Equity Flashcards
Chap 24 - Equity Valuation: Applications and Processes
Intrinsic value
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 valueanalyst estimate - price = *(Instrinsic valueactual - price) + **(Instrinsic valueanalyst estimate - Intrinsic valueactual)
* represents true mispricing (alpha)
** represents error
Fair market value
the price at which a hypothetical willing, informed and able seller would trade an asset to a willing, informed and able buyer
Investment value
value to a specific buyer after including any additional value attributable to synergies
Porter’s 5 forces
- 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 categories
- 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)
Absolute valuation model
Absolute valuation model estimates an asset’s intrinsic value -> (e.g.: DDM)
Relative valuation model
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)
Sum-of-the-parts valuation
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
Method of forecasted fundamentals
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
Conglomerate discount
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
Chapter 25: Return Concepts
Holding period return (HPR)
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
Required return
An asset’s required return is the minimum expected return an investor requires given the asset’s characteristics
If expected return > required return, asset is
undervalued
if expected return < required return, asset is
overvalued
Internal rate of return (IRR)
IRR is the rate that equates the discounted CF to the current price
If the markets are efficient, then the IRR = required return
Equity risk premium (ERP)
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
Gordon growth model equity risk premium
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
Ibbotsen-Chen (Macroeconomic model)
Ibbotsen-Chen ERP = ([1 + expected inflation] x [1+expected real EPS growth] x [1+expected changes in P/E]) -1 + (expected income) - rf
Macroeconomic models are only appropriate for developed countries where public equities represent a relatively large share of the economy
Models used to estimate required return on equity
CAPM (but no flashcard since I’m familiar)
Multifactor model
Multifactor model:
required return = rf + (risk premium)1 + (risk premium)2+…+(risk premium)n
risk premiumi = (factor sensitivity)i x (factor risk premium)i
factor sensitivity = factor beta (the asset’s sensitivity to a particular factor, all else being equal)
Estimating required rate of return: Fama-French Model
FFM is a multifactor model that attempts to account for the higher returns generally associated w/small-cap stocks
required return of stock j = rf + betamkt, j x (Rmkt - rf) + betasize, j x (Rsmall - Rbig) + betavalue, j x (RHBM - RLBM)
(Rmkt - rf) = market risk premium
(Rsmall - Rbig) = small-cap risk premium (smaller size risk premium)
(RHBM - RLBM) = value risk premium
If book/market is low, that implies that P/B is
high -> therefore it’s a growth stock
if book/market is high, that implies P/B is
low -> which means it’s a value stock
Pastor-Stambaugh model
Pastor-Stambaugh model is an extension of FFM: it adds liquidity factor to FFM
required rate of return = FFM + betaliquidity x degree of liquidity
naturally, lower liquidity requires higher ‘r’
Macroeconomic multifactor models for estimating required rate of return
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
Build-up model
Usually applied to private companies whose betas are not readily obtainable
required return = rf + ERP + size premium + company-specific premium
Bond-yield plus risk premium model
This is a form of build-up model that’s appropriate if the company has publicly traded debt
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
Adjusted beta for public companies
B/c beta tends to revert to the mean, it’s recommended that you adjust the beta
adjusted beta = (2/3 x regression beta) + (1/3 x 1)
Beta estimates for thinly traded stocks and private companies
4 steps to estimate beta for thinly traded stocks and private companies:
- ID a benchmark company that’s publicly traded and similar to company ABC in its operations
- Estimate the beta of that benchmark company (we’ll call it company XYZ)
- Unlever the beta estimate for XYZ
unlevered beta for XYZ = (betaXYZ) x [1/(1+(DXYZ/EXYZ))]
- Re-lever the unlevered beta for XYZ:
estimate beta for ABC = (unlevered beta of XYZ) x (1+DABC/EABC)
Strengths of the methods used to estimate required rate of return on equity
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
Weaknesses of methods use to estimate required rate of return on equity
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
Country spread model
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
Chapter 26: Industry and Company Analysis
Bottom up approach
Bottom-up analysis starts w/analysis of an indiviudal company or reportable segments of a company
Top-down analysis
Top-down analysis begins w/expectations about a macroeconomic variable (usually expected GDP growth rate)
If the average cost of production decreases as industry sales increase, the industry exhibits
economies of scale
A company w/economies of scale will have…
lower costs and higher operating margins as production volume increases. There should be a positive correlation between sales volume and margins
Net debt
Net debt = gross debt - (cash+cash equivalents+short-term securities)
NOPLAT
NOPLAT = EBIT(1-t)
Chapter 27: Discounted Dividend Valuation
When to use dividends as definition of cash flow
- 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
When free cash flow models are appropriate for stock valuation
- 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
Residual income model is most appropriate for firms that
- don’t pay dividends
- have negative free cash flow for the foreseeable future
PVGO
V0 = (earnings/required return) + PVGO
Value of perpetual preferred shares
Vpreferred = DP/rp
H-model
Chapter 28: Free Cash Flow valuation
FCFF
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
FCFF
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
FCFE
FCFE = FCFF - Int(1-t) + net borrowings
net borrowings = debt issued - debt repaid
For forecasting FCFE, use
FCFE1 = NI - [(1 - DR) x (FCInv - Dep)] - [(1 - DR) x WcInv]
DR = target debt ratio
Chapter 29: Market-based Valuation: Price and Enterprise value multiples
Method of Comparables
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.
Justified price multiple
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
Rationale for using P/E (Price to Earnings)
- Earnings power is a chief driver of investment value
- Widey recognized and used
Drawbacks of P/E
- 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)
Trailing P/E
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).
Forward P/E (Leading P/E)
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
P/B
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.)
Advantages of P/B
- 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
Disadvantage of using P/B
- 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
Advantages of P/S ratio
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
Disadvantages of P/S ratio
- 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
Advantages of using P/CF ratio
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
Disadvantages of using P/CF
- 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
Advantages of the Dividend Yield (D/P)
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
Disadvantages of D/P
- The focus on dividend yield is incomplete b/c dividend yield is only 1 component of total return
- Many stocks don’t pay dividend
Trailing D/P
Trailing D/P = (4 x most recent quarterly dividend)/market price per share
Leading D/P
Leading D/P = forecasted dividends over the next 4 quarters/market price per share
underlying earnings
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)
Normalized earnings
normalized earnings = level of EPS expected under mid-cycle conditions
Normalized earnings - the method of historical EPS
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
Normalized earnings - the method of average return on equity
Under the method of average ROE, normalized EPS is estimated as the average return on equity multiplied
Explain and justify the use of earnings yield (EPS0/P0)
EPS0/P0 = earnings yield (also known as inverse price ratio)
We use earnings yield to solve the problem caused by low, negative, or zero EPS
Justified P/E multiple
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)
Justified trailing P/E
Justified trailing P/E = P0/E0 = [(1-RR)(1+g)]/(r-g)
Justified leading P/E
justified leading P/E = P0/E1 = (1-RR)/(r-g)
Justified P/B ratio
Given that the sustainable growth rate = ROE x RR and E1 = BV0 x ROE:
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)
Justified P/S multiple
Justified P/S = [(E0/S0) x (1-RR) x (1+g)]/(r-g)
net profit margin = NI/rev = E0/S0
Justified P/S is an increasing function of net profit margin and earnings growth rate
PEG ratio
PEG ratio = P/E ratio/g
- 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
Firms with multiples below the benchmark are…
Undervalued
Firms with multiples above the benchmark are…
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
P/CF -> earnings-plus-noncash-charges (CF)
1 commonly used proxy for cash flow is earnings-plus-noncash-charges
CF = NI + depreciation + amortization
P/CF -> adjusted cash flow
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
harmonic mean will be less than
arithmetic mean
Enterprise Value (EV)
EV = MVequity + MVdebt - (cash+marketable securities) - investments
Which of the following investment strategies is most consistent with choosing high dividend yield stocks?
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.
Advantages of EV/EBITDA
EBITDA is useful for valuing capital-intensive businesses w/high levels of depreciation and amortization.
Chapter 30: Residual income valuation
Residual income
Residual income = NI - charge for common stockholders’ opportunity cost of capital
(Residual income)t = EPSt - (r x BVt-1)
Economic Value Added (EVA)
EVA = NOPAT - (WACC x total capital)
NOPAT = EBIT(1-t)
Market Value Added (MVA)
MVA = market value - total capital
The fundamnetal drivers of residual income are…
ROE in excess of the total cost of equity
- earnings growth rate
Intrinsic value of stock based on residual income valuation
V0 = BV0 + RI1/(1+r)1 + RI2/(1+r)2 + RI3/(1+r)3…
BV0 = current book value
r = required return on equity
Single stage residual income model
V0 = BV0 + [(ROE - r) x BV0]/(r-g)
Continuing residual income
The residual income that is expected over the long term
Strengths of residual income models
- 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
Weakness of residual income valuation models
- Models rely on accounting data that can be manipulated by mgmt
Residual income models are appropriate under these circumstances:
- Firm doesn’t pay dividends or too difficult to accurately forecast dividend payments
- Expected FCF are negative for the foreseeable future
