Equity Flashcards
Calculate the implied growth rate in residual income given the market price-to-book ratio and an estimate of the required return on equity.
Distinguish between required return and expected return.
Calculate and interpret the present value of growth opportunities (PVGO) and the component of the leading price-to-earnings ratio (P/E) related to PVGO.
Define invested capital.
Cash and cash equivalents plus net fixed assets plus operating assets less operating liabilities (i.e., working capital requirements). Operating assets reflect receivables, inventories, and prepaid expenses. Operating liabilities include payables and accrued expenses.
List the steps in the development of a sales-based pro forma company model.
Identify the two primary versions of the three-stage growth models.
Describe the two major sources of errors in the valuation exercise of a sensitivity analysis.
Describe the top-down approach to projecting future revenue.
Explain and calculate the weighted-average cost of capital (WACC) for a company.
Judge the competitive position of a company based on a Porter’s five forces analysis.
Determine the company’s position with regard to the threat of substitute products, rivalry among existing competitors, threat of new entrants, and the bargaining power of suppliers and customers.
Describe the adjustments to earnings and capital required for the EVA interpretation.
Explain the justified price multiple for a stock.
The justified price multiple uses fair or relative value. Based again on the market perspective, market price multiples less than justified multiples are undervalued and market multiples greater than justified multiples are overvalued.
Evaluate whether a stock is undervalued, fairly valued, or overvalued based on a free cash flow valuation model.
Evaluate the use of net income and EBITDA as proxies for cash flow in valuation.
Calculate the equity control premium adjustment for valuing a private company.
Evaluate whether a stock is overvalued, fairly valued, or undervalued by the market based on a DDM estimate of value.
Explain the appropriate adjustments to net income, EBIT, EBITDA, and cash flow from operations (CFO) to calculate FCFF.
FCFF = NI + NCC + Int(1−t) − FCI − WCI
=CFO + Int (1−t) − FCI
=EBIT (1−t) + Dep − FCI − WCI
=EBITDA (1−t) + Dep(t) − FCI − WCI
Evaluate the effects of technological developments on demand, selling prices, costs, and margins.
Describe how control premiums are determined.
Explain the use of sensitivity analysis in FCFF and FCFE valuations.
Calculate and interpret the implied growth rate of dividends using the Gordon growth model and current stock price.
Identify the reasons why earnings may need to be adjusted upward for profitable private companies.
Describe a hybrid approach.
Describe strengths and limitations of the Gordon growth model and justify its selection to value a company’s common shares.
Compare growth rates in the first stage for the two versions of the two-stage free cash flow model.
Estimate the required return on an equity investment iusing the capital asset pricing model.
Calculate the value of noncallable fixed-rate perpetual preferred stock.
Explain how dividends, share repurchases, share issues, and changes in leverage affect future FCFF and FCFE?
List the concerns analysts have when estimating the required return on equities in a global context.
Estimate the required return on an equity investment using the BIRR model.
Calculate residual income using the model for valuing small businesses in tax cases.
Calculate the value of a common stock using the Gordon growth model (GGM) and explain the model’s underlying assumptions.
List the advantages and drawbacks of dividend yield.
Dividend yield is a component of total return and is less risky than the capital gains component. The market may or may not price these two components of total return differently.
Higher dividend yield implies lower earnings growth.
Explain strengths and weaknesses of residual income models.
Explain how competitive factors affect prices and costs and describe the relationship between return on invested capital and competitive advantage.
Define sustainable growth rate (SGR).
Explain continuing residual income and justify an estimate of continuing residual income at the forecast horizon given company and industry prospects. Calculate and interpret the intrinsic value of a common stock using a multistage residual income model.
Describe the justified EV/EBITDA multiple based on fundamentals, all other things remaining the same.
Calculate and interpret the sustainable growth rate g of a company, and demonstrate the use of DuPont analysis to estimate a company’s sustainable growth rate.
Explain how to forecast industry sales and costs when they are subject to price inflation or deflation.
Forecast nonoperating costs (e.g., financing costs and income taxes).
Explain the use of spreadsheet modeling to forecast dividends and to value common shares.
Calculate the value of a company using the free cash flow, capitalized cash flow, and excess earnings methods.
Explain the income, market, and asset-based approaches to private company valuation.
Income – The value of an asset as the present value of its expected future cash flows.
Market – The value of an asset based on market price and enterprise value multiples from recently sold comparable assets.
Asset-based – The value of a business as the net value of its assets less liabilities.
Evaluate whether a stock is overvalued, fairly valued, or undervalued based on a residual income model.
Perspectives on valuation from the market price:
Undervalued: P < V
Fairly valued: P = V, +/−
Overvalued: P > V
Describe why the relation between r and g is critical.
Compare models used to estimate the required rate of return to private company equity
Calculate the value of a private company based on the prior transaction method (PTM).
Evaluate the effects on private company valuations of discounts and premiums based on control and marketability.
Where discounts for both control and marketability are appropriate, first reduce the marketable control position to noncontrolling and then the marketable minority position to nonmarketable:
VNMP = VMCP(1−DLOC) (1−DLOM)
Caution: Lack of control may be indicated by using nonnormalized earnings metrics.
Calculate the value of a private company using pricing multiples derived by any market approach method.
Explain why the rationale that companies with lower negative P/Es are preferred for companies with zero or negative earnings.
Calculate and interpret the justified P/S ratio for a stock based on forecasted fundamentals.
How are residual income, economic value added, and market value added used?
If a company is generating more (less) income than its cost of capital, it is generating positive (negative) residual income, and therefore creating (destroying) value. Alternatively stated, the firm creates value when its ROE exceeds it’s required return on equity.
This may be used for performance incentives.
Explain why revenue and expenses associated with nonoperating real estate are removed from the income statement during normalization.
Explain the effects on private company valuations of discounts and premiums based on control and marketability.
Describe rationales for and possible drawbacks to using alternative price multiples and dividend yield in valuation.
Explain the bottom-up approach to projecting future revenue.
Describe noncash charges (NCC).
Explain the two approaches to overcoming the weaknesses in required return estimation for developing countries.
Describe the disadvantages of price to cash flow.
Describe the Pastor-Stambaugh model (PSM).
Describe the advantages and disadvantages of the guideline public company method (GPCM).
Describe free cash flow if a company also has preferred stock in its capital structure.
Compare public and private company valuation.
Describe how working capital accounts are typically forecast using efficiency ratios.
Explain an analyst’s choices in developing projections beyond the short-term forecast horizon.
Explain the advantages of price to cash flows.
Justify the selection of a residual income model to value a company’s common stock.
Explain the disadvantages of enterprise value to EBITDA.
Calculate the intrinsic value of a common stock using the residual income model.
Explain the assumptions and justify the selection of the H-model. Calculate and interpret the value of common shares using the H-model.
Explain limitations to the cross-sectional regression methodology for predicting P/E.
The regression may have poor predictive quality when applied to other stocks, or outside the sample period. Changing market valuation of earnings may diminish the predictive power of the model.
Such regressions tend to suffer from multicollinearity, which makes it difficult to interpret individual regression coefficients.
Explain market value added (MVA).
Calculate and interpret the justified leading and trailing P/Es using the Gordon growth model (GGM).
Define market value.
Explain alternative definitions of cash flow used in price and enterprise value (EV) multiples, and describe limitations of each definition.
List the types of bottom-up approaches.
Compare the free cash flow to the firm (FCFF) and free cash flow to equity (FCFE) approaches to valuation.
Interpret an equity risk premium using historical and forward-looking estimation approaches.
Explain the going-concern assumption, and contrast a going-concern value to a liquidation value.
Calculate and interpret the value of a common stock using the dividend discount model (DDM) for single and multiple holding periods.
Describe rationales for using the price-to-sales ratio.
Describe approaches for forecasting FCFF and FCFE.
Define internal rate of return.
Calculate and interpret residual income (also Edwards-Bell-Ohlson model or the discounted abnormal earnings model).
Residual income explicitly deducts a charge for capital to determine cash flows available.
RI = Income − Capital charge = NI − (Ke × re) OR = NI − (KT × WACC)
WACC in this case is calculated using book rather than market values for debt and equity.
Evaluate whether a stock is overvalued, fairly valued, or undervalued based on comparisons of multiples.
What special types of items should be included in calculating book value of equity for residual income valuation?
Describe “clean surplus” issues to be adjusted in applying residual income models.
Explain the use of the arithmetic mean, the harmonic mean, the weighted harmonic mean, and the median to describe the central tendency of a group of multiples.
Explain the discount rate.
Discount rate – Any rate used to find the PV of cash flows.
ri = p + E(I) + RPi
=real disutility of delayed consumption + expected inflation + asset − specific risk premiums
=rf + RPi
Compare value recognition in residual income models and other present value models.
Define investment value.
Describe Porter’s 5 forces and 3 generic strategies framework for assessing a firm’s competitive environment.
Intra-industry rivalry
threat of new entrants
threat of substitutes
supplier
buyer power
Cost leadership, differentiation, and focus.
Describe valuation multiples used in market approach methods.
Price/earnings, where earnings are normalized
Market value of invested capital (MVIC) – Market values of debt and equity
Enterprise value (EV) = MVIC – Cash & equivalents
Denominators include EBITDA for larger companies that use leverage, net income for smaller firms, and revenues for microfirms.
Describe the method and basis used to value the equity interest.
Calculate the value of a private company based on the guideline transaction method (GTM).
Calculate and interpret alternative price-earnings multiples and dividend yield.
Forward P/E: P0/E1 (Also, prospective/leading)
Trailing P/E: P0/E0 (Also, current P/E)
Trailing P/E is used when an accurate earnings forecast is difficult.
Forward dividend yield: Div1/P0
Compare dividends, free cash flow, and residual income as inputs to discounted cash flow models and identify investment situations for which each measure is suitable.
Identify the advantages of price to book value.
BV usually remains positive even when the company reports negative earnings and is typically more stable over time than reported earnings. BV reflects market values for financial sector companies and is useful in valuing liquidating businesses.
Studies suggest that differences in P/B ratios over time are related to differences in long-term average returns on stocks.
Calculate the equity risk premium (ERP) based on survey estimates.
Describe intrinsic value.
Define valuation and intrinsic value, and explain sources of mispricing.
Describe the asset-based (cost) approach to private company valuation.
Fair value of assets less fair value of liabilities.
If fair value is not available or applicable, the weaker cost approach may be used (e.g., liquidations) using “orderly liquidation.”
This approach may also be reasonable for companies with assets/liabilities estimated based on fair market values (banks/financials) or market value (real estate investment companies).
Explain the appropriate adjustments to net income, EBIT, EBITDA, and cash flow from operations (CFO) to calculate FCFE.
Describe market approach methods.
Explain beta estimation for thinly traded public companies and nonpublic companies.
Explain the single-stage (i.e., constant growth) FCFF and FCFE models.
Distinguish between the method of comparables and the method based on forecasted fundamentals as approaches to using price multiples in valuation, and explain economic rationales for each approach.
Describe questions that should be addressed in conducting an industry and competitive analysis.
List the applications of equity valuation.
Evaluating business strategies and models; inferring market expectations; selecting stocks
Communicating with analysts and shareholders; evaluating corporate events
Appraising private business; rendering fairness opinions
Share-based payments
Calculate and interpret the P/E-to-growth ratio (PEG) and explain its use in relative valuation.
Estimate the implicit inflation rate for a time period nusing T-bonds and Treasury inflation-protected securities (TIPS).
Explain the ways in which it is possible for a stock’s current market price to imply a negative PVGO.
Explain cash flow estimation issues related to private companies and adjustments required to estimate normalized earnings.
Calculate and interpret the justified price-to-book value ratio (P/B or P/BVPS) based on forecasted fundamentals.
Forecast operating costs (e.g., cost of goods sold COGS; selling, general, and administrative SGA).
Define enterprise value to sales (EV/Sales).
Evaluate whether economies of scale are present in an industry by analyzing operating margins and sales levels.
Distinguish between the growth relative to GDP growth approach and the market growth and market share approach.
Explain considerations in the choice of an explicit forecast horizon.
Calculate and interpret the justified price-to-earnings ratio (P/E).
Calculate and interpret an equity risk premium using the Gordon growth model (GGM-forward looking).
Calculate an equity risk premium (ERP).
ERP = re − rf
E(ri) = E(rf) + ERP + RPi
Where ERP is a market risk premium for a diversified portfolio of equity securities, RPi represents an idiosyncratic risk premium for asset i.
Explain sources of differences in cross-border valuation comparisons.
Evaluate a stock by the method of comparables, and explain the importance of fundamentals in using the method of comparables.
Explain the growth stage, transition stage, and maturity stage of a business.
Calculate the fully adjusted pricing multiple for use in the guideline public company method (GPCM).
Adjustments for growth and risk should be made before adjusting for control:
Public company multiple × (1 + Adj for growth/risk)
= Multiple adj for growth/risk
×(1 + Adj for control)
= Multiple adj for growth/risk & control
Explain the assumptions and justify the selection of the two-stage DDM. Calculate and interpret the value of common shares using the two-stage DDM.
Describe the direct and indirect approaches for valuing FCFE.
The direct approach values FCFE directly while the indirect approach first calculates FCFF and then subtracts debt from the valuation. The indirect approach subtracts the nontax deductible part of interest and net borrowing (repayments less new borrowing) from
FCFF: FCFE = FCFF − Int(1−t) + net borrowing
Explain the discount for lack of marketability (DLOM) where private equity has been valued as liquid.
Explain adjustments made to the book value in order to (1) make book value more reflective of shareholders’ investment and (2) to increase its comparability across companies.
Describe relative strength indicators and their use in valuation.
Identify the types of abrupt changes that can be a challenge in long-term forecasting.
Describe the pure-play method analysts use to estimate the beta of a particular project or a nonpublic company.
Describe uses of private business valuation and explain applications of greatest concern to financial analysts.
Contrast absolute and relative valuation models, and describe examples of each type of model.
Distinguish between realized holding-period return (HPR) and expected HPR.
Describe the long-run sustainable growth rate in both versions of the two-stage free cash flow model.
g = ROE(1−DPR) = ROE(RR)
For a declining industry, the second-stage growth rate could be slightly lower than the GDP growth rate.
For an industry with brighter prospects, the second-stage growth rate could be slightly higher than the GDP growth rate.
Explain broad criteria for choosing an appropriate approach for valuing a given company.
Explain the strengths and weakness of the CAPM model.
Estimate the required return on an equity investment using the Fama-French model (FFM).
Distinguish between the recognition of value between the residual income model and the dividend discount and free cash flow models.
Explain factors relevant to selecting among the income, market, and asset-based approaches to private company valuation.
Income – Cash flows are available or can be projected. Estimates can be made for variables required to justify a valuation.
Market – Comparable firms with marketable security prices are available but reasonable cash flows or other variables are not.
Asset-based – An income or market value is not available, or the individual assets less liabilities would have greater value than the ongoing enterprise (liquidation value).
Describe other issues to be adjusted in applying residual income models.
Calculate and interpret the intrinsic value of a common stock using a single-stage (constant-growth) residual income model.
Identify the disadvantages of price to book value.
Explain methods of normalizing EPS for the effect of business cycles.
Calculate and explain the use of price multiples in determining terminal value in a multistage discounted cash flow (DCF) model.
Calculate and interpret enterprise value, and evaluate the use of EV/EBITDA.
EV= MVE + MVD + MVP − Cash − STInv
Minority interest should be added if not included elsewhere.
EV is positive even when earnings are negative. EV/EBITDA removes effects of interest and depreciation, so is useful for valuing firms with different financial and operating leverage. It is useful for assessing a control perspective.
Explain the discount for lack of control (DLOC) where private equity has been valued using a control perspective.
Describe considerations for assessing multiples.
Differentiate between depreciation forecasts and capital expenditure forecasts.
Explain the macroeconomic and statistical factors for estimating returns required returns on stocks.
Describe sum-of-the-parts valuation and conglomerate discounts.
Describe momentum indicators and their use in valuation.
Describe adjustments to the valuation multiple appropriate for risk and growth.
Estimate the value of a company’s equity when the firm owns significant nonoperating assets.
Ve = Aoperating + ANonoperating − Debt − Preferred
Where debt and preferred shares are at market value.
Describe definitions of value, and justify which definition of value is most relevant to public company valuation.
Describe drawbacks to using the price-to-sales ratio.
Explain the assumptions and justify the selection of the three-stage DDM. Calculate and interpret the value of common shares using the three-stage DDM.
The growth phase gives way to a transitional growth phase, possibly using the H-model, and then continues with mature growth.
Describe the three types of general tax rates.
Calculate and interpret economic value added (EVA).
Explain the ownership perspective implicit in the FCFE approach. Compare the FCFE model and dividend discount models.
Estimate a required return based on any DDM, including the Gordon model and the H-model.
Calculate and interpret underlying earnings.
Estimate the required return and equity risk premium on an equity investment using macroeconomic multifactor models.
Explain why effective tax rates may differ.
Effective tax rates differ when a company operates in multiple jurisdictions with different statutory tax rates.
Effective tax rates increase when a company earns higher profits in countries with higher statutory tax rates.
