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Key Facts > EQUITY > Flashcards

EQUITY Flashcards

1
Q

Describe INTRINSIC VALUE

A

Value based on fundamental characteristic: 1. Future cash flow 2. Risk operating 3. Risk financial 4. Growth rate 5. Discount rate

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2
Q

What is the best available estimate of intrinsic value according to efficient market theory

A

Market price

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3
Q

What does Rational Efficient Markets theory say about Intrinsic value, who said it?

A

Grossman Stiglitz Market price does not reflect intrinsic value Investors would not incur analysts costs otherwise

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4
Q

What is “Perceived mispricing”

A

Perceived Mispricing = Estimate of True Value - Market Price Perceived Mispricing = True mispricing + error in Estimate of True Value Consists of two components: 1. True mispricing =(unobservable) True Value - Market Price 2. Error in estimate of Intrinsic value = Estimate of True Value - (unobservable) True Value

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5
Q

Going concern

A

A company that will Continue operations for the foreseeable future in a value-maximizing manner and maintain an optimal capital structure

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6
Q

Liquidation value

A

Financial distress eliminates human capital, Goodwill etc Liquidation value = Fire sale of all assets and company dissolved Orderly liquidation value=orderly sale of assets. Liquidation value assumes the company is dissolved and assets liquidated

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7
Q

Fair market value

A

Arms length transaction between knowledgeable willing parties.

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8
Q

True mispricing

A

Difference between intrinsic value (true price) and market price = V - P

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9
Q

What does convergence from market price to intrinsic price yield?

A

Realized: Excess risk adjusted return Abnormal return Alpha

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10
Q

INVESTMENT VALUE

A
  1. Unique value 2. Particular buyer 3. Premium to Fair Market Value
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11
Q

Mnemonic for equity valuation process

A

UFSCA Understand the business Forecast performance Select valuation model Convert forecasts to valuation Apply valuation to draw conclusions

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12
Q

What accounts for difference between “going concern” and “liquidation” value?

A
  1. Going concern has Human capital that adds value by operating the business 2. Liquidation value is the value by selling all the assets of the business. 3. The value obtained in a liquidation increases with the time available to liquidate assets
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13
Q

Reasons for appraising a private business

A
  1. Transactional (e.g. Sale or IPO) 2. Tax (e.g. Estate purposes)
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14
Q

Describe HHI

A

Herfindahl-Hirschman Index 1. Measures Market Concentration 2. Sum of squared market shares 3. Large values for proposed mergers attract regulatory scrutiny

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15
Q

What are Porters 5 forces?

A

SERB Substitutes Supplier power Entrants Rivalry Buyer power Substitutes

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16
Q

Describe Porters three generic strategies? What do they show?

A

They describe strategies for above average performance through competitive advantage Cost leadership - lowest cost produce with sector level quality Differentiation - unique product or service that attracts premium Focus - within a target segment. Establish advantage through cost leadership or differentiation

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17
Q

What are the main components of high quality earnings?

A
  1. Adequate - cover the cost of capital 2. Sustainable - Persistant and Recurring
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18
Q

Describe pro-forma adjustments to income statement to assess earnings quality

A

Exclude non recurring items, e.g. exclude one-off expenses

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19
Q

Issues with non-recurring expenses

A

Subjective. Reduce operating expense. May be abused.

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20
Q

Describe how a simple regression is used to test for earnings persistence

A
  1. Do past earnings model future earnings? Earns(t+1)=a + B.Earns(t) + err
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21
Q

Explain how earnings can be broken down into a better regression model

A

Break earnings into: 1. Cash Flow 2. Non discretionary accruals 3. Discretionary accruals

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22
Q

Explain the effect of accruals and cashflow on earnings persistence

A

Greater Accruals are negatively correlated with persistence, lead to lower earnings quality Increased Cashflow is positively correlated with increased persistence. Receivables are a form of Accruals

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23
Q

Which type of accrual is more easily manipulated?

A

Discretionary “abnormal” accruals.

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24
Q

What accelerates mean reversion of earnings?

A

Higher discretionary (abnormal) accruals.

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25
Q

What are the main types of earnings manipulation?

A
  1. Revenue recognition 2. Expense capitalisation
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26
Q

Provide 3 examples of manipulation of Revenue Recognition

A
  1. Bill and hold 2. Channel stuffing 3. Heavy discount
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27
Q

What is the implication of receivables growing faster than revenue

A
  1. Receivables is a form of accruals. 2. Revenue manipulation. 3. Check trend of increase in Days Sales Outstanding (DSO)
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28
Q

What is the formula for Days Sales Outstanding

A

DSO=(avg Receivables x 365) / Revenue

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29
Q

The proportion of X vs Y in earnings indicates Z

A

X=Cashflow Y=Accruals Z=Warning of low quality earnings.

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30
Q

What does consensus earnings tracking indicate?

A

Low quality earnings

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31
Q

Warning signs of earnings quality from X such as falling Y and rising Z

A

X= Data inconsistencies Y= capacity utilisation Z= Sales

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32
Q

Earnings quality is also affected by X transactions such as a large Y to a Z

A

X=Related Party Y=SALE Z=Subsidiary

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33
Q

What does a trend of increasing DSO imply? What changes the implication?

A
  1. A problem collecting receivables 2. Deteriorating quality of receivables (debtors) If trend is in line with industry it may be due to providing looser payment terms than before to compete.
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34
Q

Current operating expenses can be manipulated to increase current earnings by?

A
  1. Capitalising part of current expense to increase non-current assets. 2. Depreciating non-current assets into the future.
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35
Q

Falling X with rising Y indicates Z

A

X=Asset Turnover Ratio (revenue / assets) Y=Net Income and non-current assets Z=Capitalisation (reduction) of operating expense to increase non-current assets and increase net income.

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36
Q

A lower X expense than industry average indicates Y

A

X=Depreciation Y=increases current net income at expense of future net income

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37
Q

Problematic related party transactions include X and Y

A

X=shifting company resources to another entity Y=Propping practices - related entities boost profits

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38
Q

Earning quality warnings include mischaracterisation of Cash flow from X as Cash flow from Y

A

X=financing e.g overdraft Y= Operations

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39
Q

False earnings persistence and masked X can be achieved by classifying Y as Z

A

X=decline in operating income Y=non recurring income Z=recurring income

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40
Q

What are the two approaches to company forecasting?

A
  1. Top-Down 2. Bottom up
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41
Q

Describe Top-Down forecasting

A
  1. International macroeconomic forecast 2. National macroeconomic forecast 3. Industry / Sector forecast 4. Asset forecast 5. Company forecast
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42
Q

Describe bottom-up forecasting

A
  1. Aggregate company forecasts to give sector / industry forecasts 2. Aggregate sector / industry forecasts to give macroeconomic forecasts.
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43
Q

Contrast absolute vs relative valuation models

A
  1. Both are based on going concern 2. Absolute valuation models 2a. Look for intrinsic value 2b. Includes all Present value models 2c. Asset based models - sum of the market values of all components 3. Relative valuation models 3a. Look for comparable assets (that are fairly valued) 3b. Based on ratios 3c. Price multiples 3d. Earnings multiples 3e. Enterprise values
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44
Q

Describe sum of the parts valuation

A
  1. Break-up value / private market value 2. Each business unit valued individually as a going concern 3. Company value is the sum of these.
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45
Q

What does trend in market share indicate?

A

Competitive Advantage

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46
Q

Sources of company information

A

Company report Regulators Filings 3rd Parties

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47
Q

What is a conglomerate discount applied to? When is a Conglomerate discount applied?

A
  1. Applied to sum of the parts or break up value 2. Due to compensate for: (A) lack of focus (B) Inefficient capital allocation (C) Endogenous factors e.g. the company performs poorly and acquires other companies to improve performance
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48
Q

Explain Conglomerate Discount How does it arise?

A
  1. Does not exist 2. Merely flawed measurement A. It arises for endogenous reasons when an underperforming business acquires companies with unrelated business. B. For example on divestment because: - its non-core sale is not damaging (to it) since it does not rely on core business. - it can be fairly valued separately. - its sale price implies a higher break up value than the going concern value of the entire business.
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49
Q

Which valuation model is preferred when financial data is difficult to obtain?

A

Relative valuation models

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50
Q

What is the formula for Holding Period Return on Equity

A

HPR=(Price at end of holding - Price at start + Dividends over holding period) / (Price at start)

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51
Q

Holding period return for equity can be broken down into X and Y

A

X= Price appreciation return (P1-P0)/P0 Y= Dividend return = D/P0

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52
Q

What is the difference between RHPR and EHPR?

A
  1. RHPR=historical, past information, the realised HPR 2. EHPR=forward looking holding period return. E.g. future price and dividend
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53
Q

Explain Required Rate of Return

A
  1. Minimum compensation for all risk assumed over the period. 2. Opportunity cost of investing in this asset vs a different asset with similar risk.
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54
Q

What is the formula for Expected Alpha? Two other names for expected alpha are X and Y

A

Expected Alpha=Expected Return - Required Return X=ex ante Alpha Y=expected abnormal return

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55
Q

Describe one of the problems with annualising short HPR

A

The return may not be realistic for an entire year

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56
Q

What is the formula for realized alpha Realized alpha is also called X

A

Realised Alpha = HPR - Required Return X= ex post alpha

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57
Q

What are the two components of expected (HPR) return for an asset mispriced from intrinsic value?

A
  1. Return from convergence of P to V 2. Required return
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58
Q

What is the formula for return from convergence of price to value

A

(Vo - Po)/Po

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59
Q

How is EHPR calculated

A
  1. Required rate + 2. Return due to convergence
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60
Q

Rearrange GGM to estimate Required Return

A

Vo=Po=Dn/(Rr-g) (Rr-g)=Dn/Po Rr=(Dn/Po)+g

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61
Q

What is the internal rate of return

A

Discount rate that makes the PV of all future cashflows equal to the current Price

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62
Q

Critique the statement: “no equity investor needs to understand valuation models because real-time market prices for equities are easy to obtain online”

A
  1. Infers all investors believe market prices reflect all relevant information and intrinsic value. (Strong EMH) 2. Active investors do not believe all relevant information is reflected in market prices. 3. Grossman-Stiglitz paradox: if investors do not bother to obtain and analyse information the market pricing mechanism is less reliable. 4. Rational Efficient Markets formulation: investors would not incur costs of gathering data and analysis if there was no possibility of being rewarded. 5. Market prices are not available for private companies 6. Market prices are stale for illiquid stocks 7. Market prices are less reliable for smaller companies with low analyst coverage.
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63
Q

Grossman - Stiglitz paradox

A

If investors do not gather and analyse information then market efficiency is reduced, which makes it attractive to gather and analyse information stocks because this could reveal mispricing.

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64
Q

Rational Markets Hypothesis

A
  1. Grossman-Stiglitz 2. Investors would not rationally incur cost of gathering information unless they expected to be rewarded by higher gross returns
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65
Q

What type of valuation can trigger a spin-off or divestiture?

A

A break-up value higher than the going concern value

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66
Q

Why is true intrinsic value unobservable?

A

Because 1. You cannot have full knowledge of all risks 2. There is uncertainty in any forecast

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67
Q

Why is intrinsic value not relevant to liquidation value?

A
  1. It does not take into account “going concern” characteristic destroyed by selling assets individually. 2. Going concern assumption includes human capital that adds value to the assets by running the business. This is destroyed by selling the assets individually.
68
Q

Why is inventory worth more under going concern than liquidation value

A
  1. Established sales channels will achieve a higher price than a Fire-sale would.
69
Q

What is the formula to unlever a comparable company’s beta?

A

After Tax Asset Beta = Company Beta x 1/[1+ (1-t) x D/E]

Gross Asset Beta = Company Beta x 1/[1+ D/E]

70
Q

What formula re-levers the unlevered beta of comparable company to match Leverage Ratio of target company?

A
  1. Use target D and E. 2. Multiply comparable after tax unlevered Beta x [1+(1-t) x D/E] 3. Use Pre-tax Beta x [1+D/E]
71
Q

What is the after tax cost of capital for the firm?

A

WACC= (%D x kd) (1-t) + (%E x ke)

72
Q

How does survivorship bias affect historical estimates of equity risk premium

A
  1. Inflates the observed equity risk premium because companies that are losing relative value are eliminated from the index. 2. These companies exhibit negative returns which are then removed from the index and the observed historical returns do not reflect these.
73
Q

What is the appropriate discount rate for FCFE?

A

Required Return on Equity = Ke

74
Q

What is the appropriate discount rate for FCFF?

A

WACC = the weighted return for all providers of capital

75
Q

Give three reasons why FCFF and FCFE are better stated in nominal terms than real terms.

A
  1. Tax rate is nominal 2. Pre-tax earnings is nominal 3. Cash flow in real terms use anticipated purchase power which may not be realised
76
Q

Why is beta not used in calculating cost of equity from BYPRP?

A
  1. The bond yield (HTM) includes company specific risk premiums 2. The equity premium is added to company bond yield therefore is fully exposed to company specific risk factors.
77
Q

Give 2 special factors to consider when valuing private companies.

A
  1. Controlling interests 2. Marketability Note liquidity is not included
78
Q
  1. What is the Blume adjustment for? 2. How is it calculated?
A
  1. Raw betas tend to revert to the market (=1) over time. 2. The raw beta is adjusted to weight the expected tendancy towards 1 Adjusted beta = [raw beta x (2/3)] + [1 x (1/3)]
79
Q

In which fundamental stock multi factor models is Rf included?

A

CAPM=capital asset pricing model FFM=Fama French PSM=Pastor Stambaugh

80
Q

Build up method. What type of company is the build-up method good for? What type of beta does it use? How many components? What is the formula?

A
  1. Private companies (without publicly traded debt) 2. It is beta free! 3. Four components 3. Ke = Rf + ERPmkt + Size + Company specific premium
81
Q

Name one fundamental and one macro model for forward looking ERP

A
  1. GGM 2. Ibbotson-Chen
82
Q

Derive ERP using a fundamental forward looking model.

A
  1. GGM= [P=D1/(Rm-g)] = [(Rm-g) =(D1/P)] = Rm=[(D1/P) +g] 2. ERP=Rm -R longtermdebt 3. ERP=[(D1/P) +g] -R longtermdebt
83
Q

Derive forward looking ERP using a supply side model

A
  1. Rm=PIE+DIG Rm= [(1+EG_PE)(1+E_INFL)(1+EG_EPS) -1] + E_INC 2. ERP = [(1+EG_PE)(1+E_INFL)(1+EG_EPS) -1] + E_INC - Expected RF 3. This is Ibbotson-Chen model, Rm= PIE + DIG 3 (I) P/E growth 3 (II) Inflation 3 (III) Earnings growth 4 (IV) Dividend or income yield
84
Q

Explain E_INFL

A

EINF = [(1+YTM 20yr TBonds)/(1+YTM 20yr TIPS)] -1

85
Q

Explain EGR_EPS

A
  1. Expected growth rate in real(inflation adjusted) earning per share. 2. Track’s growth in GDP. 3. Real GDP growth=labour productivity growth + labour supply growth. E.g. 2% growth in labour productivity and 1% growth in labour supply = (1+EG_EPS)=1.03
86
Q

Explain EG_PE

A
  1. Reference level zero. 2. Positive (if undervalued) or negative (if over valued) 3. If fairly valued (1+EG_PE)=1
87
Q

Explain E_INC

A

The long term expected dividend yield of the S&P 500

88
Q

Why is residual income model suitable for startup companies?

A

Based on value of accrued earnings less cost of generating the earnings It does not require: 1. Free cash flow or 2. Dividends

89
Q

What is a factor risk premium?

A

Excess return above Rf attributed to the single factor as if it were the only factor in a single factor model

90
Q

What are the factor betas in FFM and what are their baselines

A

Re=Rf + [betas x factors] Market Beta = 1 Size Beta=0 Value Beta=0

91
Q

Describe the factor that Market Beta is exposed to in FFM

A

RMRF=Equity Risk Premium = Rm-Rf

92
Q

Describe the factor that Size Beta is exposed to in FFM

A
  1. Baseline is zero 2. Assumes small stocks are riskier than large stocks 3. Premium for investing in small stocks 4. R_small - R_big 5. Positive coefficient means smaller size
93
Q

Describe the factor that Value Beta is exposed to in FFM

A
  1. Difference in return of value and growth stocks 2. Book to Market ratio 3. A higher book to market ratio is riskier than a low book to market since lower market price is proxy for lower value added to the assets of the company compared with growth companies. 4. A positive coefficient means lower growth, higher book to market (value) 5. A positive value can also be a sign of financial distress
94
Q

What additional factor is present in Pastor-Stambaugh vs FFM

A

Liquidity

95
Q

How many factors in the Burmeister, Roll and Ross model? Name them.

A

Five factors CiTi IBM Confidence Time horizon Inflation Business Cycle Market timing The above are surprise factors except for Market Timing which is a function of the other 4

96
Q

Describe the BIRR equation.

A

Re=T_bill + (beta x Confidence Risk) + (beta x Time Horizon Risk) + (beta x Inflation Risk) + (beta x Business Cycle Risk) + (beta x Market Timing Risk)

97
Q

What is pure-play method?

A

Method to estimate Beta of a private company (target) as follows: 1. Unlever the beta of a comparable public company 2. Use Leverage Ratio of target company to reliever the beta from step 1

98
Q

What assumption about debt does pure-play make?

A

Beta of debt is zero. Debt has no exposure to equity risk factors

99
Q

Compare Pre-tax WACC with After-Tax WACC

A

Pre-tax WACC = Rd x [D/(D+E)] + Re x [E/(D+E)] After-tax WACC= Rd x (1-t) x [D/(D+E)] + Re x [E/(D+E)]

100
Q

What international concerns affect estimation of required Return?

A
  1. FX rates 2. Data issues 3. Model issues
101
Q

Explain how FX can affect estimation of required return

A
  1. ERP in local currency can be very different to ERP in foreign currency 2. ERP uses equity and bond data. FX gains and losses for equity are not matched by FX gains abd losses for bonds 3. ERP in FX is skewed from ERP in local currency
102
Q

Explain how data affects required Return estimation

A

Difficult to estimate ERP in foreign currency due to skew between Equity fx and bond fx

103
Q

How is fx risk factored into ERP estimation?

A

Add a country risk premium to ERP for developed market ERPi = ERP developed + Country Risk Premium

104
Q

Describe the Pastor-Stambaugh (PSM) model

A

PSM, Re = FFM (Market, Size, Growth) + LIQ (illiquidity premium) All factors have a factor beta LIQ baseline= zero LIQ + means less liquidity - > Re increases LIQ - means more liquidity - > Re decreases

105
Q

What is Build-up method for?

A

Closely held companies

106
Q

Describe required Return for closely held company using build up method

A

Beta Free Re = Rf + ERP_index + Size + Company Specific Company Specific = unsystematic, non diversifiable risk premium

107
Q

Name three additional considerations affecting price for closely held company using build up method

A
  1. Shareholder diversity 2. Controlling stakes 3. Marketability 4. illiquidity
108
Q

Describe and classify bond yield plus risk premium model of required return

A
  1. A Build up method 2. Estimates required equity return 3. Requires publicly traded debt for bond yield 4. Traded debt includes company specific risk premiums 5. Adds an Equity premium to the cost of debt capital BYPRP equity = YTM_Ltdebt + Risk Premium
109
Q

What is the most important forecast for forward looking financial statements?

A

Revenues

110
Q

Name three categories that are applied for top down forecasts

A
  1. Geographic 2. Business segment 3. Product line
111
Q

Where are sector disclosures found?

A
  1. Company reports under US GAAP & IFRS 2. Any segment with 10% or more of combined company revenues.
112
Q

Why is geographical analysis important?

A
  1. Different growth rates 2. Different competitive dynamics
113
Q

Why is segment analysis important?

A

Different segments can have significantly different 1. Economics 2. Growth rates 3. Competitive advantage

114
Q

Why is product analysis important

A

To understand 1. Revenue concentration around a one or few products 2. Competitiveness of product

115
Q

What is Country Premium

A

The extra risk an investor requires for emerging market risk

116
Q

Describe Country Risk Rating Model

A
  1. Regression model 2. Uses developed market ratings to develop model 3. Developing risk ratings are substituted into model
117
Q

Why is marginal after tax rate preferable to effective tax rate in WACC calculations?

A
  1. Marginal tax reflects companies cost of raising additional funds 2. Therefore forward looking 3. Effective tax rate is influenced by non recurring items
118
Q

How do you back out market value of equity from after tax WACC

A

MV enterprise = FV of all cashflows / WACC Since A = L + E MV enterprise = D + E MV equity = MV enterprise - Debt

119
Q

What discount rate is used for FCFE models

A

Required Return on Equity - > Re

120
Q

Which discount rate is correct for FCFF

A

After-Tax WACC

121
Q

Why is it preferable to use cash flows stated in nominal terms vs Real terms?

A

Nominal cash flows reflect tax more accurately than real cash flows

122
Q

What is the Top-Down valuation ontology

A

Economy Industry Sector Target EconomIST

123
Q

Name 3 factors contributing to conglomerate discounts

A

CLEER Capital allocation inefficiencies Lack of focus Endogenous Exogenous Research and measurement errors

124
Q

Give one example of Exogenous factor leading to conglomerate discount

A

Acquisition of businesses in unrelated sectors (neither horizontal or vertical) , leading to lack of focus

125
Q

What is the academic rationale for conglomerate discount

A
  1. Business diversification leads to frictions that lead to diminishing cash flows. 2. Business diversification reduces the upside potential of corporations. 3. Investors demand greater returns for negative skew in company returns which may be also due to other reasons.
126
Q

Explain holding period return for an equity investment

A

The holding period return (HPR) is the return over the entire investment horizon.

The return on an equity investment comes from investment income (dividends) and price appreciation (capital gains).

Therefore, the holding period return can be broken down into the dividend yield (DH/P0) and the price appreciation return [(PH − P0)/P0].

127
Q

Describe the Required Rate of return

A

The required return represents the minimum rate of return required by an investor to invest in an asset over a specified period of time, given its level of risk.

Stated differently, it represents the opportunity cost of investing in the asset (i.e., the highest level of expected return available from another asset of similar risk).

128
Q

What type of Alpha is ex-post alpha

A

Realised Alpha

129
Q

What is the return from convergence of price to value

A

Realized alpha is also known as ex-post alpha, and equals actual holding period return less
required return.

130
Q

Explain the IRR for a dividend-paying stock

A

IRR is the discount rate that equates the present value of expected cash flows from the asset to its price.

If the market price equals its intrinsic value, the IRR is equal to the required return on equity.

131
Q

Describe GGM estimate of ERP

A
132
Q

Explain the state of dividends, growth and bond yields during a recession

A

Dividends are higher due to price falls

growth is low dues to recession

bond yields are low

133
Q

Describe the difference in value between going concern and liquidation value

A

Going-concern value exceeds liquidation value by the application of human capital to the assets’ continuing productive capacity.

134
Q

What does D/E ratio of 1.8 imply for respective weight of debt and equity in the capital structure?

A

The weight of debt in the capital structure = 1.8 / 2.8 = 0.6429

The weight of equity in the capital structure = 1 / 2.8 = 0.3571

135
Q

To which factors in the BIRR model (macroeconomic) do Stocks generally have negative sensitivities.

A

Inflation risk - Higher-than-expected inflation is a negative for stocks.

Time horizon risk - An increase in the difference between long-term and short-term government bonds reduces the equity market risk premium and is a negative for stock prices.

136
Q

Describe working capital

A

Net current assets Current Assets - Current liabilities

137
Q

Which financial projections are important for forward looking income statements?

A

Revenue Operating costs a. Fixed: PPE b. COGS: % of sales c. SG&A: % of sales Non operating items Operating Profit (by division) Corporate income tax

138
Q

What financial projections are important for forecast cash flow statement

A

Operating Profit (from income statement based forecast) Capex Depreciation Working capital (as percentage of sales)

139
Q

What does cum dividend price include?

A

The dividend announced for that year but not yet paid out.

140
Q

Describe Growth phase (DDM)

A

High earnings High profit margins Low or zero payout ratio High investment Negative FCFE

141
Q

Describe Transition phase (DDM)

A

Above average earnings growth Lower profit margin and sales growth than growth phase Declining capital expense Positive FCF Increasing div payout

142
Q

Describe Mature phase

A

Stable, sustainable earnings growth, dividend payout ratios and ROE GGM is suitable

143
Q

Explain the difference between NI and Net Profit Margin

A

NI= sales x Net Profit Margin Net Profit=Net Income

144
Q

Critique the statement “no equity investor needs to understand valuation models because real-time market prices for equities are easy to obtain online” R24, Q1

A
  1. Not all equity is publicly traded. 2. Information content- “No Equity investor.. “ is flawed. Active investors believe market prices do not reflect all information. 3. Stale prices - publicly traded equities may have stale prices due to low volumes/liquidity. 4. Valuation models - (a) Translate investor forecasts into value estimates (b) Allow for comparison with the market
145
Q

Intrinsic value is defined as “the value of an asset given a hypothetically complete understanding of the assets investment characteristics”. Discuss why “hypothetical” with examples. R24, Q2

A
  1. Knowledge of intrinsic value is hypothetical due to uncertainty of intrinsic value estimates: (a) Analyst forecasts (b) All sources of risk 2. Knowledge of investment characteristics is always incomplete. 3. An analyst can only make estimates of intrinsic value and there is always risk of mistakes.
146
Q

Explain why liquidation value is generally not relevant to estimating intrinsic value for profitable companies. R24, Q3(a)

A
  1. A profitable business is a going concern. 2. Going concern is a characteristic recognised by intrinsic value. 2. Liquidation value assumes the value added by using all the assets and human capital in the business etc. is zero, therefore not suitable for estimating intrinsic value of a stock.
147
Q

Explain whether making a going concern valuation affects the value placed on a company’s inventory R24, Q3(B)

A

To do

148
Q

Compare the difference in adjustments to get FCFF from EBIT and EBITDA

A

EBIT adds back full value of depreciation and amortization EBITDA adds back the tax shield for Depreciation and Amortization

149
Q

What adjustments are the same to get FCFF from EBIT and EBITDA

A

Earnings x (1-T) - Capex - WC

150
Q

Outline Capitalized Cashflow Method

A
  1. Constant growth in Cashflow over infitine period. 2. Firm Value = One period GGM using FCFF, WACC and sustainable growth rate 3. Value of equity = Firm Value - Market Value of Debt
151
Q

Explain how the procedure to infer future growth of a company is different using valuation based on (a) market expectation and (b) independent estimate.

A

(a) Market Price is used as the input to the model to blackout inferred growth. (b) For independent valuation the market price is an unknown variable determined by analyst estimates of other variables in the model.

152
Q

What are the implications for valuation of a company when increasing the discount rate, to maintain the same price forecast?

A
  1. Future cashflows would need to be higher 2. This implies that a higher growth rate is required.
153
Q

Why is the U in UFSCA important for performing sensitivity analysis?

A

Highlights the critical inputs that affect the key business aspects and hence most important for a forecast.

154
Q

MFG has a current price of 7.73 and projected dividends of 0.05 analyst projects its future price as 9.20. What other information is needed to form an opinion?

A
  1. Time frame is required. 2. Cost of equity 3. Growth rate
155
Q

What is the effect of the following pre-acquisition policies on a target: 1. Targets must pay up all expenses before acquisition, example all pending accounts payable. 2. After acquisition normal expense patterns are resumed.

A
  1. Acceleration of payment recognition reduces target earnings pre acquisition. 2. Following acquisition, earnings growths normalise and push up acquirers growth rate.
156
Q

What sources of perceived Mispricing (alpha) do active managers exploit?

A

The difference between intrinsic (unobservable) value and market price. Estimated intrinsic value is not used to determine alpha.

157
Q

Which valuation model is suitable for a high growth company with negative earnings and no dividends?

A

FREE CASH FLOW

158
Q

Top down forecasts must include the following forecasts

A

MICA GE Macroeconomic Industry Company Asset General economic conditions affect company

159
Q

Name two aspects when converting forecasts to valuations

A

Sa Sa converts forecasts Situational adjustments Sensitivity adjustments

160
Q

Explain the relationship between Expected return, price appreciation and dividend yield

A

Expected return = Price appreciation + Dividend yield

161
Q

What is the effect on Equity risk premium of including earlier returns of an index?

A
  1. Many companies do not survive and survivorship bias lowers equity risk premium. 2. Therefore including more older returns increases estimate of equity risk premium.
162
Q

What is the effect on required Return on Equity if Rf is based on short-term rate that overstates inflation or is higher than the long term rate.

A

Required Return on Equity will increase because: a) Rf is higher than expected to be in the future b) Rm will be higher

163
Q

What did Eva say to PAT

A

Eva said NoPAT don’t WACC TopCAT EVA = NOPAT - (WACC x Total Capital) NoPAT = EBIT x (1-T)

164
Q

Compare concept of Residual income with accounting income

A
  1. It explicitly deducts all cost of capital 2. It compares net income with the opportunity cost for shareholder capital
165
Q

What is Residual Income

A

Net Income adjusted for the cost due to the Equity holders if they made a charge that year.

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