Chap 1-6 Flashcards
Beta technologies
Calculates the risk measures: Betas
Calculates the normal return for risk
Ignores any arbitrage opportunities
Alpha Technologies
Tries to gain abnormal returns by exploiting arbitrage opportunities from mispricing
Fundamental risk
The chance of losing value because of the outcome of business activities
Price risk
- Is the risk of trading at the wrong price:
- Paying too much
- Selling for too little
Difference between fundamental risk and price risk
- Fundamental risk arises from the inherent risk in the business, from sales revenue falling or expenses rising unexpectedly, for example.
- Price risk is the risk of prices deviating from fundamental value.
Prices are subject to fundamental risk, but can move away from fundamental value, irrespective of outcomes in the fundamentals. When an investor buys a stock, she takes on fundamental risk – the stock price could drop because the firm’s operations don’t meet expectations – but she also runs the (price) risk of buying a stock that is overpriced or selling a stock that is underpriced.
Difference between beta and alpha technologies
A beta technology measures the risk of an investment and the required return that the risk requires. The capital asset pricing model (CAPM) is a beta technology; is measures risk (beta) and the required return for the beta.
An alpha technology involves techniques that identify mispriced stocks than can earn a return in excess of the required return (an alpha return).
Difference between active and passive investor
- A passive investor does not investigate the price at which he buys an investment. He assumes that the investment is fairly (efficiently) priced and that he will earn the normal return for the risk he takes on.
- The active investor investigates whether the investment is efficiently priced. He looks for mispriced investments that can earn a return in excess of the normal return.
P/E Ratio
- Price-to-Earnings Ratio is the ratio for valuing a company that measures its current share price relative to its earnings per share.
- If an investor expects to earn 10% on her investment in a stock, then earnings/price should be 10% and price/earnings should be 10. Any return above this would be considered “high” and any return below it “low.”
The three different business activities
- Financial Activities
Raising cash from investors and returning cash to investors - Investing Activities
Investing cash raised from investors in operational assets - Operating Activities
Utilizing investments to produce and sell products
Value of the firm formula
Value of the firm = Value of Assets = Value of Debt + Value of Equity (Eget kapital).
Difference between the outside analyst and inside analyst
- The outside analyst values the firm
The outside analyst understands the firm’s value in order to advise outside investors - The inside analyst values strategies for the firm
The inside analyst evaluates plans to invest within the firm to generate value
Value-Based Management
(Three steps)
- Develop strategic ideas and plans
- Forecast payoffs from the strategy
- Calculate value from forecasted payoffs
IPO
Initial Public Offering, a stock launch is a public offering in which shares of a company is sold to institutional investors and usually also to individual investors.
The four financial statements
- Balance Sheet
Shareholders equity. lists assets, liabilities, and stockholders/shareholders equity. These are divided into current (generate cash/cash will be needed, within one year) and long-term.
Equity = Assets - Liabilities - Income Statement
Net income available to common. reports how shareholders equity increased or
decreased as a result of business activities with the buttom line being net income/earnings/profit.
o Net income = Revenue – Expenses - Cash Flow Statement
Change in cash. describe how the firm generated and used cash during the
period and are divided into operating-, financing-, and investing activities. o Change in cash = Cash from ops + Cash from inv + Cash fr financing - Statement of Shareholders’ Equity
Ending Equity start with beginning equity and ends with end equity and explain how it changed over the period. Owner’s equity increases from earnings in business activities (comprehensive income) and decrease if there is a net pay out to owners.
Accounting standard: GAAP
General Accepted Accounting Principals
US - Issued by FSAB (Financial Accounting Standards Board)
Oversight by SEC (Securities and Exchange Commission)
Accounting Standard: IFRS
International Financial Reporting Standards
Issued by ISAB (Internatinal Accounting Standards Board)
Mandatory for listed companies in Europe
Arbitrage
Arbitrage is an investment strategy in which an investor simultaneously buys and sells an asset in different markets to take advantage of a price difference and generate a profit
Why is the matching principle important?
- Matching nets expenses against the revenues they generate. Revenues are value added to the firm from operations; expenses are value given up in earning revenues. Matching the two gives the accountant’s measure of net value added, and so measures the success in operations. Matching uncovers profitability.
- Matching principle is the accounting principle that recognizes expenses when the revenue for which they are incurred i recognized.
Total Liabilities
The combined debt and obligations that an individual or company owes to outside parties
Comprehensive income
Totalresultat, “alla förändringar i eget kapital under en period förutom de som är ett resultat av investeringar av ägare och utdelningar till ägare”
Is the sum of a company’s net income
Net income is the profit left after deducting (avdrag) total business expenses from gross income
Holding return
- Holding period return (or yield) is the total return earned on an investment during the time that it has been held.
- A holding period is the amount of time the investment is held by an investor, or period between the purchase and sale of a security.
Glamour stocks and value stocks
- Glamour stock is a stock that is fashionable and trades at high multiples (viewed by contrarian investors as overvalued). Sometimes referred to as a growth stock.
- Value stock is a stock that trades at low multiples (viewed by value investors as undervalued). Compare with growth stock.
EPS
- Earnings per share is a companys net profit divided by the number of common shares it has outstanding.
- EPS indicates how much money a company makes for each share of its stocks and is a widely used metric for estimating corporate value
P/E ratio
P/E ratio compares the stock price to annual earnings
Multiples Approach
A valuation method that compares a target company’s financial metrics to those of similar companies
Multiple
- A valuation metric calculated by dividing the value of an asset or equity by a specific financial metric
- A multiple is simply the ratio of the stock price to a particular number in the financial statements.
- The most common ratios multiply the important summary numbers in the statements-earnings, book values, sales, and cash flows- hence the price-earnings ratio (P/E), the price-to-book ratio (P/B), the price-to-sales ratio (P/S), and the ratio ofprice-to- cash flow from operations (P/CFO).
Intrinsic value
What an investment is worth based on forecasted payoffs from the investment. Payoffs are forecasted with information so intrinsic value is sometimes said to be the value justified by the information
Liability
Someting a person or company owes, usually a sum of money
Cash flow
The sum of the cash flows from the three activities explains the increase or decrease in the firm’s cash (at the bottom ofthe statement):
Cash from operations + Cash from investment (2.3) + Cash from financing = Change in cash
Asset-based valuation
Asset-based valuation estimates a firm ‘s value by identifying and summing the value of its assets.
Leverage
- Financial leverage results from using borrowed capital as a funding source when investing to expand the firm’s asset base and generate returns on risk capital. Leverage is an investment strategy of using borrowed money—specifically, the use of various financial instruments or borrowed capital—to increase the potential return of an investment. Leverage can also refer to the amount of debt a firm uses to finance assets.
- Examples of financial leverage usage include using debt to buy a house, borrowing money from the bank to start a store and bonds issued by companies.
Fundamental analysis
(5 steps)
uses a company’s revenues, earnings, future growth, return on equity, profit margins, and other data to determine a company’s underlying value and potential for future growth.
- Knowing the business
- Analyzing information
- Developing forecasts
- Converting forecasts to a valuation
- Trading on the valuation
Parsimony
(in valuation) is the ability to value a firm from a reduced amount of information
Perpetuity
A perpetuity is a constant stream that continues without end. The periodic payoff in the stream is sometimes referred as an annuity, so a perpetuity is an annuity that continues forever.
Dividends
Are cash flows paid out of the firm (to shareholders)
Free cash flow
- Is cash from operations that results from investments minus cash used to make investments
- Is the cash left over after a company has paid its operating expenses and capital expenditures.
Steps for the discounted cash flow model (DCF)
- Forecast free cash flow to a horizon
- Discount the free cash flow to present value
- Calculate a continuing value at the horizon with an estimated growth rate
- Discount the continuing value to the present
- Add 2 and 4
- Subtract net debt
Abnormal Earnings Growth (AEG)
Is growth in earning over the required growth rate. AEG is the focus for P/E valuation
Is growth over normal earnings
AEG = Cum-Dividend earnings - Normal Earnings
Cum-Dividend Earnings
Cum dividend earnings is earnings with the prior year’s dividend reinvested
Normal Earnings
Is earnings growing at the required rate of return
Ex 1.05*5.0 = 5.25
Forward Earnings
Forward earnings are an estimate of a company’s earnings for upcoming periods, usually the completion of the current fiscal year (räkenskapsår) and often the following fiscal year
Principles of Fundamental Investing
(3 things)
- Don’t mix what you know with speculation
- Anchor a valuation on what you know rather than speculation
- Beware of paying to much for growth
What explains the difference between cash flow from operations and earnings?
The difference is explained by net (after-tax) interest payments and the total accruals in earnings:
Earnings = Cash from operations – net interest payments + accruals
That is, cash flow from operations is the part of earnings (before interest) that is not accruals.
What explains the difference between free cash flow and earnings?
- Free cash flow is earnings (before after-tax interest) minus operating accruals and cash investment in operations:
C – I (free cash flow) = Earnings + net interest payments – accruals – cash investment
Or, as in equation 4.11 and Box 4.7,
Earnings = C – I - net interest payments + accruals + cash investment
For finite horizon forecast we need three ingredients..
- Current book value
- Forecasts of residual earnings to horizon
- Forecasted premium at the horizon (Continuing value)
ROE
- Return on equity (ROE) is a measure of financial performance calculated by dividing net income by shareholders’ equity. Because shareholders’ equity is equal to a company’s assets minus its debt, ROE is considered the return on net assets.
- ROE is considered a gauge of a corporation’s profitability and how efficient it is in generating profits. The higher the ROE, the more efficient a company’s management is at generating income and growth from its equity financing.
Driver
A driver, in finance and economics, refers to some key factor that has a large influence on some outcome of interest.
Advantages and Disadvantages with:
Residuals Earning Model
Advantages:
- Focus on value drivers
Focuses on profitability of investment and growth in investment that drive value; directs strategic thinking to theses drivers
- Incorporates the financial statements
- Uses accrual accounting
- Versatility
- Aligned with what people forecasts
- Protection
- Reduces reliance on speculation
Disadvantages:
- Accounting complexity
Requires an understanding of how accrual accounting works
- Suspect accounting
Relies on accounting number that can be suspect (chap 18)
ROCE
rate of return on common equity, the amount of profit or net income a company earns per investment dollar
Price-to-Book (P/B) Ratio
- The price-to-book (P/B) ratio measures the market’s valuation of a company relative to its book value.
- The market value of equity is typically higher than the book value of a company’s stock.
- The price-to-book ratio is used by value investors to identify potential investments.
- P/B ratios under 1.0 are typically considered solid investments by value investors.
- A good P/B ratio is relative to a business and its industry.
Book Value
Book value is the net value of a firm’s assets found on its balance sheet, and it is roughly equal to the total amount all shareholders would get if they liquidated the company.
Market Value
Market value is the company’s worth based on the total value of its outstanding shares in the market, which is its market capitalization.
Market value tends to be greater than a company’s book value since market value captures profitability, intangibles, and future growth prospects.
Enterprise Value
Totala marknadsvärdet på ett företag. EV är summan av vad ett företag är värt för samtliga investerare, det vill säga för både aktieägare och långivare.
Gross margin
Bruttomarginal, mått på hur mycket vinst ett företag kan få från sina intäkter
Intangible asset
Immateriella tillgångar, tex varumärke, patent eller licensrättigheter
An asset that is not physical in nature, such as patent, trademark or copyright
Value of Equity (Värdet av Eget Kapital)
Värdet av ett företag som är tillgängligt för ägare/aktieägare. Företagsvärdet plus alla likvida medel, kort och långfristiga investeringar och minus alla kortfristiga skulder, långfristiga skulder och minoritetsintressen
Dirty surplus item
An accounting item in shareholders’ equity other than transactions with shareholders or income closed from the income statement
Matching Principle
Is the accounting principle by which expenses are matched with the revenue for which they incurred
Operating activites
The functions of a business directly related to providing its goods and/or services to the market
Residuals Earnings model
Is a model that measures value added to book value from forecasts of residual earnings
Financing activities
- Raising cash from investors and returning cash to investors, does not add value!
- Financing activities include sources of cash from investors or banks, and the uses of cash paid to shareholders, such as payment of dividends or stock repurchases, and the repayment of loans.
Accruals
Periodiseringar, lägga ihop räntor eller olika investeringar under en tidsperiod
Business activities
Alla händelser som genomförs av ett företag i syfte att erhålla en vinst, tjäna pengar.
Investing activities
Investing activities relate to the long-term use of cash, such as buying or selling a property or piece of equipment, or gains and losses from investments in financial markets and operating subsidiaries.
Revenue
Omsättning, avser ett företags eller en organisations total försäljning under en viss tidsperiod, vanligen per år. Notera att omsättning inte är samma sak som vinst, då utgifter ej räknas bort från omsättningen
Asset pricing model
- Model to calculate the discount rate in a valuation model
- A mathematical model that estimates the expected return of an investment based on its riskiness relative to the rest of the market
Operating asset
Used to produce goods and services to sell to customers in operations
Operating liability
Obligation incurred in producing goods and services for customer
Market value added
The amount by which the shareholder wealth increases in the market plus any dividend received. Is equal to the stock return
Free Cash Flow
- The cash a company generates after accounting for cash outflows to support operations and maintain its capital assets
- To calculate a company’s CFC: free cash flow = operating cash flow - capital expenditures
Difference between operating asset and financial asset
- An operating asset is used to produce goods or services to sell to customers in operations.
- A financing asset is used for storing excess cash to be reinvested in operations, pay off debt, or pay dividends.
Difference between operating liability and financial liability
- An operating liability is an obligation incurred in producing goods and services for customers.
- A financial liability is an obligation incurred in raising cash to finance operations.
What drives free cash flow?
Operations drive free cash flow. Specifically, value is added in operations through operating earnings, and free cash flow is the residual after some of this value is added to net operating assets: C – I = OI - ΔNOA.
Free cash flow
- Is the amount of cash a business generates after subtracting operating costs and capital expenses
- Tells investors wheather a company can pay its bills and still have enough cash to fund growth
- An importerat financial metric to track the financial health and sustainability of a business
- If FCF is negative, it may not be an good investment
Why are reformulated statements necessary to discover operating profitability?
Without the reformulation, operating profitability is confused with financing profitability, and the return on financial assets (and borrowing cost for financial obligations) is typically different from operating profitability. Operations add value whereas financing typically does not, so financing activities need to be separated out to uncover the operating profitability.
ACCOUNTING STANDARDS - GAAP VS IFRS
- IFRS requires only two years of comparative income statements while U.S Gaap requires three
- IFRS permits expenses in the income statement to be shown by nature (ex. raw material costs, personnel costs) or by function (selling costs, R&D costs) while Gaap requires their classification into current and noncurrent
- IFRS allows some revaluation of assets in certain circumstances
current = make them useful within one year
THE COMPONENTS OF THE INCOME STATEMENT
- Net Revenue - Cost of Goods Sold = Gross Margin
- Gross Margin - Operating Expenses = Operating Income
- Operating Income - Interest Expense + Interest Income = Income before Taxes
- Income before Taxes - Income Taxes = Income after Taxes and before Extraordinary Items
- Income before Extraordinary Items + Extraordinary Items = Net Income
- Net Income - Preferred Dividends = Net Income Available to Common
- Operating income is sometimes called earnings before interest and taxes (ebit)
HOW BALANCE SHEET COMPONENTS FIT TOGETHER
- Assets = Liabilities + Shareholders’ Equity
or - Shareholders’ Equity = Assets - Liabilities
compare to - Value of Equity = Value of Firm - Value of Debt
Cash Conservation Equation
C - I = d + F
- C = Net cash from operations
- I = Net cash outflow for investing
- C-I = Free Cash Flow
- d = Net dividends (common dividends + share repurchases - share issues )
- F = Net cash outflow to debt holders and debt issuers (the net cash flow from borrowing and lending) = Net principal payments + net interest paid (i)
Operating Income
- The difference between operating revenue and operating expense is called operating income
- OI = OR - OE
Reformulated Income Statement
- Operating income:
Operating Revenue (OR) - Operating Expense (OE) = OI - Net financial expense:
Financial Expense (FE) - Financial Revenue (FI) = NFE
Comprehensive income = CI
- If OI = CI then we have a CLEAN SURPLUS no dirty surplus (NFE) Important!
Why identifying the value drivers of ROCE?
By identifying the value drivers (aka profitability drivers) we get a tool for:
- Decision making
- Strategy analysis
- Managerial planning
- Valuation and forecasting:
Where is the firm now?
How will it be different in the future?
Three drivers of ROCE
- Profitability of operations (RNOA)
- Financial Leverage, FLEV = NFO/CSE
- Operating Spread, RNOA-NBC
Value Added Growth
For Value Added Growth we need to focus on:
– residual earnings
– abnormal earnings growth
Core Earnings
Are earnings that can be repeated (sustained) in the future and
which can grow (aka sustainable or persistent earnings).
Core OI vs UI
Core OI is persistent income from core business
UI is unusual items that are non-recurring, sometimes called transitory items.
Book Value vs Market Value
- Book Value is the net value of a firm’s assets found on its balance sheet, and it is roughly equal to the total amount all shareholders would get if they liquidated the company.
- Market value is the company’s worth based on the total value of its outstanding shares in the market, which is its market capitalization.
