Compendium Flashcards
Assume the investment pattern can be repeated for 40 years. From a valuation perspective, why is this almost the same as assuming the pattern will be repeated in eternity?
- due to the present value factor cash flows in 40 years will be of extremely little value today.
Which are the two major groups of valuation techniques? Which factors from the companies account are each group built upon?
- The equity value (Dividends/Net Income/Equity) and The enterprise value (Operating earnings/Capital employed)
Describe the formula and process for calculating the value of equity in the company, starting with EBIT?
- EV=EBIT/CCE, E=EV-ND-MI
Which are the two major components for calculating the required rate of return of equity for the stock market?
- We calculate this by comparing historical returns of the market with the one of 10y government bonds (e.g. risk free rate), the difference is the risk premium
What are the three components for calculating the required rate of return for equity in an individual company?
- Risk free interest rate+risk premium (market) + risk premium (company)
Describe the beta value and how it is used in company valuation.
Beta value, which measures the share price volatility in a company compared to the market. A high-risk company has a beta above 1,0 and a low-risk company is below 1,0. Most listed companies range between 0,6 and 1,4. To calculate a company specific risk premium the market risk premium is multiplied by the beta. For example, with a beta of 1,2 and a market risk premium of 5 percent, the total risk premium for the company is 6 percent (1,2 x 5 percent).
The p/e-ratio is normally used as a market based approach to valuation. Describe how the p/e-ratio is calculated and used this way.
-By using earnings estimates for listed comparable companies in the same industry as well as their current price and multiplying this with the estimated earnings of the company we get the expected price of the company as of today.
Describe the different ways investors group PE-ratios?
- Most often into sectors, to compare with companies with similar growth opportunities and risk. Also, common to discuss p/e-ratio for a stock exchange or an equity index.
Comparing the market values for S&P 500 companies with net earnings, which was the normal range for the PE-ratio between 1986 and today.
- around 10-15, but sometimes as high as 25 and as low as 7
The PE-ratio for the stock market is affected by, not only the cost of capital and the risk premium, but also a third factor, which?
- Inflation, this is the basis for all calculations of required rate of return because it affects the interest rate.
Between 1970 and 2010, the long-term PE-ratio in the U.S correlated well with one important macro economic factor – which?
- When the inflation rate is high 1970-1985 the p/e-ratio is low, around 10. When inflation is starting to decline at the end of the eighties (dramatic decline in the oil price) the p/e-ratio is structurally shifted upwards and reach a level of around 20 in the beginning of the nineties. At the peak of the technology bubble the p/e reached 37. Parallel to this, inflation shifted even lower, which created a very favorable stock market environment, consisting of high growth and low interest rates.
Between 1989-1994, the Stockholm Exchange had a high PE-ratio, well above what could be considered normal compared to the interest rate level in Sweden. Give one possible explanation to why this was not an example of an overvalued stock market.
- the pe ratio can be rewritten 1/r, and r constitutes of inflation+real rate of return+risk premium, thus this should have to do with either a low real rate of return (e.g. lower results) or lower risk premiums due to some circumstances
How does the calculation of the “WACC” differ from the calculation of the cost for capital employed?
- in wacc, market value is used on E/D in percent of CE, and cost of debt is calculated after tax, while CCE is calculated with book values and before tax, but still E/D and CE
Describe how the capital is measured in the WACC calculation?
- the capital measure they focus on is Capital Employed, and this is valued at fair value, i.e. market value.
How is the interest coverage ratio calculated?
- EBIE/Interest costs
Describe how the default risk premium can be calculated using the Damodoran technique.
- He has come up with the conclusion that the S&P rating to a great extent follows the interest coverage ratios. Thus, based on this one can calculate a default spread that is added to the risk-free rate and we can thereby estimate the cost of debt.
We estimate the development in the company PMAB for five years, using a constant debt to equity ratio and come up with a value of the equity of 300. As an alternative the development for PMAB is estimated with the capital requirement expected to be financed by debt. In this case the value increases to 400. Describe why the two valuations are not comparable?
- because they are using different levels of debt. This implies that it is easier to get a higher return, but that the company faces a higher risk of default, hence these values are not comparable
Describe how the working capital in the DCF model is estimated.
-Working capital is related to revenue. The definition of working capital is current assets, less current liabilities. Excluded from current assets are financial assets, like cash and marketable securities. Excluded from current liabilities is short-term interest bearing debt, like the short-term portion of bonds and bank loans.
In the DCF model, how will the relationship between debt and equity effect the valuation?
It will affect the risk-level of the company, i.e. higher gearing implies higher risk but also higher estimated returns. Thus, our WACC should be adjusted depending on this relationship. We henceforth assume a constant debt to equity ratio, so that the company has similar risk over the years, otherwise comparing cash flows is difficult.
Describe the difference between the P/e-ratio and the EBIT-multiple.
The EBIT-multiple is based on the enterprise value (EV) and operating earnings (EBIT). The EBIT-multiple is calculated by dividing EV with the estimated EBIT, the same way as the share price is divided by estimated net earnings when calculating the p/e. The interpretation of the EBIT- multiple is equal to the interpretations of the p/e-ratio. High growth and high profitability will result in a high EBIT-multiple. The major advantage with this concept compared to the p/e, is that the EBIT-multiple is not affected by the leverage in the company, since the enterprise value is the value of all external capital the company use, regardless of it is debt or equity.
Describe the difference between income statements presented by functions, compared to income statements presented by nature.
- If the income statement is presented by function, it is divided into functions such as production, marketing, administrative and more. If it is presented by natur, one shows raw material, employee costs, depreciation and more. Most companies on the Swedish market present by functions.
In which of the two statements is it possible to calculate the EBITDA using information on the face of the income statement?
- If it is presented by nature, since this would imply having a specific line with depreciation. Which the functions do not have.
When understanding the structure of the income statement and the balance sheet, it is important to distinguish between two major company groups – which and why it is important?
- One should distinguish between financial and non-financial companies. The reason being that the structure of the financial reports are very different, and it is very difficult to compare the two.
When professional users of financial reports use accounting data, they normally distinguish between operating and financial data. Why is this important on a segment level of a business?
- they do this to be able to value different segments of a company, it is difficult to value a business segment merely on net income (tax purposes etc.), and by dividing them and valuing separately one should achieve a more precise valuation, since different segments often present different growth and risks.