Equity

Question 1

Chap 24 - Equity Valuation: Applications and Processes

Intrinsic value

Answer 1

Intrinsic value = value of an asset or security estimated by someone who has a thorough understanding of the characteristics of the asset or issuing firm.

Intrinsic value_{analyst estimate} - price = *(Instrinsic value_actual - price) + **(Instrinsic value_{analyst estimate} - Intrinsic value_actual)

* represents true mispricing (alpha)

** represents error

Question 2

Fair market value

Answer 2

the price at which a hypothetical willing, informed and able seller would trade an asset to a willing, informed and able buyer

Question 3

Investment value

Answer 3

value to a specific buyer after including any additional value attributable to synergies

Question 4

Porter’s 5 forces

Answer 4

1. Threat of new entrants in the industry
2. Threat of substitutes
3. Bargaining power of buyers
4. Bargaining power of suppliers
5. Rivalry among existing competitors

Question 5

Quality of Earnings issues categories

Answer 5

• Accelerating or premature recognition of income
• Reclassifying gains and nonoperating income as operating income (hides underperformance or decline in sales)
• Expense recognition and losses (e.g. delaying the recognition of expenses, capitalizing expenses, bad debt reserve etc.)
• Amortization, depreciation, and discount rates
• Off-balance sheet issues (firm’s BS may not fully reflect the assets and liabilities of the firm -> SPE etc)

Question 6

Absolute valuation model

Answer 6

Absolute valuation model estimates an asset’s intrinsic value -> (e.g.: DDM)

Question 7

Relative valuation model

Answer 7

determines the asset’s value in relation to the value of other assets

Common approaches: comparing P/E ratio to those of firms in the industry)

Question 8

Sum-of-the-parts valuation

Answer 8

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

Question 9

Method of forecasted fundamentals

Answer 9

The method of forecasted fundamentals values a stock based on the ratio of its value from a DCF model to some fundamental variable (e.g EPS)

The rationale for the method of forecasted fundamentals is that the value used in the numerator of the justified price multiple is derived from a DCF model -> think of how we derive intrinsic value using DCF

Question 10

Conglomerate discount

Answer 10

the amount by which market price is lower than the sum-of-the-parts value

The price reduction applied by markets to firms that operate in multiple industries

Question 11

Chapter 25: Return Concepts

Holding period return (HPR)

Answer 11

HPR = (P₁-P₀+CF₁)/P₀ = [(P₁+CF₁)/P₀] -1

The holding period can be any length

Assumption: cash flow comes at the end of the period

Question 12

Required return

Answer 12

An asset’s required return is the minimum expected return an investor requires given the asset’s characteristics

Question 13

If expected return > required return, asset is

Answer 13

undervalued

Question 14

if expected return < required return, asset is

Answer 14

overvalued

Question 15

Internal rate of return (IRR)

Answer 15

IRR is the rate that equates the discounted CF to the current price

If the markets are efficient, then the IRR = required return

Question 16

Equity risk premium (ERP)

Answer 16

ERP is the return over the risk-free rate that investors require for holding equity securities

ERP = required return on equity index - risk-free rate

The risk-free rate should correspond to the time horizon for the investment

There are many ways to estimate ERP

Question 17

Gordon growth model equity risk premium

Answer 17

GGM equity risk premium = (1-yr forecasted dividend yield on market index) + (consesus long-term earnings growth rate) - (long term gov bond yield)

Weakness:

• assumption of stable growth rate not always appropriate (esp in rapidly growing economies)
• highly sensitive to estimates

Question 18

Ibbotsen-Chen (Macroeconomic model)

Answer 18

Ibbotsen-Chen ERP = ([1 + expected inflation] x [1+expected real EPS growth] x [1+expected changes in P/E]) -1 + (expected income) - r_f

Macroeconomic models are only appropriate for developed countries where public equities represent a relatively large share of the economy

Question 19

Models used to estimate required return on equity

CAPM (but no flashcard since I’m familiar)

Multifactor model

Answer 19

Multifactor model:

required return = r_f + (risk premium)₁ + (risk premium)₂+…+(risk premium)_n

risk premium_i = (factor sensitivity)_i x (factor risk premium)_i

factor sensitivity = factor beta (the asset’s sensitivity to a particular factor, all else being equal)

Question 20

Estimating required rate of return: Fama-French Model

Answer 20

FFM is a multifactor model that attempts to account for the higher returns generally associated w/small-cap stocks

required return of stock j = r_f + beta_{mkt, j} x (R_mkt - r_f) + beta_{size, j} x (R_small - R_big) + beta_{value, j} x (R_HBM - R_LBM)

(R_mkt - r_f) = market risk premium

(R_small - R_big) = small-cap risk premium (smaller size risk premium)

(R_HBM - R_LBM) = value risk premium

Question 21

If book/market is low, that implies that P/B is

Answer 21

high -> therefore it’s a growth stock

Question 22

if book/market is high, that implies P/B is

Answer 22

low -> which means it’s a value stock

Question 23

Pastor-Stambaugh model

Answer 23

Pastor-Stambaugh model is an extension of FFM: it adds liquidity factor to FFM

required rate of return = FFM + beta_liquidity x degree of liquidity

naturally, lower liquidity requires higher ‘r’

Question 24

Macroeconomic multifactor models for estimating required rate of return

Answer 24

Example: Burmeister, Roll, and Ross model (BIRR model)

Incorporates these 5 factors

• Confidence risk
• Sensitvity to time horizon
• sensitivity to inflation risk
• sensitivity to business cycle risk
• sensitivity to market timing risk

The factor values are multiplied by a sensitivity coefficient (e.g. beta). The products are summed and added to a risk-free rate

Question 25

Build-up model

Answer 25

**Usually applied to private companies** whose betas are not readily obtainable ## Footnote **required return = r_f + ERP + size premium + company-specific premium**

Question 26

Bond-yield plus risk premium model

Answer 26

This is a **form of build-up model** that's **appropriate if the company has publicly traded debt** ## Footnote r = YTM of company's bond + risk premium (usually estimated at 3-5%) _Rationale_ **YTM in company's bonds include:** - effects of inflation - effects of leverage - firm sensitivity to business cycle **That's why you can simply a risk premium on top of all that**

Question 27

Adjusted beta for public companies

Answer 27

B/c beta tends to revert to the mean, it's recommended that you adjust the beta ## Footnote **adjusted beta = (2/3 x regression beta) + (1/3 x 1)**

Question 28

Beta estimates for thinly traded stocks and private companies

Answer 28

**4 steps** to estimate beta for thinly traded stocks and private companies: 1. ID a benchmark company that's publicly traded and similar to company ABC in its operations 2. Estimate the beta of that benchmark company (we'll call it company XYZ) 3. Unlever the beta estimate for XYZ **unlevered beta for XYZ = (beta_XYZ) x [1/(1+(D_XYZ/E_XYZ))]** 4. Re-lever the unlevered beta for XYZ: **estimate beta for ABC = (unlevered beta of XYZ) x (1+D_ABC/E_ABC)**

Question 29

Strengths of the methods used to estimate required rate of return on equity

Answer 29

**CAPM:** simple to use and only uses 1 factor **Multifactor models:** higher explanatory power (not always but mostly true) **Build-up models:** simple and can be used for private companies

Question 30

Weaknesses of methods use to estimate required rate of return on equity

Answer 30

**CAPM:** can lead to low explanatory power and choosing the appropriate factor (i.e if stock trades in more than 1 market, which beta do you use?) **Multifactor models:** more complex + expensive **Build-up models:** uses historical values as estimates, which may or may not be relevant to current market conditions

Question 31

Country spread model

Answer 31

The country spread model uses a corresponding developed market as a benchmark and adds a premium for the emerging market risk. Premium = yield on bonds in emerging market - yield on bonds in the developed market

Question 33

Chapter 26: Industry and Company Analysis Bottom up approach

Answer 33

Bottom-up analysis starts w/analysis of an indiviudal company or reportable segments of a company

Question 34

Top-down analysis

Answer 34

Top-down analysis begins w/expectations about a macroeconomic variable (usually expected GDP growth rate)

Question 35

**If the average cost of production decreases as industry sales increase**, the industry exhibits

Answer 35

economies of scale

Question 36

A company w/economies of scale will have...

Answer 36

**lower costs and higher operating margins as production volume increases**. There should be a **positive correlation** between **sales volume and margins**

Question 37

Net debt

Answer 37

Net debt = gross debt - (cash+cash equivalents+short-term securities)

Question 38

NOPLAT

Answer 38

NOPLAT = EBIT(1-t)

Question 39

Chapter 27: Discounted Dividend Valuation When to use **dividends** as definition of cash flow

Answer 39

* 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**

Question 40

When free cash flow models are appropriate for stock valuation

Answer 40

* Company **doesn't pay dividends** or has a dividend payment history **not related to earnings** * Free cash flow corresponds w/the firm's profitability * The asset is being valued from the **position of a controlling shareholder**

Question 41

Residual income model is most appropriate for firms that

Answer 41

* don't pay dividends * have negative free cash flow for the foreseeable future

Question 42

PVGO

Answer 42

V₀ = (earnings/required return) + PVGO

Question 43

Value of perpetual preferred shares

Answer 43

V_preferred = D_P/r_p

Question 44

H-model

Answer 44

Question 45

Chapter 28: Free Cash Flow valuation **FCFF**

Answer 45

FCFF is cash available to all suppliers of capital (debt and shareholders) after the firm buys and sells products, providers services, pays its cash operating expenses, and makes short/long-term investments

Question 46

FCFF

Answer 46

FCFF = NI + NCC + Int(1-t) - FCInv - WCInv You can substitute NI in w/EBIT, EBITDA, CFO **FCInv = CapEx - proceeds from sales of long term assets** *If no long term assets were sold during the year:* **FCInv = ending net PP&E - beginning net PP&E + depreciation**

Question 47

FCFE

Answer 47

FCFE = FCFF - Int(1-t) + net borrowings net borrowings = debt issued - debt repaid

Question 48

For **forecasting** FCFE, use

Answer 48

**FCFE₁ = NI - [(1 - DR) x (FCInv - Dep)] - [(1 - DR) x WcInv]** **DR = target debt ratio**

Question 49

Chapter 29: Market-based Valuation: Price and Enterprise value multiples Method of Comparables

Answer 49

The **method of comparables** values a stock based on the **average price multiple** of the stock of **similar companies**. Remember, this is a **relative valuation method**, so we can **only** assert that the stock is over or undervalued **relative** to the benchmark value.

Question 50

Justified price multiple

Answer 50

A **justified price multiple** is what the multiple **should** be **if** the stock is fairly valued. That's why it's called "justified" b/c it's justified by the fundamentals. If the actual multiple \> justified price multiple, the stock is **overvalued** If actual multiple \< justified price multiple, the stock is **undervalued**

Question 51

Rationale for using P/E (Price to Earnings)

Answer 51

* **Earnings power is a chief driver of investment value** * **Widey recognized and used**

Question 52

Drawbacks of P/E

Answer 52

* EPS can be 0, negative or very small relative to P₀ -\> In these cases, the P/E makes no economic sense * EPS is a **highly managed number (e.g. mgmt can manipulate # of outstanding shares through buybacks)**

Question 53

Trailing P/E

Answer 53

**Trailing P/E = market price per share/EPS over previous 12 months -\> (P₀/E₀)** Use when: * if forecasts aren't possible Trailing P/E isn't useful for forecasting and valuation if the company has changed (e.g. as a result of an acquisition).

Question 54

Forward P/E (Leading P/E)

Answer 54

**Forward P/E = market price per share/forecasted EPS over next 12 months -\> P₀/E₁** * **Valuation is forward looking**, so it makes sense to use a forward P/E Forward P/E may not be relevant if earnings are sufficiently volatile so that next year's earnings aren't accurately forecastable

Question 55

P/B

Answer 55

**P/B = market value of equity/book value of equity = market price per share/book value per share** book value = common shareholder's equity = (Σassets - Σliabilities) - preferred stock Remember, the book value represents on a per share basis, the investment common shareholders have made in the company **Rationale for using P/B:** - Cumulative balance sheet amount -\> thus, book value \> 0 even when EPS \< 0 - book value/share is more stable than EPS - appropriate for valuing companies composed chiefly of liquid assets (finance, investment, insurance, banks etc.)

Question 56

Advantages of P/B

Answer 56

* P/B is useful in valuing companies that are expected to go out of business * Book value is a cumulative amount that's usually positive, even when the firm reports a loss and EPS is negative. Thus, P/B can be used in situations that P/E can't * Book value is more stable than EPS

Question 57

Disadvantage of using P/B

Answer 57

* P/B doesn't reflect value of intangible economic assets, such as human capital reputation etc. * Diffuclt to compare companies w/different asset size/base (capital vs labor intensive) -\> a firm that outsources its production will have fewer assets, lower book value, and thus a higher P/B ratio than a firm in the same industry that doesn't outsource production * Different accounting conventions can make it tricky to compare P/B across firms and countries

Question 58

Advantages of P/S ratio

Answer 58

P/S = market value of equity/total sales = market price per share/sales per share * **Sales are less subject to distortion/manipulation** * Sales \> 0 even when EPS \< 0 * **Sales more stable than EPS** * P/S is appropriate for mature, cylical and zero-income firms

Question 59

Disadvantages of P/S ratio

Answer 59

* Share price reflects the effect of debt, **sales do not** -\> thus, P/S is a logical mismatching * P/S ratios don't reflect differences in cost structures * revenue recognition practices can distort P/S

Question 60

Advantages of using P/CF ratio

Answer 60

P/CF = market price per share/cash flow from operations per share * CF is harder to manipulate than earnings * CF is more stable than earnings * Sidesteps issues related to accounting choices

Question 61

Disadvantages of using P/CF

Answer 61

* Some definition of cash flow inadequate * FCFE is more appropriate than CFO but FCFE is more volatile than CFO. * CF is still open to some manipulation

Question 62

Advantages of the Dividend Yield (D/P)

Answer 62

D/P = common dividend/market price * dividend yield is a component of total return * Dividend is less risky than capital appreciation component of total return

Question 63

Disadvantages of D/P

Answer 63

* The focus on dividend yield is incomplete b/c dividend yield is only 1 component of total return * Many stocks don't pay dividend

Question 64

Trailing D/P

Answer 64

**Trailing D/P = (4 x most recent quarterly dividend)/market price per share**

Question 65

Leading D/P

Answer 65

**Leading D/P = forecasted dividends over the next 4 quarters/market price per share**

Question 66

underlying earnings

Answer 66

**underlying earnings = earnings that exclude non-recurring components (such as gains and losses from asset sales, asset write-downs, provisions for future losses, and changes in accounting estimates)**

Question 67

Normalized earnings

Answer 67

**normalized earnings = level of EPS expected under mid-cycle conditions**

Question 68

Normalized earnings - the method of historical EPS

Answer 68

Under the **method of historical average EPS**, the normalized EPS is estimated as the average EPS over some period, usually the most recent business cycle Downside is this method doesn't account for size

Question 69

Normalized earnings - the method of average return on equity

Answer 69

Under the method of average ROE, normalized EPS is estimated as the average return on equity multiplied

Question 70

Explain and justify the use of earnings yield (EPS₀/P₀)

Answer 70

EPS₀/P₀ = earnings yield (also known as inverse price ratio) ## Footnote We use earnings yield to solve the problem caused by low, negative, or zero EPS

Question 71

Justified P/E multiple

Answer 71

The justified P/E multiple is a P/E ratio with the "P" in the numerator equal to the fundamental value derived from a valuation model (E.g. GGM, DDM etc)

Question 72

Justified trailing P/E

Answer 72

**Justified trailing P/E = P₀/E₀ = [(1-RR)(1+g)]/(r-g)**

Question 73

Justified leading P/E

Answer 73

**justified leading P/E = P₀/E₁ = (1-RR)/(r-g)**

Question 74

Justified P/B ratio

Answer 74

Given that the **sustainable growth rate = ROE x RR** and **E₁ = BV₀ x ROE**: ## Footnote justified P/B ratio = P₀/BV₀ = ROE-g/r-g **Derivation:** V₀ = P₀ = D₁/(r-g) = [E₁ x (1-RR)]/r-g P₀ = [BV₀ x ROE x (1-RR)]/(r-g) P₀/BV₀ = [ROE x (1-RR)]/(r-g) RR = g/ROE (from SGR formula) **Thus, P₀/BV₀ = [ROE x (1-g/ROE)]/(r-g) -\> ROE-g/(r-g)**

Question 75

Justified P/S multiple

Answer 75

Justified P/S = [(E₀/S₀) x (1-RR) x (1+g)]/(r-g) ## Footnote net profit margin = NI/rev = E₀/S₀ **Justified P/S is an increasing function of net profit margin and earnings growth rate**

Question 76

PEG ratio

Answer 76

PEG ratio = P/E ratio/g ## Footnote - PEG ratio is interpreted as P/E per unit of expected growth -\> this ratio "standardizes" the P/E ratio w/different expected growth rates Rule of thumb: stocks w/lower PEGs are more attractive than stocks w/higher PEGs assuming that risk is similar

Question 77

Firms with multiples below the benchmark are...

Answer 77

Undervalued

Question 78

Firms with multiples above the benchmark are...

Answer 78

Overvalued \*However, **the fundamentals of the stock should be similar to the fundamentals of the benchmark** before we can make direct comparisons and draw any conclusions about whether the stock is overvalued or undervalued

Question 79

P/CF -\> earnings-plus-noncash-charges (CF)

Answer 79

1 commonly used proxy for cash flow is **earnings-plus-noncash-charges** CF = NI + depreciation + amortization

Question 80

P/CF -\> adjusted cash flow

Answer 80

Another proxy for cash flow in P/CF is adjusted cash flow CFO is often adjusted for nonrecurring CF **US GAAP requires interest paid, interest received, and dividends received to be classified as operating cash flows** **IFRS** is more flexible: **interest paid** can be either **CFO or CFF**; **dividends received** can be either **CFO or CFI**

Question 81

harmonic mean will be less than

Answer 81

arithmetic mean

Question 82

Enterprise Value (EV)

Answer 82

EV = MV_equity + MV_debt - (cash+marketable securities) - investments

Question 83

Which of the following investment strategies is most consistent with choosing high dividend yield stocks?

Answer 83

Value Dividend yield is **positively related** to the **required rate of return** and **negatively** **related** to the **forecasted growth rate in dividends**. Thus, choosing high dividend yield stocks reflects a value - rather than a growth-style orientation.

Question 84

Advantages of EV/EBITDA

Answer 84

EBITDA is useful for valuing capital-intensive businesses w/high levels of depreciation and amortization.

Question 85

Chapter 30: Residual income valuation **Residual income**

Answer 85

Residual income = NI - charge for common stockholders' opportunity cost of capital (Residual income)_t = EPS_t - (r x BV_t-1)

Question 86

Economic Value Added (EVA)

Answer 86

EVA = NOPAT - (WACC x total capital) NOPAT = EBIT(1-t)

Question 87

Market Value Added (MVA)

Answer 87

MVA = market value - total capital

Question 88

The fundamnetal drivers of residual income are...

Answer 88

ROE in excess of the total cost of equity - earnings growth rate

Question 89

Intrinsic value of stock based on residual income valuation

Answer 89

V₀ = BV₀ + RI₁/(1+r)¹ + RI₂/(1+r)² + RI₃/(1+r)³... BV₀ = current book value r = required return on equity

Question 90

Single stage residual income model

Answer 90

V₀ = BV₀ + [(ROE - r) x BV₀]/(r-g)

Question 91

Continuing residual income

Answer 91

The residual income that is expected over the **long term**

Question 92

Strengths of residual income models

Answer 92

* Terminal value doesn't dominate the instrinsic value estimate * Models are applicable to firms that don't pay dividendds or that don't have positive expected FCF in the short run * Models are applicable even when cash flows are volatile

Question 93

Weakness of residual income valuation models

Answer 93

* Models rely on accounting data that can be manipulated by mgmt

Question 94

Residual income models are appropriate under these circumstances:

Answer 94

* Firm doesn't pay dividends or too difficult to accurately forecast dividend payments * Expected FCF are negative for the foreseeable future