Chapter 7 - Company Analysis and Valuation of Equity Securities Flashcards

1
Q

What is the difference between GAAP and IFRS?

A

GAAP had been the standard for over 75 years in the US and Canada.
Canadian publicly accountable enterprises gave up on GAAP and switched to IFRS (International Financial Reporting Standards) in 2011.
IFRS is almost entirely principles-based while US GAAP is primarily rules-based.

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2
Q

How does principles-based accounting differ from rules-based accounting?

A

Guidelines are more general with principles-based accounting as the goal is to have the completed statements achieve a set of good reporting objectives, such as sufficient disclosure of data.
Rules-based accounting is more rigid, meaning specific procedures are observed when preparing statements. This results in less ambiguity, but also increases complexity as it’s difficult to find rules that fit every situation.

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3
Q

What are the 4 major financial statements from a company?

A
  1. Statement of financial position
  2. Statement of cash flows
  3. Statement of changes in equity
  4. Statement of comprehensive income
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4
Q

What are the 3 general categories of sources/uses of a company’s cash?

A
  1. Cash flow from operating activites - revenues - cash used to generate revenue
  2. Cash flow from investing activities - cash from sale of long-term assets minus cash used to buy long-term assets plus any dividends received
  3. Cash flow from financing activities - cash received from sale of new shares or issuance of debt minus cash paid to buy back shares, repay debt, or pay dividends
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5
Q

How do you calculate a change in a company’s cash from one period to the next as reported on the statement of financial position?

A

Cash flow from operating activities + cash flow from investing activities + cash flow from financing activities

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6
Q

How do companies listed on a Canadian stock exchange file audited annual financial statements?

A

Through SEDAR (System for Electronic Document Analysis and Retrieval)

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7
Q

What must companies listed on Canadian stock exchanges file in additional to audited annual financial statements?

A

Interim anaudited financial statements.

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8
Q

What are the 3 factors that determine the degree of a company’s sustained competitive advantage?

A
  1. Low costs - low cost structure
  2. Differentiation - unique products/services
  3. Focus - underserved customer base
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9
Q

Which 4 areas of a company’s operations does qualitative analysis consider to determine whether a company has a sustained competitive advantage?

A
  1. Corporate issues
  2. Products and markets
  3. Production and distribution
  4. Level of competition
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10
Q

What are some factors that qualitative analysis considers to determine whether a company has a sustained competitive advantage in the area of products and markets?

A

Qualitative analysis looks for companies with a variety of well differentiated products with healthy R&D budgets and a diverse customer base with sufficient marketing strategies and excellent customer service.

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11
Q

How is financial statement analysis performed?

A

Spreadsheet models of a company’s historical and projected financial results are used, often mapping data and relationships among several worksheets and files.

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12
Q

What are a company’s ‘key drivers’?

A

Key drivers can include revenue, cost of sales, depreciation and capital expenditures. Analysts are particularly interested in identifying and analyzing these key drivers of a company’s performance.

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13
Q

What are the 4 general categories of ratios for analyzing company performance?

A
  1. Liquidity analysis
  2. Risk analysis ratios
  3. Operating performance ratios
  4. Value ratios
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14
Q

What are liquidity ratios?

A

Measure a company’s ability to meet its short-term obligations. These include the current ratio and the quick ratio.

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15
Q

What are risk analysis ratios?

A

Used to determine how well a company deals with its debt obligations. These include asset coverage, debt-to-equity ratio, cash flow to total debt, and interest coverage.

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16
Q

What are operating performance ratios?

A

Determine a company’s long-run growth and survival prospects by measuring how well the company uses its resources. These include gross profit margin, net profit margin, net return on common equity, and inventory turnover.

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17
Q

What are value ratios?

A

These guage the market’s perception of the value of a company’s shares relative to its dividends, earnings, or other measures. These include the percentage of available earnings paid out as common dividend, earnings per common share, dividend yield, P/E ratio, equity value per common share.

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18
Q

Which type of company forecast made by an equtiy analyst is given the most attention?

A

The earnings forecast.

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19
Q

What is ‘earnings season’?

A

A large number of companies report earnings in the weeks following the end of March, June, September and December.

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20
Q

How is earnings per share calculated at the most basic level? (Basic EPS)

A

Profit divided by the weighted-average number of common shares outstanding.

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21
Q

How is fully diluted EPS calculated and how is it different than basic EPS?

A

It includes all stock options, unexpired warrants, shared that could be issued from other convertible securities in addition to the weighted average number of common shares outstanding.
Fully diluted EPS is essentially a hypothetical number that reflects all granted and unexpired claims for potential common shares.

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22
Q

What would the weighted average number of shares outstanding be if there were 1,000,000 shares outstanding on January 1 and 400,000 were issued on June 1?

A

1,000,000 x 5/12 = 416,667
1,400,000 x 7/12 = 816,667
= 1,233,334

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23
Q

What is the purpose of calculating the weighted average number of shares outstanding?

A

Factors in the length of time shares were issued and outstanding during the fiscal time period.

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24
Q

What is ‘return on equity’ (ROE)?

A

Company’s return on common equity. This is the retained earnings that represent the cumulative profit or loss that accrues to the company’s common shareholders.

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25
Q

Why do analysts often break down the ROE number into components and comment on each one?

A

The purpose of breaking down ROE is to determine where either a growth or decline in a company’s ROE came from.

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26
Q

What is the DuPont Model for ROE breakdown?

A

This is commonly used by analysts to break down a company’s ROE. It’s net profit margin x total asset turnover x financial leverage.

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27
Q

What is total asset turnover?

A

Revenue / total assets

Total revenue a company generates for the amount of total assets. Analysts look for a trend that points towards an increasing revenue relative to the company’s total assets.

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28
Q

What is a company’s financial leverage?

A

Total assets / common equity

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29
Q

What is a company’s net profit margin?

A

Profit / revenue

Measures a company’s rate of profit after allowing for all expenses and taxes.

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30
Q

Why would a higher ROE due to higher financial leverage be concerning?

A

Financial leverage is total assets / common equity. Higher financial leverage means the company has more debt, and therefore potentially more risk.

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31
Q

What is the ‘sustainable growth rate’ for either a company’s earnings or dividends?
How is it calculated?

A

Estimated growth rate of earnings and dividends that the company can sustain for a given level of ROE based on the company’s capital structure remaining constant and no additional common stock being issued.
Calculated as the earnings retention rate (opposite of dividend payout ratio) x ROE

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32
Q

How is a company’s retention ratio related to the dividend payout ratio?

A

The retention ratio is the opposite of the dividend payout ratio. Where the dividend payout ratio is total dividends / net income, the retention ratio is retained earnings / net income.

33
Q

What does a low earnings retention ratio imply?

A

The company is keeping only a small percentage of earnings to fund its future growth.

34
Q

When would leverage (borrowing money) benefit a company?

A

If the company uses the borrowed funds to increase its return to shareholders, thus increasing ROE.

35
Q

Which types of investors are not concerned about stock valuation?

A

Passive investors.

36
Q

What is another term for a stock’s actual/true value? What does this refer to specifically?

A

Intrinsic value - refers to an analyst’s estimate of what a stock’s market price should be, either today or at some point in the future.

37
Q

Which two categories do all valuation models fall into?

A

Absolute valuation models
Relative valuation models

38
Q

What are absolute valuation models?

A

These models use a forecast of company fundamentals to determine an estimate for the intrinsic value of a stock. The two most widely used absolute valuation models are the dividend discount model and discounted cash flow model.

39
Q

What are relative valuation models?

A

These models determine a stock’s intrinsic value by comparing one or more of its value ratios or price multiples (P/E, price-to-book, etc.) to a benchmark value. If the current price multiple is less than the benchmark value, it’s undervalued, and vice versa.

40
Q

What do dividend discount models assume?

A

That a stock’s intrinsic value is equal to the present value of a stream of future dividends.

41
Q

How are appropriate discount rates determined when valuing a stock?

A

Discount rates represent an analyst’s estimate of the market’s required or expected return on a stock. This usually consists of the risk-free rate + a risk premium.

42
Q

How is the risk premium for a stock (which is used to determine an appropriate discount rate) determined?

A

It’s usually based on an asset pricing model, such as CAPM.

43
Q

What is the problem with the general form of the dividend discount model?

A

It is impossible to implement as it requires forecasting an indefinite number of future dividends. Simplified versions are often used instead.

44
Q

What is the Gordon growth model?

A

Also called the constant growth model, this is a version of the dividend discount model that uses an assumption of constant growth. It adds the estimated dividend growth rate into the dividend discount model.

Intrinsic value = this year’s dividend x (1 + growth rate) / discount rate - growth rate

Example: value = $1.50 x 1.04 / 0.06 - 0.04 = $78 stock’s intrinsic value

45
Q

How can you use the Gordon growth model (constant growth model) to estimate a stock’s expected return?

A

Re-arrange the valuation model.
r (expected return) = (current year’s dividend / current market price) + dividend growth rate

46
Q

What is often referred to as a stock’s “terminal value”? When is this value used?

A

Analysts often come up with an estimate for the intrinsic value of the company’s stock on the last forecast dividend date.

The terminal value is used to calculate the current intrinsic value for a stock with a changing dividend growth rate (such as during early growth stages)

47
Q

What are discounted cash flow models?

A

They assume that a stock’s intrinsic value is equal to the PV of a stream of future cash flow. They use either ‘free cash flow to equity’ (FCFE) or ‘free cash flow to the firm’ (FCFF).

48
Q

What is FCFE and how is it different from FCFF?

A

Free cash flow to equity is cash flow available to a company’s common shareholders (could potentially be used to pay dividends) after paying operating expenses, debt payments, and investing in working capital/fixed assets.

Free cash flow to the firm is cash flow available to both a company’s common shareholders and debt holders. It includes FCFE + after-tax interest expense minus net new borrowing.

49
Q

What is the discount rate used in free cash flow to the firm?

A

Weighted average cost of capital (WACC). This is the weighted average of the required return on a company’s debt and equity securities.

50
Q

When are dividend discount models, FCFE and FCFF more appropriate to be used?

A

FCFE is more appropriate for valuing a company that is likely to be taken over or have a change in management.

Dividend discount model is appropriate when changes in corp control are more difficult to effect because of size/legal restrictions.

FCFF is appropriate for valuing companies with high leverage or in the process of changing leverage. FCFF is also appropriate when FCFE is negative.

51
Q

Why is multiplying an appropriate P/E with a company’s EPS the most common method for estimating share prices?

A

Relates share price to the company’s earnings, simple to compute, P/E ratios for most common stocks are readily available. P/E ratios are also believed to be proxies for other characteristics, such as growth/risk characteristics.

52
Q

How do you calculate historical/trailing P/E?

A

Market price per share / EPS of the last 4 quarters

53
Q

What increases a P/E ratio?

A

Increases in the growth rate of dividends/earnings or decreases in the discount rate would both increase P/E ratios.

54
Q

Which types of investors look for stocks that sell below their book value? Which types look for stocks that sell above their book value?

A

Value investors typically look for stocks that sell below their book value. Growth investors typically look for stocks that sell at high multiples of their book value.

55
Q

How do you calculate the P/B ratio?

A

Market price per common share / book value per common share

56
Q

How can a company’s P/B ratio be compared with ROE? What does it tell you?

A

Large discrepancies can be a warning sign. An overvalued stock would have a low ROE and a high P/B.

57
Q

What are the disadvantages of using the P/B ratio? For which type of companies is P/B insignificant for?

A

Only useful when examining capital-intensive companies or those with plenty of tangible assets.
Not relevant for companies with high debt load or sustained losses as it can effectively wipe out the value of a company’s tangible assets, hiding productive assets.
As well, share buybacks and other corporate activities can distort the P/B.
Insignificant for service companies which have little tangible assets and significant goodwill and other intangibles.

58
Q

What is the price-to-sales (P/S) ratio?

A

Places a monetary value on each dollar of a company’ sales. P/S ratio is generally less volatile than P/E as revenues are not as volatile as earnings, and is available for even the most troubled/cyclical companies.

59
Q

What are petroleum reserves?

A

Estimate of the amount of hydrocarbons owned by an exploration and production company that is still in the ground.

60
Q

Whata are the 3 classifications that petrol reserves are divided into?

A
  1. Proved (>90% confidence interval), P90 or 1P reserves
  2. Probable (50% recovery confidence interval), P50, 2P, proved + probable
  3. Possible (10% confidence interval), P10, 3P, proved + probable + possible
60
Q

How is the “proved” category of petrol reserves classified? (3 sub-classes)

A
  1. Proved developed reserves (PDP) - existing wells/facilities, currently generating cash flow
  2. Proved developed non-producing reserves (PDNP) - discounted/risked by about 25% as not currently generating cash flow
  3. Proved undeveloped reserves (PUD) - potentially recoverable with existing tech, but not commercially recoverable due to some risks. Risked by about 35%
61
Q

What is the global unit measure of the oil and gas industry?
How is it calculated?

A

Barrel of oil equivalent (BOE) = barrels of oil (bbls) + amount of reserves (in standard cubic feet, scf) / 6,000 scf conversion ratio.

Example: total BOE = 35 million bbls + (120 billion scf / 6,000 scf per BOE) = 55 million BOE

62
Q

How is the daily production rate for oil and gas companies expressed as?

A

Expressed as barrels of oil equivalent per day (BOE/D), bringing all forms of production to one common unit for analysis

63
Q

How is economic value (EV) calculated?
Why is EV an appropriate measure for resource-based companies?

A

market value of company’s equity + book value of outstanding debt - amount invested in cash/short-term securities

Appropriate because it incorporates net debt. Resource-based companies can include a significant amount of debt in their capital structure.

64
Q

What is the most common production valuation metric for an oil and gas exploration production company?

A

The economic value per barrels of oil equivalent per day (EV/BOE/D)

65
Q

What is the major difference between mining industries with oil and gas?

A

The definition and calculation of reserves

66
Q

Which national instrument are mining reserves defined under?

A

NI 43-101

67
Q

What are the categories of mineral resources under NI 43-101?

A
  1. Inferred mineral resource (insufficient data as to continuity)
  2. Indicated mineral resource (sufficient data for reasonable expectation of continuity)
  3. Measured mineral resource (sufficient data to confirm continuity)
  4. Probable (economically mineable portion of indicated resource)
  5. Proven (economically mineable portion of measured resource)
68
Q

What are pre-production mining companies?

A

Mining companies solely focused on the discovery of mineral resources and/or the development of a discovered resource, and are not capable of any metals production in the short- to immediate-time period.

69
Q

What is the primary equity valuation metric applied to early-stage mining companies?

A

Market value per ounce of resource or reserve (MV/ounce)

70
Q

Which type of mineral resources have the lowest market value assigned per ounce?

A

Inferred resources, while proven and probable have the highest MV/ounce

71
Q

What is the primary equity valuation applied to early-stage mining companies that are well into development and have published a project feasibility analysis?

A

Instead of MV/ounce, it switches to an estimate of the company’s market price to net asset value per share (P/NAVPS)

72
Q

What are the 2 operational and financial goals of mining companies that are currently in production?

A
  1. Maximize immediate cash flow
  2. Increase mineral resource and reserve base, and life of mine estimate
73
Q

What is the most frequently used cash flow-based valuation metric to value equity for a currently producing mining company?

A

Economic value per earnings before interest, taxes, depreciation and amort. (EV/EBITDA).
This indicates the degree of the mining company’s operational efficiency.

74
Q

Why is cash flow efficiency important for a currently producing mining company?

A
  • Ability to finance potential growth of operations
  • Ability to return capital to shareholders
  • Reduces company’s potential need to access capital markets in the future
75
Q

What is a mining company’s operational life commonly referred to as?

A

“Life of mine”

76
Q

Why is increased stock valuation a motivating factor for management to exaggerate financial records?

A
  • If stock options are received as part of compensation, higher stock prices = greater option values.
  • Access to equity financing opportunities.
  • Pricing of equity finance opportunities improves if the stock has a better valuation.
77
Q
A