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CFA Level II 2020 COPY (552) > Equity > Flashcards

Equity Flashcards

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1
Q

Intrinsic Value

A

a calculated value determined through fundamental analysis (could differ from MV)

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2
Q

What to look for in the financial statement footnotes

A

a. Reclassifying gains and nonoperating income
b. Off-balance-sheet issues
c. Expense recognition
d. Accelerating of income
e. Amortization, depreciation, and discount rates

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3
Q

Absolute vs Relative Valuation Models

A

Absolute valuation models:

valuation based solely on investment characteristics, not outside firms

a. Dividend discount models
b. FCF,
c. RI

Valuation Models:

determining value in relation to the value of other assets (e.g. P/E)

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4
Q

Conglomerate discount

A

Purpose: investors apply a markdown for companies in multiple industries.

Because:

a. Internal capital inefficiency
b. Research valuation errors

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5
Q

How to Annualize a Return

A

To annualize the return

Formula: (1 + r)^t - 1

Example: (for 1% in 1 month):

(1 + 0.01)^12 - 1 = 0.1268 or 12.68%

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6
Q

Equity Risk Premium

A

Rm - Rf

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7
Q

Required Return for a Stock

A

CAPM: RF + B(equity risk premium)

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8
Q

Gordon Growth Model Equity Premium

A

(D1 / P) + g - RF

Weakness:

  1. assumes stable growth rate
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9
Q

Gordon Growth Model Expected Return

A

(D1 / P) + g

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10
Q

Build Up Method for Required Return

A

RF + equity risk premium + size premium + specific company premium

Can be used for closely held companies

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11
Q

Types of Return

A

Geometric < Arith

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12
Q

What is Beta?

A

Systematic risk

Tends to drift towards 1

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13
Q

What is Adjusted Beta?

A

Blumes Adjusted Beta: (2/3 x beta) + (1/3 x 1)

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14
Q

What are Porter’s Five Forces?

A
  1. Threat of New Entrants
  2. Threat of Substitutes
  3. Bargaining Power of Buyers
  4. Bargaining Power of Suppliers
  5. Rivalry Among Existing Competitors
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15
Q

Strategy Industry Styles

A

Adaptive Less Predictable Less Malleable

Classical More Predictable Less Malleable

Shaping Less Predictable More Malleable

Visionary More Predictable More Malleable

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16
Q

Classical Industry Style

A

Goal is to optimize efficiency (Using Porters 5 forces is an example)

Industry Examples: Oil companies, household products, tobacco. auto

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17
Q

Adaptive Industry Style

A

have to react quickly to change.

Goal is to maximize flexibility

Industry Examples: Specialty retail, office electronics, construction materials, biotech

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18
Q

Shaping Industry Style

A

goal is to influence their environment (Software is a good example)

Look to define new markets and technologies

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19
Q

Visionary Industry Style

A

Follows a “build it and they will come” approach. Very risky

i. Must have adequate resources and be long-term

Industry examples: food products, gas utilities, aerospace and defense, media, and insurance

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20
Q

Economies of scale

A

occurs if costs decreases and sales increase

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21
Q

COGS Forecast

A

forecast COGS = (historical COGS / revenue) x (estimate of future revenue)

OR

(1 - gross margin)(estimate of future revenue)

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22
Q

Forecasting financing costs; net debt and net interest expense

A

Net debt = gross debt - cash/short-term securities

Net interest expense = gross interest expense - interest income - cash/short-term securities

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23
Q

ROIC

A

better than ROE since it compares different capital structures

ROIC = NOPLAT / (operating assets - operating liabilities)

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24
Q

When to use dividend discount models

A

i. Company has a history of dividend payments
ii. Dividend policy is clear and related to the earnings of the firm
iii. Perspective from a minority shareholder

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25
Q

What is FCFF?

A
  1. Purpose: cash that can be paid out to bondholders and shareholders
  2. It is the cash after the firms buys/sell products, provides services, pay operating expenses, and makes short/long-term investments.
  3. FCFF = firm value
  4. discounted at the WACC
  5. Can use when FCFE is negative
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26
Q

What is FCFE?

A
  1. It is the cash available to common shareholders after funding capital requirements, working capital, and debt financing
  2. FCFE is discounted at the required return on equity
  3. FCFE is also Equity value = firm value - MV of debt
  4. Use when capital structure is not volatile
  5. Leverage affects FCFE
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27
Q

When to use FCFF and FCFE

A

i. Firms that do not have a dividend history or one that is not related to earnings
ii. When free cash flow is related to earnings
iii. Perspective from a controlling shareholder

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28
Q

Residual Income Definition

A

Purpose: earnings that exceeds the required return

Can be applied to negative free cash flow and non-dividend paying firms.

Firms must have high quality reporting

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29
Q

One and Two Period DDM Valuation

A

One Period DDM: V0 = D1 + P1 / 1 + R

Two Period DDM: V0 = D1 / (1 + R) + D2 + P2 / (1 + R)²

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30
Q

Leading and Trailing GGM

A

Leading GGM: D1 / r - g

Trailing GGM: D0 x (1 + g) / r - g

31
Q

GGM Assumptions

A

Assumptions:

  1. Dividend is expected in 1 year and grow forever at a constant rate
  2. Dividends related to earnings
  3. G is less than r
32
Q

PVGO

A

PVGO: V0 = E1 / R + PVGO

33
Q

Justified leading P/E

A

Justified leading P/E = (1 - b) / r - g)

34
Q

Justified trailing P/E

A

Justified trailing P/E = (1 - b) * (1 + g) / r - g

35
Q

GGM Strengths and Weaknesses

A

Strengths

i. Is applicable to stable, mature, dividend-paying firms.
ii. Is easily communicated

Weaknesses

i. Valuations are very sensitive to estimates of g & r
ii. Cannot use for non-dividend-paying stocks
iii. Unpredictable growth patterns would be difficult

36
Q

Growth Phases and Models to Use

A

a. Initial growth phase:
i. rapidly increasing earnings, no dividends, heavy reinvestment
ii. Use three-stage model
b. Transition phase:
i. dividends increasing but at a slower rate
ii. Use two-stage or H model
c. Mature phase:
i. earnings grow slowly and payout ratios are stable
ii. Use GGM

37
Q

H-Model

A

D0 * (1 + gL) + D0 * H * (gS - gL)

r - gL r - gL

38
Q

GGM Required Return

A

D1 / P0 + g

39
Q

Sustainable Growth Rate

A

SGR = b x ROE

ROE = NI/SE

OR

Profit margin x asset turnover x financial leverage

40
Q

DuPont

A

g = (NI - dividends) * NI * sales * total assets

NI sales total assets SH equity

41
Q

FCFF/FCFE Formula breakdowns

A
  1. Noncash Charges (NCC)
    Represents expenses that reduced NI but didn’t result in an outflow of cash
    They are Depreciation, Amortization, write-down/impairment
  2. Fixed Capital Investment (FCInv)

FCInv = ∆ of gross PP&E

OR ∆ in net PP&E + depreciation

Make sure to subtract any long-term assets that were sold

  1. Working Capital Investment (WCInv)

∆ in WC: current assets - current liabilities

Dont include cash or NP

  1. Interest Expense
  2. Net borrowing: difference between short and long-term debt accounts
42
Q

FCFF Formulas

A

  1. FCFF Net Income = NI + NCC + [Int * (1 - tax rate)] - FCInv - WCInc
  2. FCFF EBIT = [EBIT * (1 - tax rate)] + Dep - FCInv - WCinc
  3. FCFF EBITDA = [EBITDA * (1 - tax rate) + (Dep * tax rate) - FCInv - WCInc
  4. FCFF CFO = CFO + {Int * (1 - tax rate)] - FCInv

Note: EBITA is a poor proxy

If Preferred Stock is there make sure to add back

43
Q

FCFE Formulas

A
  1. FCFE from FCFF = FCFF - Int(1 - tax rate) + net borrowing
  2. FCFE from Net Income = NI + NCC - FCInv - WCInv + net borrowing
  3. FCFE from CFO = CFO - FCInv + net borrowing

Note: If Preferred Stock is there make sure to subtract

44
Q

CFO

A

CFO = Net income + NCC - WCInv

Then if you adjust for taxes it = FCFF

Then add net borrowing it = FCFE

45
Q

Single-Stage FCFF Model

A

(same as GGM) used for stable mature firms

Formula: FCFF1 / WACC - g

OR

FCFF0 * (1 + g) / WACC - g

Assumptions: FCFF grows at a constant rate

g < WACC

46
Q

Single-Stage FCFE Model

A

(Same as FCFF) often used for international valuation with high inflation

FCFE1 / r - g

OR

FCFE0 * (1 + g) / r - g

47
Q

P/E Ratio

A

Advantages:

  1. widely used as a proxy for risk and growth
  2. P/E differences are related to long-run stock returns

Disadvantages:

  1. earnings can be negative
  2. volatile earnings hard to interpret
  3. management can distort earnings
48
Q

P/B Ratio

A

Advantages:

  1. Can be used with negative earnings and bankruptcy
  2. BV more stable than EPS
  3. More appropriate for firms with liquid assets (e.g. finance, insurance, and banks)

Disadvantages:

  1. Does not reflect full economic value (e.g. human capital)
  2. Difficult due to size differences
  3. Management can distort BV
49
Q

P/S Ratio

A

Advantages:

  1. Good for distressed firms, mature, cyclical industries, and START UPS
  2. Not easy to manipulate
  3. Not as volatile as P/E

Disadvantages

  1. High sales does not mean high profits
  2. Does not capture differences in cost structure
50
Q

Justified P/B ratio

A

Justified P/B ratio = ROE - g / r - g

51
Q

Justified P/S

A

Justified P/S = (Earnings/Sales) * payout ratio * (1 + g) / r - g

52
Q

Justified P/CF

A

Justified P/CF = FCFE0 * (1 + g) / r - g

THEN divide by CF

53
Q

PEG Formula

Disadvantages

A

P/E ratio / g

Lower the better

Disadvantages:

Relationship between P/E and g is not linear

Doesn’t account for risk

54
Q

Enterprise Value (EV)

A

Enterprise Value (EV) = MV of common stock + MV of preferred equity + MV of debt - cash and investments

Be able to rearrange!

Useful for comparing companies with different financial leverage

Disadvantages: if WC increases EBITDA will be overstated

55
Q

Residual Income Per Share Formula

A

RI = EPS1 - (BVPSt-1 * r)

EPS = BVPS * ROE

56
Q

Economic Value Added (EVA)

AKA

Economic Profit

A

Purpose: measures the value added for shareholders

Formula: NOPLAT - (WACC * total capital)

OR

[EBIT x (1 - t)] - $WACC

57
Q

Single Stage RI valuation

A

Remember:

  1. g = retention ratio * ROE!!!!!
  2. RI reverts to 0 over time
  3. r is the COST OF EQUITY

Also: 1 + r is the value now (instead of r - g)

58
Q

RI implied growth rate

A
59
Q

RI Strengths/weaknesses

A

Strengths:

  1. Terminal value does not dominate the intrinsic value estimate
  2. Applicable even without dividends or positive cash flow

Weaknesses:

  1. can be manipulated by management.
  2. requires numerous and significant adjustments.
  3. The models assume that the clean surplus relation holds
60
Q

RI should be used when?

A
  1. Firm pays no dividends
  2. Expected cash flow is negative
  3. TV forecast is highly uncertain
  4. Evaluates managerial effectiveness
61
Q

Clean surplus violations are

A
  1. Pension adjustments
  2. Operating leases
  3. SPEs
  4. AFS changes
  5. Foreign currency G/L

Solution: Calc ROE using comprehensive income (NI + ∆OCI)

62
Q

Definitions of value

A
  1. Fair value: used for tax purposes and financial reporting
    1. Cash price based on free market and well-informed buyer/seller
  2. Market value: used for appraisals (used for Real Estate)
    1. Requires willing and informed seller/buyer, appraised value
  3. Investment value: value specific to a buyer
    1. Think about future cash flows, perceived risk, appropriate discount rates, financing costs, synergies
  4. Intrinsic value: derived from investment analysis
63
Q

What to use when valuing private companies?

A
  1. Early stages = asset-based

a. Assets - liabilities
b. Lowest valuation. Used for poorly performing firms, REITS, intangible assets

  1. Growth stage = income approach
    a. values a firm at the PV of future income
  2. Mature = market value
    a. values a firm using price multiples based on recent sales
64
Q

Discount for Lack of Control (DLOC)

A

Minority shareholders are at a disadvantage b/c they have less power

DLOC = 1 - [1 / 1 + control premium]

65
Q

Combining DLOC and DLOM

A

DLOC and DLOM = 1 - [(1 - DLOC)(1- DLOM)]

66
Q

Market value added (MVA)

A

difference between l/t debt and equity and the BV of invested capital

MV equity + MV of debt - total capital

67
Q

Growth Rate of Dividends

A

(Latest Dividend / Beginning Dividend)^1 / n

Then - 1

n = # of years between dividends

68
Q

Capitalized Cash Method (CCM)

A

good when no comparables are available, stable growth expected

69
Q

Excess earnings method (EEM)

A

Excess earnings method (EEM): excess earnings over required return

Allows for WC, FC, and intangible assets to use different discount rates.

Used for small firms with significant intangible assets

70
Q

Capitalization rate

A

(WACC – Long-term growth rate)

71
Q

Breaking down Debt-to-Equity Ratio

A

D/E / (1 + D/E)

Example: Debt to equity of 0.3

0.3 / (1 + 0.3) = 23.08%

That is the debt %

72
Q

Residual Income Standard Formula

A

NI - equity charge

NI also = EBIT - interest expense - income tax expense

equity charge = equity capital * cost of equity

73
Q

RI Income with Persistance

A

BV0 + [(ROE - r)*BV0] / 1 + cost of equity - w]

w = persistence factor (assumption of a decreasing RI)

74
Q

Justified Forward P/E

A

Is it P0 / E1 which = (1 - b) * (r - g)

CFA Level II 2020 COPY (552) (13 decks)

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