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. The difference between the analyst’s estimate of intrinsic value and the current price is made up of two components: the difference between the actual intrinsic value and the market price, and the difference between the actual intrinsic value and the analyst’s estimate of intrinsic value:
IVanalyst − price = (IVactual − price) + (IVanalyst − IVactual)
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. Investment value is an appropriate measure for strategic buyers pursuing acquisitions.
Describe applications of equity valuation.
Equity valuation is the process of estimating the value of an asset by (1) using a model based on the variables the analyst believes influence the fundamental value of the asset or (2) comparing it to the observable market value of “similar” assets. Equity valuation models are used by analysts in a number of ways. Examples include 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, and portfolio management.
Describe questions that should be addressed in conducting an industry and competitive analysis.
The five elements of industry structure as developed by Professor Michael Porter are: Threat of new entrants in the industry. Threat of substitutes. Bargaining power of buyers. Bargaining power of suppliers. Rivalry among existing competitors.
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.
An absolute valuation model is one that estimates an asset’s intrinsic value (e.g., the discounted dividend approach). Relative valuation models estimate an asset’s investment characteristics compared to the value of other firms (e.g., comparing P/E ratios to those of other firms in the industry).
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. Conglomerate discount is an apparent price reduction applied by the markets to firms that operate in multiple industries.
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, and 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.
Return concepts:
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. The holding period can be any length. Usually, it is assumed the cash flow comes at the end of the period:
An 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). The mispricing can lead to a return from convergence of price to intrinsic value.
The discount rate is a rate used to find the present value of an investment.
The 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.
The equity risk premium is the return over the risk-free rate that investors require for holding equity securities. It can be used to determine the required return for specific stocks:
required return for stock j = risk-free return + βj × equity risk premium
where:
βj = the “beta” of stock j and serves as the adjustment for the level of systematic risk
A more general representation is:
required return for stock j = risk-free return + equity risk premium + other adjustments for j
A historical estimate of the equity risk premium consists of the difference between the mean return on a broad-based, equity-market index and the mean return on U.S. Treasury bills over a given time period.
Forward-looking or ex ante estimates use current information and expectations concerning economic and financial variables. The strength of this method is that it does not rely on an assumption of stationarity and is less subject to problems like survivorship bias.
There are three types of forward-looking estimates of the equity risk premium:
Gordon growth model.
Macroeconomic models, which use current information, but are only appropriate for developed countries where public equities represent a relatively large share of the economy.
Survey estimates, which are easy to obtain, but can have a wide disparity between opinions.
The Gordon growth model can be used to estimate the equity risk premium based on expectational data:
GGM equity risk premium = 1-year forecasted dividend yield on market index + consensus long-term earnings growth rate − long-term government bond yield
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 (e.g., bond yield plus risk premium).
Models used to estimate the required return on equity:
CAPM:
required return on stock j = current risk-free return + (equity risk premium × beta of j)
Multifactor model:
required return = RF + (risk premium)1 + … + (risk premium)n
Fama-French model:
required return of stock j = 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, thinly traded public companies, and non-public companies.
Beta estimation:
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)
For thinly traded stocks and non-publicly traded companies, an analyst can estimate beta using a 4-step process: (1) identify publicly traded benchmark company, (2) estimate the beta of the benchmark company, (3) unlever the benchmark company’s beta, and (4) 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.
Each of the various methods of estimating the required return on an equity investment has strengths and weaknesses.
The 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.
In making estimates of required return in the international setting, an analyst should adjust the required return to reflect expectations for changes in exchange rates.
When dealing with emerging markets, a premium should be added to reflect the greater level of risk present.
Two methods for estimating the size of the risk premium:
1. 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 to estimate the required return for the emerging market.
Explain and calculate the weighted average cost of capital for a company.
The weighted average cost of capital (WACC) is the required return averaged across all suppliers of capital (i.e., the debt and equity holders).
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 and those to equity at the required return on equity.
An analyst may wish to measure the present value of real cash flows, and a real discount rate should be used in that case. In most cases, however, analysts discount nominal cash flows with nominal discount rates.
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. A 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.
The “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 the following costs: cost of goods sold, selling general and administrative costs, financing costs, and income taxes.
COGS is primarily a variable cost and is often modeled as a percentage of estimated future revenue. Expectations of changes in input prices can be used to improve COGS estimates.
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.
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.
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.
Some items on a pro forma balance sheet, such as retained earnings, flow from forecasted income statement items. Net income less dividends declared will flow through to retained earnings. Working capital items can be forecast based on turnover ratios. In a simple case, 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) and may be improved by analyzing capital expenditures for maintenance separately from capital expenditures for growth. Historical depreciation should be increased by the inflation rate when estimating capital expenditure for maintenance because replacement costs can be expected to increase.
Describe the relationship between return on invested capital and competitive advantage.
While analysts use varying definitions of ROIC, it can be thought of as net operating earnings adjusted for taxes (NOPLAT), divided by invested capital (operating assets minus operating liabilities), and 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 competitive factors affect 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. If suppliers are few, these suppliers may be able to extract a larger portion of any increase in profits.
- Companies have less pricing power when the bargaining power of customers is high, especially in a circumstance where a small number of customers are responsible for a large proportion of a firm’s sales 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. Significant barriers to entry into an industry make it possible for existing companies to maintain high returns on invested capital.
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. The effect on sales of increasing product prices to reflect higher COGS will depend on the elasticity of demand for the products, and on the timing and amount of competitors’ price increases.
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. One way for an analyst to model the introduction of new substitutes for a company’s products is to estimate a 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 a buy-side analyst, the appropriate forecast horizon to use may simply be the expected holding period for a stock.
For highly cyclical companies, the forecast horizon should include the middle of a cycle so that the analyst can forecast normalized earnings (i.e., expected mid-cycle 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.
It may be the case that the forecast horizon to use is dictated by the analyst’s manager.
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. Using a P/E multiple approach, the estimated earnings in the final forecast period are multiplied by a company’s historical average P/E (possibly adjusted for the phase of the business cycle).
Because the terminal value using the discounted cash flow approach is calculated as the present value of a perpetuity, small changes in the estimated (perpetual) growth rate of future profits or cash flows can have large effects on the estimates of the terminal value and thus the current stock value.
Demonstrate the development 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.
Compare dividends, free cash flow, and residual income as inputs to discounted cash flow models and identify investment situations for which each measure is suitable.
In stock valuation models, there are three predominant definitions of future cash flows: dividends, free cash flow, and residual income.
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 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 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.
Calculate and interpret the value of a common stock using the dividend discount model (DDM) for single and multiple holding periods.
Stock valuation can be approached using DDMs for single periods, two periods, and multiple holding periods. No matter what the holding period, 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.
Calculate the value of a common stock using the Gordon growth model and explain the model’s underlying assumptions.
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.
Calculate the value of non-callable fixed-rate perpetual preferred stock.
The value of a fixed-rate perpetual preferred stock is equal to the dividend divided by the required return:
Calculate and interpret the implied growth rate of dividends using the Gordon growth model and current stock price.
If P0 is fairly priced:
P0 = V0 = D1 / (r − g)
g = r − (D1 / P0)
Calculate and interpret the present value of growth opportunities (PVGO) and the component of the leading price-to-earnings ratio (P/E) related to PVGO.
The value of an asset is equal to the current earnings stream divided by the required return, plus the present value of growth opportunities (PVGO):
Calculate and interpret the justified leading and trailing P/Es using the Gordon growth model.
The Gordon growth model can also be used to estimate justified leading and trailing P/E ratios based on the fundamentals of the firm:
