Equities Flashcards
Define valuation and intrinsic value and explain sources of perceived mispricing.
Intrinsic value: is the value of an asset or security estimated by someone who has complete understanding of the characteristics of the asset or issuing firm.
To the extent that market prices are not perfectly (informationally) efficient, they may diverge from intrinsic value.
Explain the going concern assumption and contrast a going concern value to a liquidation value.
The going concern assumption: is simply the assumption that a company will continue to operate as a business as opposed to going out of business.
The liquidation value: is the estimate of what the assets of the firm would bring if sold separately, net of the company’s liabilities.
Describe definitions of value and justify which definition of value is most relevant to public company valuation.
Fair market value: is the price at which a hypothetical willing, informed, and able seller would trade an asset to a willing, informed and able buyer.
Investment value: is the value to a specific buyer after including any additional value attributable to synergies.
Describe applications of equity valuation.
Equity valuation models are used by analysts by:
- stock selection
- reading the market
- projecting the value of corporate actions
- fairness opinions
- planning and consulting
- communication with analysts and investors
- valuation of private business
- portfolio management
What are Porter’s 5 elements of industry structure “forces”?
- Threat of new entrants in the industry.
- Threat of substitutes.
- Bargaining power of buyers.
- Bargaining power of suppliers.
- Rivalry among existing competitors.
What are some of the Quality of earnings issues?
Quality of earnings issues can be broken down into several categories:
- Accelerating or premature recognition of income.
- Reclassifying gains and nonoperating income.
- Expense recognition and losses.
- Amortization, depreciation, and discount rates.
- Off-balance-sheet issues.
It may be that these issues are addressed only in the footnotes and disclosures to the financial statements.
Contrast absolute and relative valuation models and describe examples of each type of model.
Absolute valuation model: is one that estimates an asset’s intrinsic value (DDM).
Relative valuation models: estimate an asset’s investment characteristics compared to the value of other firms (P/E ratios).
Describe sum-of-the-parts valuation and conglomerate discounts.
Sum-of-the-parts valuation: is the process of valuing the individual components of a company and then adding these values together to obtain the value of the whole company.
Conglomerate discount: refers to the amount by which market price is lower than the sum-of-the-parts value.
Explain broad criteria for choosing an appropriate approach for valuing a given company.
When selecting an approach for valuing a given company, an analyst should consider whether:
- the model fits the characteristics of the company
- is appropriate based on the quality and availability of input data
- is suitable, given the purpose of the analysis
Contrast realized holding period return, expected holding period return, required return, return from convergence of price to intrinsic value, discount rate, and internal rate of return.
Holding period return: is the increase in price of an asset plus any cash flow received from that asset, divided by the initial price of the asset.
Asset’s required return: is the minimum expected return an investor requires given the asset’s characteristics. If expected return is greater (less) than required return, the asset is undervalued (overvalued).
Discount rate: is a rate used to find the present value of an investment.
Internal rate of return (IRR): is the rate that equates the discounted cash flows to the current price. If markets are efficient, then the IRR represents the required return.
Calculate and interpret an equity risk premium using historical and forward-looking estimation approaches.
Equity risk premium: is the return over the risk-free rate that investors require for holding equity securities.
Forward-looking or ex ante estimates: use current information and expectations concerning economic and financial variables.
There are 3-types of forward-looking estimates of the equity risk premium:
- Gordon growth model
- Macroeconomic models, only appropriate for developed countries
- Survey estimates, which are easy to obtain, but can have a wide disparity between opinions.
Determine the required return on an equity investment using the capital asset pricing model, the Fama–French model, the Pastor–Stambaugh model, macroeconomic multifactor models, and the build-up method?
Fama-French model = RF + βmkt,j × (Rmkt − RF) + βSMB,j × (Rsmall − Rbig) + βHML,j × (RHBM − RLBM)
where:
(Rmkt − RF) = market risk premium
(Rsmall − Rbig) = a small-cap risk premium
(RHBM − RLBM) = a value risk premium
The Pastor-Stambaugh model: adds a liquidity factor to the Fama-French model.
Macroeconomic multifactor models: use factors associated with economic variables that would affect the cash flows and/or discount rate of companies.
The build-up method: is similar to the risk premium approach. One difference is that this approach does not use betas to adjust for the exposure to a factor. The bond yield plus risk premium method is a type of build-up method.
Explain beta estimation for public companies.
A regression of the returns of a publicly traded company’s stock returns on the returns of an index provides an estimate of beta.
For forecasting required returns using the CAPM: an analyst may wish to adjust for beta drift using an equation such as:
adjusted beta = (2/3 × regression beta) + (1/3 × 1.0)
Explain beta estimation for thinly traded public companies, and non-public companies.
An analyst can estimate beta using a 4-step process:
- identify publicly traded benchmark company
- estimate the beta of the benchmark company
- unlever the benchmark company’s beta
- relever the beta using the capital structure of the thinly traded/nonpublic company
Describe strengths and weaknesses of methods used to estimate the required return on an equity investment.
CAPM: is simple but may have low explanatory power.
Multifactor models: have more explanatory power but are more complex and costly.
Build-up models: are simple and can apply to closely held companies, but they typically use historical values as estimates that may or may not be relevant to the current situation.
Explain international considerations in required return estimation.
Analyst should adjust the required return to reflect expectations for changes in exchange rates.
A premium should be added for the risk present regarding emerging markets.
2-methods for estimating the size of the risk premium:
- The country spread model: uses a corresponding developed market as a benchmark and adds a premium for the emerging market risk. The premium can be estimated by taking the difference between the yield on bonds in the emerging market minus the yield of corresponding bonds in the developed market.
- The country risk rating model: estimates an equation for the equity risk premium for developed countries and then uses the equation and inputs associated with the emerging market.
Explain and calculate the weighted average cost of capital (WACC) for a company.
The weighted average cost of capital (WACC) is the required return averaged across all suppliers of capital.
The term (1 − tax rate) is an adjustment to reflect the fact that, in most countries, corporations can take a tax deduction for interest payments.
The tax rate should be the marginal rate.
Evaluate the appropriateness of using a particular rate of return as a discount rate, given a description of the cash flow to be discounted and other relevant facts.
The discount rate should correspond to the type of cash flow being discounted:
- cash flows to the entire firm at the WACC.
- cash flows toe quity at the required return on equity.
Analysts discount nominal cash flows with nominal discount rates. However, an analyst may wish to measure the present value of real cash flows, and a real discount rate should be used in that case.
Compare top-down, bottom-up, and hybrid approaches for developing inputs to equity valuation models.
Bottom-up analysis: starts with analysis of an individual company or reportable segments of a company.
Top-down analysis: begins with expectations about a macroeconomic variable, often the expected growth rate of nominal GDP.
Hybrid analysis: incorporates elements of both top-down and bottom-up analysis.
Compare “growth relative to GDP growth” and “market growth and market share” approaches to forecasting revenue.
When forecasting revenue with a
“growth relative to GDP growth” approach: the relationship between GDP and company sales is estimated, and then company sales growth is forecast based on an estimate for future GDP growth.
“market growth and market share” approach: begins with an estimate of industry sales (market growth), and then company sales are estimated as a percentage (market share) of industry sales. Forecast revenue then equals the forecasted market size multiplied by the forecasted market share.
Evaluate whether economies of scale are present in an industry by analyzing operating margins and sales levels.
A company with economies of scale will have lower costs and higher operating margins as production volume increases, and should exhibit positive correlation between sales volume and margins.
Demonstrate methods to forecast cost of goods sold (COGS), R&D, and selling general and administrative costs (SG&A).
COGS: is primarily a variable cost and is often modeled as a percentage of estimated future revenue.
The R&D and corporate overhead components of SG&A: are likely to be stable over the short term, while selling and distribution costs will tend to increase with increases in sales.
Demonstrate methods to forecast financing costs.
The primary determinants of gross interest expense: are the amount of debt outstanding (gross debt) and interest rates.
Net debt: is gross debt minus cash, cash equivalents, and short-term securities.
Net interest expense: is gross interest expense minus interest income on cash and short-term debt securities owned.
Demonstrate methods to forecast income taxes.
The expected effective tax rate times the forecasted pretax income provides a forecast of income tax expense.
Any expected change in the future effective tax rate should be included in the analysis.
Describe approaches to balance sheet modeling (pro forma).
Net income less dividends declared will flow through to retained earnings.
Working capital items can be forecast based on turnover ratios. In a simple
Items such as inventory, receivables, and payables will all increase proportionately to revenues.
Property, plant and equipment (PP&E) on the balance sheet is determined by depreciation and capital expenditures (capex).
Historical depreciation should be increased by the inflation rate when estimating capital expenditure for maintenance.
Describe the relationship between return on invested capital and competitive advantage.
ROIC: is net operating earnings adjusted for taxes (NOPLAT), divided by invested capital (operating assets minus operating liabilities)
It is a return to both equity and debt.
Firms with ROIC consistently higher than those of peer companies are likely exploiting some competitive advantage in the production and sale of their products.
Explain how a firm’s competitive environment affects prices and costs.
There are no formulas or clear rules on how a firm’s competitive environment affects its future revenue and costs, but expectations of a firm’s future competitive success are important factors in forecasting future revenue and financial statements.
Evaluate the competitive position of a company based on a Porter’s five forces analysis.
- Companies have less (more) pricing power when the threat of substitute products is high (low) and switching costs are low (high).
- Companies have less (more) pricing power when the intensity of industry rivalry is high (low).
- Company prospects for earnings growth are lower when the bargaining power of suppliers is high.
- Companies have less pricing power when the bargaining power of customers is high, and when switching costs are low.
- Companies have more pricing power and better prospects for earnings growth when the threat of new entrants is low (no significant barriers to entry into an industry)
Explain how to forecast industry and company sales and costs when they are subject to price inflation or deflation.
Increases in input costs will increase COGS unless the company has hedged the risk of input price increases with derivatives or contracts for future delivery.
Vertically integrated companies are likely to be less affected by increasing input costs.
Evaluate the effects of technological developments on demand, selling prices, costs, and margins.
Some advances in technology decrease costs of production, which will increase profit margins, at least for early adopters.
Other advances in technology will result in either improved substitutes or wholly new products.
cannibalization factor: the percentage of a new product’s sales that are stolen from an existing product’s sales.
Explain considerations in the choice of an explicit forecast horizon.
For highly cyclical companies, the forecast horizon should include the middle of a cycle so that the analyst can forecast normalized earnings.
When there have been recent impactful events, such as acquisitions, mergers, or restructurings, these events should be considered temporary, and the forecast horizon should be long enough that the perceived benefits of such events can be realized.
Explain an analyst’s choices in developing projections beyond the short-term forecast horizon.
Earnings projections over a forecast period beyond the short term are often based on the historical average growth rate of revenue over the previous economic cycle.
An analyst will typically estimate a terminal value for a stock at the end of the forecast horizon, using either a price multiple or a discounted cash flow approach.
Small changes in the estimated (perpetual) growth rate of future profits or cash flows can have large effects on the estimates.
What are the steps of a sales-based pro forma company model.
The development of sales-based pro forma financial statements includes the following steps:
- Estimate revenue growth and future expected revenue.
- Estimate COGS.
- Estimate SG&A.
- Estimate financing costs.
- Estimate income tax expense and cash taxes, taking into account changes in deferred tax items.
- Model the balance sheet based on items that flow from the income statement and estimates for important working capital accounts.
- Use historical depreciation and capital expenditures to estimate future capital expenditures and net PP&E for the balance sheet.
- Use the completed pro forma income statement and balance sheet to construct a pro forma cash flow statement.
Dividends are appropriate to value a stock when?
Dividends are appropriate when:
- The company has a history of dividend payments.
- The dividend policy is clear and related to the earnings of the firm.
- The asset is being valued from the position of a minority shareholder.
Free cash flows are appropriate to value a stock when?
Free cash flow is appropriate when:
- The company does not have a dividend payment history or has a dividend payment history that is not related to earnings.
- The free cash flow corresponds with the firm’s profitability.
- The asset is being valued from the position of a controlling shareholder.
Residual income is appropriate to value a stock when?
Residual income is most appropriate for firms that:
- Do not have dividend payment histories.
- Have negative free cash flow for the foreseeable future.
- Have transparent financial reporting and high-quality earnings.
What is a stock valuation using the dividend discount model (DDM)?
Stock valuation can be approached using DDMs for single periods, two periods, and multiple holding periods.
The stock price is the present value of the forecasted dividends plus the present value of the estimated terminal value, discounted at the required return.
The Gordon growth model assumes that?
The Gordon growth model assumes that:
- Dividends grow at a constant growth rate.
- Dividend policy is related to earnings.
- Required rate of return r is greater than the long-term constant growth rate g.
Describe strengths and limitations of the Gordon growth model.
Advantages:
- Very applicable to stable, mature dividend-paying firms.
- Can be applied to indices very easily.
- Easily communicated and explained because of its straightforward approach.
- Useful in determining price-implied growth rates, required rates of return, and value of growth opportunities.
- Can be added to other more complex valuations.
Disadvantages:
- Valuations are very sensitive to estimates of growth rates and required rates of return, both of which are difficult to estimate with precision.
- The model cannot be easily applied to non-dividend-paying stocks.
- Unpredictable growth patterns of some firms would make using the model difficult.
Explain the growth phase, transition phase, and maturity phase of a business.
Most firms go through a pattern of growth that includes three stages:
- An initial growth stage, where the firm has rapidly increasing earnings, little or no dividends, and heavy reinvestment.
- A transition stage, in which earnings and dividends are still increasing but at a slower rate as competitive forces reduce profit opportunities and the need for reinvestment.
- A mature stage, in which earnings grow at a stable but slower rate, and payout ratios are stabilizing as reinvestment matches depreciation and asset maintenance requirements.
Describe terminal value and explain alternative approaches to determining the terminal value in a DDM.
No matter which dividend discount model we use, we have to estimate a terminal value.
The Gordon growth model assumes that in the future, dividends will begin to grow at a constant, long-term rate. Then the terminal value at that point is just the value derived from the Gordon growth model.
Using market price multiples to estimate the terminal value is done by forecasting earnings and a ratio at the forecast horizon and then estimating the terminal value as the ratio multiplied by the earnings estimate.
Explain the assumptions and justify the selection of the two-stage DDM, the H-model, the three-stage DDM, or spreadsheet modeling to value a company’s common shares.
There are several multistage growth models, with the most appropriate being the one that most closely matches the firm’s actual growth pattern. The terminal value for multistage models is estimated using the Gordon growth model or market price multiples.
- The two-stage model has two distinct stages with a stable rate of growth during each stage.
- The H-model also has two stages but assumes that the growth rate declines at a constant linear rate during the first stage and is stable in the second stage:
- The three-stage model can either have stable growth rates in each of the three stages or have a linearly declining rate in the second stage.
- The spreadsheet model can incorporate any number of stages with specified rates of growth for each stage. This is most easily modeled with a computer spreadsheet.
