Chapter 8-16

Question 1

OI

Answer 1

Operating Income (OI) is income from the business (enterprise income)

Question 1

NOA

Answer 1

Net Operating Assets (NOA) is the net investment in the business (in the operating activities)

Question 2

Free Cash Flow

Answer 2

Free cash flow is the free cash flow from operating activities: The generation of cash flow
– Free cash flow provides info about the firm’s ability to produce cash thru its operations minus cash investments in PPE

Question 3

Reformulation

Answer 3

The key to reformulation is the separation of operating and
financing activities

Question 4

Why is a fundamental investor suspicious about a required return estimated from the capital asset pricing model (CAPM)?

Answer 4

The measure of the required return from the CAPM is imprecise. It involves an estimate of a beta and the market risk premium. Betas are estimated with standard errors of about 0.25, so if one estimated a beta of 1.2, say, it could actually be 0.95 or 1.45 with reasonable probability. And the market risk premium is a big guess. See the appendix to Chapter 3. Fundamental investors do not like to put speculation into a valuation, and the CAPM required return is speculative.

Question 5

Why is Growth risky?

Answer 5

Growth refers to outcomes in the long-term, and the long-term is uncertain. Growth can be competed away so that, unless the firm has protection―has build a moat around its castle―it’s expected growth may not materialize. Buying growth is thus risky.

Question 6

Residual Earnings

Answer 6

residual earnings is comprehensive earnings less a charge against book value for required earnings . Also referred to as residual income, abnormal earnings, or excess profit

A measure that captures the value added to book value is residual earnings or residual income. For the one period for this project (where the investment is at time 0),
Residual earnings 1 =Earnings, - (Required return x Investment0)

Question 7

A firm currently has a growth rate for residual earnings of 16 percent, but investors
agree that the very long-term growth rate should be the GDP growth rate of 4 per- cent. What determines the speed by which the 16 percent rate fades to the 4 percent rate over time?

Answer 7

The degree of competition and the ability of the firm to protect itself from competition―with a brand, with proprietary technology, by adaptive behavior and innovation, for example. The period over which growth reverts to the average is sometimes referred to as the “competitive advantage period” and the speed of reversion to the average as the “fade rate.”

Question 8

A share trades at a P/B ratio of 0.8. The no-growth value indicates a P/B of 1.2. What do you infer from this compatison?

Answer 8

The market sees negative growth in the future.

Question 9

BPS

Answer 9

Book Value Per Share

Question 10

Financial Obligations

Answer 10

Financial obligations represent any outstanding debts or regular payments that a party must make. For example, if you owe or will owe money to anybody, that is one of your financial obligations.

Question 11

Minority Interest

Answer 11

• Minority interest, also referred to as non-controlling interest (NCI), is the share of equity ownership in a subsidiary’s equity that is not owned or controlled by the parent corporation
• I redovisning är minoritetsintresse den del av ett dotterbolags aktier som inte ägs av moderbolaget.

Question 12

CSE

Answer 12

Common stockholders’ equity

Question 13

RNOA

Answer 13

Return on Net Operating Assets

Question 14

FLEV

Answer 14

Financial Leverage

Question 15

NBC

Answer 15

Net Borrowing Cost

Question 16

SPREAD

Answer 16

Operating Spread

Question 17

OLLEV

Answer 17

Operating Liability Leverage

Question 18

ROOA

Answer 18

Return on Operating Assets

Question 19

Stockholders Equity

Answer 19

The remaining asset available to shareholders after all liabilities have been paid

Question 20

Deferred Charges

Answer 20

A long-term prepaid expense that is carried as an asset on a balance sheet until used/consumed

Question 21

Net Profit Margin

Answer 21

A measure, expressed as a percentage of how much net income is generated from every dollar of revenue

Question 22

Accrued Expenses

Answer 22

• Upplupna kostnader. Kostnader för varor och tjänster som ett företag fått under ett räkenskapsår men som ska faktureras och betalas under nästa räkenskapsår klassificeras som upplupna kostnader.

Question 23

Goodwill

Answer 23

• An intangible asset that is associated with the purchase of one company by another
• Is the difference between the purchase price of an acquired firm and the fair value of net assets acquired
• An asset representing the future economic benefits araising from other assets acquired in a business combination that are not individually identified and separately recognized

Question 24

Short-term notes receivable

Answer 24

Kortfristiga fordringar

Question 25

Operating Leverage vs Financial Leverage

Answer 25

• Operating leverage can be defined as a firm’s ability to use fixed costs (or expenses) to generate better returns for the firm
• Financial leverage can be defined as a firm’s ability to increase better returns and reduce the firm’s cost by paying less taxes

Question 26

Spread

Answer 26

• Is a difference between two rates of return. Examples are the operating spread, the operating liability leverage spread, and the spread between borrowing and lending rates. 367
  spread between borrowing and lending rates is the difference between the return on financial obligations and the return on financial assets

Question 27

Operating Spread

Answer 27

Is the difference between operating profitability and the net borrowing costs

Question 28

Operating liability leverage spread

Answer 28

Is the difference between the return on operating assets and the implicit borrowing rate for operating liabilities.

Question 29

Financial Leverage

Answer 29

• An investment strategy of using borrowed money to make investments that will hopefully lead to greater returns
• Financial leverage is the degree to which net operating assets are financed by borrowing with net financial obligations (NFO).

Question 30

Inventory Turnover

Answer 30

• Measures how efficiently a company uses its inventory by dividing the cost of goods sold by the average inventory value during the period.
• Inventory turnover ratios are only useful for comparing similar companies, and are particularly important for retailers.
• A relatively low inventory turnover ratio may be a sign of weak sales or excess inventory, while a higher ratio signals strong sales but may also indicate inadequate inventory stocking

Question 31

OLSPREAD

Answer 31

Is the operating liability leverage spread, that is, the spread of the return on operating assets over the after-tax short-term borrowing rate:
OLSPREAD = ROOA - Short-term borrowing rate (after tax)

Question 32

Inventory Yield

Answer 32

The inventory yield is a measure of the profitability of inventory, the profit from selling inventory relative to the inventory carried. If gross profit falls or inventories increase, the ratio will fall.

Question 33

Retained Earnings

Answer 33

The sum of a company’s earnings from prior periods, after deducting any dividends paid to the company’s shareholders

Question 34

Accounting Equation

Answer 34

Assets = Liabilities (For third parties) + Equity (For owners)

Question 35

3 Different kinds of value

Answer 35

• Book Value or Accounting Value (financial statements)
• Market Value or Market Price (Stock, trade for)
• Estimated Value, intrinsic value or fundamental value (estimate by using valuation models)

Question 36

Accrual Accounting

Answer 36

• Is a method that allows a company to record revenue before receiving payment for goods or services sold and record expenses as they are incurred. In other words, the revenue earned, and expenses incurred are entered into the company’s journal regardless of when money exchanges hands. We calculate the premium, intrinsic value, and discover sources for value creation.
• Residual earnings is central in the model.
  -Price is based on the expected future earnings that investors are buying, so the higher the expected earning the higher the P/B ratio.

Question 37

Alpha Technology

Answer 37

identify misprices stocks that earn a return in excess of required return

Question 38

Fundamental risk, price risk, intrinsic value

Answer 38

• Fundamental risk: the chance of losing value because of the outcome of business activities, compare
  with…
• Price risk: the chance of losing value from buying or selling investments at prices that differ
  from…
• Intrinsic value: what an investment is worth based on forecasted payoffs from investment.

Question 39

Tax Expense

Answer 39

Are the total amount of taxes owed by an individual, corporation or other entity to a taxing authority.

Question 40

cash equivalents

Answer 40

Cash and cash equivalents are actual cash on hand and securities that are similar to cash.

Question 41

Interest Expense

Answer 41

interest expense arises out of company borrowing money (kostnaden för att låna pengar)

Question 42

Accounts payable

Answer 42

• Leverantörsskulder
• Refers to an account within the general ledger that represents a company’s obligation to pay off a short-term debt to its creditors or suppliers

Question 43

Accrued liabilities

Answer 43

• Future payments, upplupna skulder som ännu inte har betalats

Question 44

Reformulated Balance Sheet

Answer 44

• Operating activities: Operating assets and liability
• Financial activities: Financial
• Assets and obligation
  Common Shareholders Equity

Question 45

Reformulated Equity Statement

Answer 45

• Transactions with shareholders
• Comprehensive Income

To identify comprehensive income

Question 46

Reformulated Statement of Comprehensive Income

Question 47

Tax allocation top-down

Answer 47

1. Add back the cost to operations that the tax benefit ”reduced.
2. But the benefit still exits, so we need to allocate the ”reduction” to the financing instead.

Add back to operations and allocate to financing

Question 48

Tax allocation in bottom up

Answer 48

We start with earnings, and adjust the net interest with the tax benefit so the expense is smaller

Question 49

Capital Contribution

Question 50

Growth firm

Answer 50

Is a firm that grows residual earnings (that is, it has abnormal earnings growth).

Question 51

Sustainable earnings

Answer 51

Sustainable earnings (also called persistent earnings, core earnings, or underlying earnings) are current earnings that are likely to be maintained in the future. Compare with transitory earnings.

Question 52

Transitory earnings

Answer 52

Transitory earnings (or unusual items) are current earnings that are not
likely to be repeated in the future. Compare with sustainable
earnings.

Question 53

What is a growth firm?

Answer 53

A growth firm is one that is expected to grow residual earnings. As changes in residual earnings are equal to abnormal earnings growth, a growth firm can also be defined as one that can generate abnormal earnings growth, that is, earnings growth (cum-dividend) at a rate greater than the required rate. As residual earnings is driven by return on common equity (ROCE) and growth in equity, a growth firm is one that can increase ROCE and/or grow investment that is expected to earn at an ROCE that is greater than the equity cost of capital.

Question 54

What measure tells you that a firm is a no-growth firm?

Answer 54

A no-growth firm has zero or negative residual earnings growth or, equivalently, has growth in cum-dividend earnings at a rate equal or less than the required return.

Question 55

What features in financial statements would you look for to identify a firm as a
growth company?

Answer 55

A growth company would have the following features:
* An ROCE greater than the cost of capital
* Increasing residual earnings (that amounts to abnormal earnings growth) due to
* Sales growth (with positive profit margins)
* Increasing profit margins
* Increasing asset turnover
* Growing net investment producing these features
A growth company is one that is expected to have these attributes in the future. It is possible that a firm may have had these attributes in the past but is not expected to have them in the future. And it is possible that a firm may not have these features currently (a start-up, for example), but is expected to have them in the future.

Question 56

What are transitory earnings? Give some examples.

Answer 56

Transitory earnings are aspects of current earnings that have no bearing on future earnings. Examples are earnings from a one-time contract, a write-off on unusually large bad debt, a write-down of obsolescent inventory, a one-time uninsured loss of property, a restructuring charge, and profit from an asset sale or a discontinued line of business.

Question 57

Are unrealized gains and losses on financial assets persistent or transitory
income?

Answer 57

In one sense, these gains and losses are persistent because they occur every period. But a gain or loss in the current period gives no indication of whether there will be a gain or loss in the future. That is, the expected future gain or loss is zero, irrespective of the current gain or loss. So these gains and losses are treated as transitory.

Question 58

What drives growth in residual operating income?

Answer 58

Residual operating income growth is driven by an increase in RNOA and in the NOA that earn at this RNOA. Breaking it down further, ReOI growth is driven by
1. Growth in sales (that drives growth in NOA)
2. Increase in operating profit margins
3. Increase in asset turnovers (so NOA increases but sales increase more that NOA)

Question 59

Explain what is meant by a financing risk premium in the equity cost of capital.
When will a financing risk premium be negative?

Answer 59

A financing risk premium is the additional risk that equity holders have of losing value because the firm cannot meet obligations on its net debt. The premium will be negative if the firm has net financial assets rather than net financial obligations.

Question 60

Cost of Capital for Operations

Answer 60

WACC

Question 61

Forward Enterprise P/E ratio

Answer 61

A stock valuation metric that compares a company’s share price to its projected future earnings

Question 62

Why is it important to understand the “business concept” before valuing a firm?

Answer 62

To forecast future financial statements, the analyst must know where the business is going. She must also have an idea of the key drivers that will determine the future financial statements, and these key drivers are determined by the business concept and by customers’ acceptance to the concept. Valuations are made from pro forma financial statements, and pro forma financial statements are those that the business is likely to produce in the future

Question 63

Explain why a fade diagram is helpful for forecasting.

Answer 63

• Fade diagrams give the typical patterns (within industries) of changes in drivers over time.
• The forecaster takes these patterns as a starting point and asks how the individual firm in question might be different from the average firm.

Question 64

What factors determine the rate at which high operational profitability declines over time?

Answer 64

• Competition is the primary determinant.
• But the ability of a firm to challenge the competition slows the fade rate. A slow fade rate indicates durable competitive advantage.

Question 65

What is meant by the “integrity” of a pro forma?

Answer 65

Pro forma financial statements have integrity if the various parts tie together according to the accounting relations that govern the statements.

Question 66

What is a red-flag indicator?

Answer 66

A red flag indicator is a feature within or outside the financial statements that indicates deterioration in profitability in the future.

Question 67

What is an unarticulated strategy?

Answer 67

• An unarticulated strategy is a business idea that is not developed enough to quantify it into pro forma statements.
• A strategy to research into a cure for cancer does not lend itself readily to financial valuation.

Question 68

What does it mean to say that a firm is negatively levered?

Answer 68

A negatively levered firm has more financial assets than financial obligations, that is, it has negative net debt.

Question 69

What does an operating profit margin reveal?

Answer 69

• The operating profit margin is the profitability of sales.
• The percentage of a dollar of sales that ends up in operating income after operating expenses.