2
Being the lower oust producer while offering products comparable to those of other companies
So products can be priced at or near industry average
Differentiation
Offering unique products or services that are widely valued by buyers, commanding premium prices
Focus
Seeking a competitive advantage within a target segment(s) of industry based on cost leadership or differentiation
Business model refers to…
How a company makes money
Business model 3
1 which customers it targets
2 products or services sold to those customers
3 how it delivers those products and services
Looking at historical annual reports shows how…
Management has foreseen challenges and adapted to those challenges
Qualitative factors of company’s financial and operational strategic execution 4
1 company’s ownership structure
2 company’s intellectual and physical property
3 terms of company’s intangible assets
4 contingent liabilities
An important way to assess quality of earnings is to decompose net income into…
Cash component, operating cashflows + investing cash flows
Important for accruals to…
See larger percentage of operating cashflows
Quality of earnings: recognizing revenue early 2
1 Bill and hold sales
2 recording sales of equipment or software prior to installation and acceptance by customer
Quality of earnings: recognition of revenue early
Interpretation
Acceleration in recognition of revenue boosts reported income masking decline in operating performance
Quality of earnings: classification of nonoperating income or gains as part of operations
Interpretation
Nonrecurring income or gains does not relate to true operating performance
Possibly masking declines in operating performance
Quality of earnings: recognizing too much or too little reserves in current year 3
1 restructuring reserves
2 loan-loss or bad debt reserves
3 valuation allowances against deferred tax assets
Quality of earnings: recognizing too much or too little reserves in current year
Interpretation
May boost current income at expense of future income or lower earnings at benefit of future earnings
Quality of earnings: deferral of expenses by capitalizing expenditures as an asset 2
1 customer acquisition costs
2 product development costs
Quality of earnings: deferral of expenses by capitalizing expenditures as an asset
Interpretation 2
1 may boost current income at expense of future income
2 May mask problems with underlying business performance
Quality of earnings: use of aggressive estimates and assumptions 6
1 asset impairments
2 long depreciable lives
3 long periods of amortization
4 high assumed discount rate for pension liabilities
5 low assumed rate of compensation growth for pension liabilities
6 high expected return on assets for pension
Quality of earnings: Use of aggressive estimates and assumptions
Interpretation
Aggressive estimates may indicate actions taken to boost current reported income
Changes in assumptions may indicate attempt to mask problems with underlying performance in current period
Quality of earnings: off balance sheet financing 2
1 leasing assets
2 securitizing receivables
Quality of earnings: characterization of an increase in bank overdraft as operating cash flow
Interpretation
Operating cash flow may be artificially inflated
2 perspectives for forecasting company performance
1 economic environment in which the company operates
2 company’s operating and financial characteristics
Absolute valuation model
Specifies asset’s intrinsic value
In finance theory, present value models are considered…
Fundamental approach to equity valuation
Relative valuation model
Estimates assets value relative to another asset
Sum of parts valuation AKA breakup value AKA private market value
Valuation that sums estimated values of each of companies businesses as if they were a separate going concern
Conglomerate discount
Market applies discount to stock of company operating multiple unrelated businesses compared to stock of companies with narrower focus
2 important aspects of converting forecasts to valuation are
1 sensitivity analysis
2 situational adjustments
Inventory in valuation
Inventory will be sold at a higher price if company is operating
Inventory will be sold at a lower price if the company is liquidated
Comparing PEs is an example of…
Relative valuation model
