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Equity Flashcards

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1
Q

Chap 24 - Equity Valuation: Applications and Processes

Intrinsic value

A

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

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2
Q

Fair market value

A

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

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3
Q

Investment value

A

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

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4
Q

Porter’s 5 forces

A
  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
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5
Q

Quality of Earnings issues categories

A
  • 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)
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6
Q

Absolute valuation model

A

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

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7
Q

Relative valuation model

A

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)

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8
Q

Sum-of-the-parts valuation

A

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

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9
Q

Method of forecasted fundamentals

A

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

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10
Q

Conglomerate discount

A

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

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11
Q

Chapter 25: Return Concepts

Holding period return (HPR)

A

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

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12
Q

Required return

A

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

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13
Q

If expected return > required return, asset is

A

undervalued

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14
Q

if expected return < required return, asset is

A

overvalued

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15
Q

Internal rate of return (IRR)

A

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

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

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16
Q

Equity risk premium (ERP)

A

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

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17
Q

Gordon growth model equity risk premium

A

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
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18
Q

Ibbotsen-Chen (Macroeconomic model)

A

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

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19
Q

Models used to estimate required return on equity

CAPM (but no flashcard since I’m familiar)

Multifactor model

A

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)

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20
Q

Estimating required rate of return: Fama-French Model

A

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

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21
Q

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

A

high -> therefore it’s a growth stock

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22
Q

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

A

low -> which means it’s a value stock

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23
Q

Pastor-Stambaugh model

A

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’

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24
Q

Macroeconomic multifactor models for estimating required rate of return

A

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

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25
Q

Build-up model

A

Usually applied to private companies whose betas are not readily obtainable

required return = rf + ERP + size premium + company-specific premium

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26
Q

Bond-yield plus risk premium model

A

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

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27
Q

Adjusted beta for public companies

A

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)

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28
Q

Beta estimates for thinly traded stocks and private companies

A

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 = (betaXYZ) x [1/(1+(DXYZ/EXYZ))]

  1. Re-lever the unlevered beta for XYZ:

estimate beta for ABC = (unlevered beta of XYZ) x (1+DABC/EABC)

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29
Q

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

A

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

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30
Q

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

A

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

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31
Q

Country spread model

A

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

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32
Q
A
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33
Q

Chapter 26: Industry and Company Analysis

Bottom up approach

A

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

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34
Q

Top-down analysis

A

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

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35
Q

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

A

economies of scale

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36
Q

A company w/economies of scale will have…

A

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

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37
Q

Net debt

A

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

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38
Q

NOPLAT

A

NOPLAT = EBIT(1-t)

39
Q

Chapter 27: Discounted Dividend Valuation

When to use dividends as definition of cash flow

A
  • 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
40
Q

When free cash flow models are appropriate for stock valuation

A
  • 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
41
Q

Residual income model is most appropriate for firms that

A
  • don’t pay dividends
  • have negative free cash flow for the foreseeable future
42
Q

PVGO

A

V0 = (earnings/required return) + PVGO

43
Q

Value of perpetual preferred shares

A

Vpreferred = DP/rp

44
Q

H-model

A
45
Q

Chapter 28: Free Cash Flow valuation

FCFF

A

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

46
Q

FCFF

A

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

47
Q

FCFE

A

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

net borrowings = debt issued - debt repaid

48
Q

For forecasting FCFE, use

A

FCFE1 = NI - [(1 - DR) x (FCInv - Dep)] - [(1 - DR) x WcInv]

DR = target debt ratio

49
Q

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

Method of Comparables

A

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.

50
Q

Justified price multiple

A

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

51
Q

Rationale for using P/E (Price to Earnings)

A
  • Earnings power is a chief driver of investment value
  • Widey recognized and used
52
Q

Drawbacks of P/E

A
  • 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)
53
Q

Trailing P/E

A

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).

54
Q

Forward P/E (Leading P/E)

A

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

55
Q

P/B

A

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.)
56
Q

Advantages of P/B

A
  • 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
57
Q

Disadvantage of using P/B

A
  • 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
58
Q

Advantages of P/S ratio

A

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
59
Q

Disadvantages of P/S ratio

A
  • 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
60
Q

Advantages of using P/CF ratio

A

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
61
Q

Disadvantages of using P/CF

A
  • 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
62
Q

Advantages of the Dividend Yield (D/P)

A

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
63
Q

Disadvantages of D/P

A
  • The focus on dividend yield is incomplete b/c dividend yield is only 1 component of total return
  • Many stocks don’t pay dividend
64
Q

Trailing D/P

A

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

65
Q

Leading D/P

A

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

66
Q

underlying earnings

A

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)

67
Q

Normalized earnings

A

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

68
Q

Normalized earnings - the method of historical EPS

A

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

69
Q

Normalized earnings - the method of average return on equity

A

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

70
Q

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

A

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

71
Q

Justified P/E multiple

A

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)

72
Q

Justified trailing P/E

A

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

73
Q

Justified leading P/E

A

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

74
Q

Justified P/B ratio

A

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)

75
Q

Justified P/S multiple

A

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

76
Q

PEG ratio

A

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

77
Q

Firms with multiples below the benchmark are…

A

Undervalued

78
Q

Firms with multiples above the benchmark are…

A

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

79
Q

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

A

1 commonly used proxy for cash flow is earnings-plus-noncash-charges

CF = NI + depreciation + amortization

80
Q

P/CF -> adjusted cash flow

A

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

81
Q

harmonic mean will be less than

A

arithmetic mean

82
Q

Enterprise Value (EV)

A

EV = MVequity + MVdebt - (cash+marketable securities) - investments

83
Q

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

A

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.

84
Q

Advantages of EV/EBITDA

A

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

85
Q

Chapter 30: Residual income valuation

Residual income

A

Residual income = NI - charge for common stockholders’ opportunity cost of capital

(Residual income)t = EPSt - (r x BVt-1)

86
Q

Economic Value Added (EVA)

A

EVA = NOPAT - (WACC x total capital)

NOPAT = EBIT(1-t)

87
Q

Market Value Added (MVA)

A

MVA = market value - total capital

88
Q

The fundamnetal drivers of residual income are…

A

ROE in excess of the total cost of equity

  • earnings growth rate
89
Q

Intrinsic value of stock based on residual income valuation

A

V0 = BV0 + RI1/(1+r)1 + RI2/(1+r)2 + RI3/(1+r)3…

BV0 = current book value

r = required return on equity

90
Q

Single stage residual income model

A

V0 = BV0 + [(ROE - r) x BV0]/(r-g)

91
Q

Continuing residual income

A

The residual income that is expected over the long term

92
Q

Strengths of residual income models

A
  • 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
93
Q

Weakness of residual income valuation models

A
  • Models rely on accounting data that can be manipulated by mgmt
94
Q

Residual income models are appropriate under these circumstances:

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

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