Equity Flashcards

Question 1

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5.1 Equity Valuation : Applications and Processes

Answer

A

– Define valuation and intrinsic value and explain sources of perceived mispricing.
– Explain the going concern assumption and contrast a going concern value to a liquidation value.
– Describe definitions of value and justify which definition of value is most relevant to public company valuation.
– Describe applications of equity valuation.
– Describe questions that should be addressed in conducting an industry and competitive analysis.
– Contrast absolute and relative valuation models and describe examples of each type of model.
– Describe sum-of-the-parts valuation and conglomerate discounts.
– Explain broad criteria for choosing an appropriate approach for valuing a given company.

Question 2

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Intrinsic Value and Mispricing

1- Definition of Intrinsic Value
– Intrinsic value is the “true” value of an asset, based on a complete understanding of its investment characteristics.
– It cannot be directly observed and must be estimated.

2- Market Efficiency and Intrinsic Value
– In perfectly efficient markets with perfect information, assets would trade at their intrinsic value.
– In reality, market prices often deviate from intrinsic value due to market inefficiencies, creating opportunities for mispricing.

3- Formula for Perceived Mispricing
– The formula for perceived mispricing is:
— “V_E - P = (V - P) + (V_E - V)”

4- Explanation of Variables
– V_E: Investor’s estimate of the security’s value.
– P: Current market price.
– V: Security’s “true” or intrinsic value.

5- Sources of Perceived Mispricing
– The first term “(V - P)” represents true mispricing, i.e., the difference between intrinsic value and market price.
– The second term “(V_E - V)” represents estimation error, i.e., the difference between the investor’s estimate of intrinsic value and the actual intrinsic value.

6- The Paradox of Market Efficiency (Grossman and Stiglitz, 1980)
– If prices perfectly reflect intrinsic value, investors would not expend resources to research companies, making market prices less meaningful.
– Investors must expect that active research and analysis will lead to profitable opportunities, ensuring intrinsic value is reflected in market prices.

Answer

A

Key Takeaways
– Market inefficiencies create opportunities for mispricing, allowing active investors to generate profits.
– Both true mispricing and estimation error contribute to perceived mispricing.
– The paradox of market efficiency highlights the need for active participation to maintain meaningful market prices.

Question 3

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Going-Concern Value vs. Liquidation Value

1- Going-Concern Value
– The going-concern value assumes the company will continue to operate for the foreseeable future.
– It is typically used unless the company is facing financial distress, in which case liquidation value may be more appropriate.

2- Liquidation Value
– Liquidation value is the net amount that could be generated if the company’s assets were sold, after deducting liabilities.
– It is generally lower than the going-concern value because it reflects the value of assets sold under distressed conditions.

3- Orderly Liquidation Value
– If assets can be sold in an orderly manner (not under distress), the orderly liquidation value will be higher than the typical liquidation value.

Question 4

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Fair Market Value vs. Investment Value

1- Fair Market Value
– Fair market value is the price agreed upon by a willing buyer and a willing seller under the following conditions:
— Both parties are informed about the asset.
— Neither party is compelled to trade.
– This concept is widely used across accounting standards, although definitions may vary.

2- Investment Value
– Investment value is subjective and varies based on individual circumstances.
– It reflects the value of an asset to a specific investor, considering factors such as synergies or strategic benefits.
— For instance, investment value may be higher for a buyer who can exploit potential synergies from the asset.

Question 5

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Applications of Equity Valuation

1- Selecting Stocks
– Equity analysts use valuation to identify overpriced or underpriced stocks for investment decisions.

2- Inferring Market Expectations
– Market prices reflect assumptions that can be evaluated through valuation models to determine their reasonableness.

3- Evaluating Corporate Events
– Valuation tools help assess the impact of events like mergers, acquisitions, divestitures, spin-offs, and leveraged buyouts.

4- Rendering Fairness Opinions
– Third-party valuation is often required in mergers to determine the fairness of the proposed offer price.

5- Evaluating Business Strategies and Models
– Companies use valuation to measure the impact of strategies or business models on shareholder value.

6- Communicating with Analysts and Shareholders
– Valuation concepts support discussions regarding factors that influence a company’s value.

7- Appraising Private Businesses
– Private businesses need to be valued for transactions such as sales, mergers, or initial public offerings (IPOs).

8- Share-Based Payments
– Equity valuation determines the cost of compensating executives with stock grants and other share-based payments.

Question 6

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Key Steps in the Valuation Process

1- Understand the Business
– Analyze the company’s industry, competitive position, and overall strategy to gain a clear understanding of its operations and value drivers.

2- Forecast Company Performance
– Project financial metrics such as revenue, expenses, and cash flows based on historical data, industry trends, and strategic plans.

3- Select an Appropriate Valuation Model
– Choose the valuation method that best fits the company’s characteristics and the purpose of the analysis (e.g., DCF, relative valuation).

4- Convert Forecasts to Valuation
– Use the selected model to calculate the company’s value based on the forecasted performance.

5- Apply Valuation Conclusions
– Interpret the results, compare them to market data, and make decisions based on the valuation outcomes (e.g., investment decisions or transaction pricing).

Question 7

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Understanding the Business: Industry and Competitive Analysis

1- Importance of Industry Analysis
– Analyzing the industry is critical to forecasting a company’s financial performance.
– Industries are subject to specific risks and economic drivers (e.g., airlines face labor costs and fuel prices).

2- Michael Porter’s Five Forces Framework
– Factors that make an industry more attractive:
— 1- Low rivalry among industry participants.
— 2- High barriers to entry, reducing the threat of new competitors.
— 3- Few substitutes or high switching costs for customers.
— 4- Many suppliers competing for the business of a few producers.
— 5- Many customers with limited bargaining power compared to producers.

3- Assessing the Company’s Position
– Analysts must evaluate the company’s competitive strength within the industry.

4- Porter’s Three Corporate Strategies
– To achieve above-average performance, companies can:
— 1- Be the lowest-cost producer while offering comparable products or services (e.g., low-cost airlines).
— 2- Differentiate products or services to command premium prices (e.g., luxury goods).
— 3- Focus on specific segments within an industry (e.g., niche products tailored to specific user needs).

Question 8

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Understanding the Business: Analysis of Financial Reports

1- Purpose of Financial Reports
– Financial reports provide critical insights into a company’s business model and strategic priorities.
– For instance, high advertising expenses may indicate a focus on building brand loyalty.

2- Importance of Financial Metrics
– Financial metrics are particularly significant when evaluating established companies in mature industries, where consistent data and trends are available.

3- Consideration for Younger Companies
– For younger companies or those in emerging industries, analysts may prioritize non-financial metrics, such as market share growth, user engagement, or product development progress.

Question 9

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Understanding the Business: Sources of Information

1- Primary Sources of Information
– Companies provide critical disclosures through regulatory filings, press releases, and conference calls.
– These sources offer valuable insights into a company’s operations, strategy, and financial performance.

2- Supplementary Information
– Analysts should also use third-party sources, such as:
— Industry groups.
— Regulators.
— Data providers.
— Non-governmental organizations.

3- Ethical Considerations
– According to CFA Institute Standards, analysts must not act on or encourage others to act on material nonpublic information.

Question 10

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Understanding the Business: Considerations in Using Accounting Information

1- Quality of Earnings
– Analysts should evaluate the quality of earnings by assessing:
— The accuracy of financial reporting.
— The sustainability of earnings over time.
– This involves a thorough analysis of financial statements, including the balance sheet and statement of cash flows.

2- Net Income vs. Operating Cash Flow
– Net income should align with operating cash flow over the long term.
– A high proportion of accruals relative to cash flows may indicate low-quality earnings, as cash earnings are generally more persistent.

3- Scrutiny of Footnotes and Disclosures
– Analysts should examine footnotes and other disclosures for potential red flags, such as:
— Inadequate or vague disclosures.
— Aggressive revenue recognition practices.
— Related-party transactions.
— Off-balance-sheet financing.
— High turnover rates among managers or directors.

Question 11

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Forecasting Company Performance

1- Top-Down Approach
– Focuses on the broader economic environment, then narrows to the industry, and finally to the company.
– The company’s sales forecast is derived from:
— Overall industry sales.
— The company’s market share.

2- Bottom-Up Approach
– Begins with a micro-level analysis of the company’s operations.
– Details such as prices and unit costs are aggregated to create a company-level forecast of sales and profitability.

Question 12

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Selecting the Appropriate Valuation Model: Absolute Valuation Models

1- Definition
– Absolute valuation models estimate a company’s intrinsic value, which is then compared to its market price to assess potential mispricing.

2- Present Value Models (Discounted Cash Flow Models)
– These models calculate intrinsic value based on future cash flows, discounted to the present. Commonly used metrics include:
— Dividends.
— Free Cash Flow to Equity (FCFE).
— Free Cash Flow to the Firm (FCFF).
— Residual Income (accrual accounting earnings exceeding opportunity costs).

– Challenges in equity valuation using present value models:
— Predicting future cash flows involves uncertainty.
— Estimating appropriate discount rates is complex.

3- Asset-Based Valuation
– This method estimates a company’s value based on the market value of its assets and the resources it controls.
– Often applied to natural resource companies, such as oil companies, where proven reserves are valued using market prices (e.g., oil futures contracts).

Question 13

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Selecting the Appropriate Valuation Model : Relative Valuation Models

1- Definition
– Relative valuation models estimate an asset’s value by comparing it to the value of a similar asset or a benchmark.
– Common ratios used include price-to-earnings (P/E), price-to-book (P/B), and EV/EBITDA.
– A stock with a low P/E relative to peers or the industry average is considered relatively undervalued.
– Key assumption: Identical or comparable assets should sell for the same price.

2- Applications in Investment Strategies
– Portfolio Weighting: Investors may underweight high P/E stocks and overweight low P/E stocks compared to their benchmark weights.
– Pairs Trading: A more aggressive strategy where an investor:
— Goes long on a relatively undervalued stock.
— Takes an equivalent short position in an overvalued stock from the same industry.
— Profitability depends on the undervalued stock rising more (or falling less) than the overvalued stock.

3- Limitations
– Relative valuation models do not estimate intrinsic value.
– They only assess whether an asset is relatively undervalued or overvalued compared to another asset.

Question 14

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Valuation of the Total Entity and Its Components

1- Sum-of-the-Parts Valuation
– This approach calculates the value of each business segment of an entity independently.
– It is especially useful for conglomerates, which operate in multiple, unrelated industries.

2- Conglomerate Discount
– A conglomerate discount occurs when investors perceive that:
— Capital is being inefficiently allocated across business units.
— The company is compensating for poor performance by acquiring unrelated businesses.
– It is possible that some observed conglomerate discounts are due to measurement errors rather than actual inefficiencies.

3- Breakup Value
– The sum-of-the-parts approach can reveal whether a company’s market price is lower than its breakup value, i.e., the value of its individual segments if sold separately.
– A conglomerate trading below its breakup value may present an investment opportunity.

Answer

A

Key Takeaways
– Sum-of-the-parts valuation is ideal for analyzing conglomerates with diverse business segments.
– The presence of a conglomerate discount may indicate inefficiencies or mispricing, but it could also result from valuation challenges.
– Investors can use this method to identify whether a company is undervalued relative to its breakup value.

Question 15

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Issues in Model Selection and Interpretation

1- Consistency with the Company’s Characteristics
– The selected valuation model should align with the company’s specific attributes.
— Example: Asset-based models are suitable for banks due to their large share of marketable assets.

2- Data Availability and Quality
– The chosen model must be appropriate for the data available.
— Example: A dividend discount model is unsuitable for a company that does not plan to pay dividends in the near term.

3- Purpose of the Valuation
– The model should match the valuation’s objective.
— Example:
—- Free Cash Flow to Equity (FCFE) models are ideal for minority investments.
—- Free Cash Flow to the Firm (FCFF) models are better suited for acquisitions involving a controlling majority position.

Answer

A

Key Takeaways
– Analysts must ensure the valuation model fits the company’s characteristics, the data quality, and the purpose of the analysis.
– Choosing an inappropriate model can lead to inaccurate valuations and flawed decision-making.

Question 16

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Steps in Converting a Forecast to a Valuation

1- Sensitivity Analysis
– Sensitivity analysis evaluates how changes in key inputs affect valuation outcomes.
— This is essential for uncertain parameters like growth rates or pricing strategies.

2- Situational Adjustments
– Adjustments are made based on investor circumstances and market conditions. Examples include:
— Control Premium: Investors may pay a premium for majority ownership compared to a minority share.
— Marketability Discount: Applied to private company shares to reflect the lack of a secondary market.
— Illiquidity Discount: For public companies with thinly traded shares.
— Blockage Factor: Discount to account for difficulties in executing large block trades without affecting market prices.

Answer

A

Key Takeaways
– Sensitivity analysis is crucial for assessing the robustness of valuations under different assumptions.
– Situational adjustments, including control premiums, marketability, and illiquidity discounts, address specific investor and market scenarios.
– These steps ensure the valuation reflects real-world considerations.

Question 17

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Applying the Valuation Conclusion: The Analyst’s Role and Responsibilities // Roles of Analysts in Financial Markets

1- Sell-Side Analysts
– Employed at brokerage firms, sell-side analysts produce research reports for clients, such as:
— Pension funds.
— Investment management firms.

2- Buy-Side Analysts
– Work for investment management firms, trusts, and similar institutions.
– Their analysis directly supports investment decisions.

3- Corporate Analysts
– Focus on valuing potential investments and identifying merger or acquisition targets.

4- Analyst Contributions
– Analysts help clients make informed buy and sell decisions.
– They improve market efficiency by providing valuable insights.
– Analysts also monitor management performance, aiding capital suppliers in their assessments.

Question 18

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Examining Financial and Operational Strategic Execution

1- Key Principles
– Do not solely rely on quantitative measures when assessing a company’s financial and operational performance.
– Avoid extrapolating past operating results as the sole basis for forecasting future performance.

2- Tendency to Regress to the Mean
– Successful companies may experience performance declines over time.
– Struggling companies may show improvements, moving closer to the industry average or mean.

Question 19

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Analysis of Financial Reports

1- Use of Financial Ratios
– Financial ratio analysis is particularly valuable for established companies.
– Ratios can help indicate the strategy being pursued by the company (e.g., cost leadership or differentiation).

2- Relatively High Gross Margins
– Companies with high gross margins often focus on building and maintaining a strong brand.
– This strategy typically involves:
— Significant advertising expenses to reinforce brand value.

Question 20

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Forecasting Company Performance

1- Top-Down Approach
– Begins with macroeconomic factors and narrows down to the company level.
— Step 1: Analyze the economic environment (e.g., GDP growth).
— Step 2: Project industry revenue based on GDP estimates.
— Step 3: Estimate the company’s revenue using its forecasted market share.

2- Bottom-Up Approach
– Starts with company-specific operational and financial data.
— Example: Use historical data from similar company operations to project performance.
— Step 1: Analyze the company’s operating characteristics, such as sales data.
— Step 2: Use micro-level inputs (e.g., revenue per store) to forecast total performance, like revenue at new retail locations.

Question 21

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Valuation Models and Pairs Trading

1- Types of Valuation Models
– When using a going-concern assumption, two primary valuation models are applied:
— Absolute Valuation Models: Focus on intrinsic value based on cash flows or asset values.
— Relative Valuation Models: Use the method of comparables, which assesses an asset’s value relative to similar assets or benchmarks (e.g., price-to-earnings or price-to-book ratios).

2- Pairs Trading Strategy
– Involves taking a long position in a relatively undervalued stock and an equivalent short position in a relatively overvalued stock from the same industry.
– Benefits of pairs trading:
— Creates an investment profile that is neutral to overall market risk.
— Exploits relative mispricings between the two securities to generate profit.

Question 22

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Research Reports: Contents, Format, and Responsibilities

1- Contents of a Research Report
– Key elements of a research report include:
— Investment recommendations with supporting key assumptions.
— Descriptions of valuation models and qualitative factors influencing the valuation.
— Discussion of uncertainties in intrinsic value estimates.
– Reports must be timely, clear, objective, and informative.
– Analysts must distinguish facts from opinions and disclose any actual or potential conflicts of interest.

2- Format of a Research Report
– While formats vary, most reports include:
— Table of contents.
— Investment conclusion.
— Business summary.
— Risks, valuation details, and historical data.

3- Research Reporting Responsibilities
– CFA Institute members are obligated to:
— Exercise reasonable care and independent professional judgment in their analysis.

Question 23

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Characteristics of an Effective Research Report

1- Key Components of the Report
– Provide comprehensive background information, including:
— Key assumptions.
— Specific forecasts and valuation inputs.
— A clear description of the valuation model used.
– Address underlying uncertainties proactively.
– If a target price is included, specify the time frame for achieving it.

2- Characteristics of Effectiveness
– 1: Contains timely information.
– 2: Is clearly written.
– 3: Maintains objectivity, with key assumptions explicitly identified.
– 4: Distinguishes between facts and opinions.
– 5: Is internally consistent in its analysis and conclusions.
– 6: Provides sufficient information to enable readers to critique the conclusions.
– 7: Identifies key risk factors associated with the recommendation.
– 8: Discloses conflicts of interest that may affect objectivity.

Answer

A

Key Takeaways
– An effective research report ensures clarity, objectivity, and transparency while addressing risks and uncertainties.
– It empowers readers to evaluate the quality of intrinsic value estimates and assess the validity of the conclusions.

Question 24

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Format of a Research Report

1- The Table of Contents
– Organizes the report structure.
– Essential for long research reports to help readers navigate the content.

2- The Summary and Investment Conclusions
– Provides a concise overview of key points and investment recommendations.
– Allows readers to grasp the overall message without reading the entire report.

3- The Business Summary
– Details the company’s operations, industry, and competitive landscape.
– Helps readers understand the company’s current position and strategic outlook.

4- The Risk Section
– Highlights potential risks that could impact the investment.
– Explains what could go wrong and how those risks may affect valuation or performance.

5- The Valuation Section
– Goes beyond the bottom-line valuation figure.
– Describes the valuation model used and key input assumptions that support the analysis.

6- Historical Data
– Provides factual data to substantiate the conclusions.
– Ensures the report is well-supported with evidence and trends.

Question 25

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CFA Institute Standards of Professional Conduct Pertaining to Research Reports

1- Standard I(B): Independence and Objectivity
– Members and Candidates must maintain independence and objectivity in their professional activities.
– They must not offer, solicit, or accept any gift or benefit that could compromise their independence or objectivity.

2- Standard I(C): Misrepresentation
– Members and Candidates must avoid knowingly making any misrepresentations in investment analysis, recommendations, or other professional activities.

3- Standard V(A): Diligence and Reasonable Basis
– V(A)1: Members and Candidates must exercise diligence, independence, and thoroughness in their investment analysis and actions.
– V(A)2: They must have a reasonable and adequate basis for their recommendations, supported by appropriate research and investigation.

4- Standard V(B): Communication with Clients and Prospective Clients
– V(B)1: Members and Candidates must disclose to clients the principles of their investment processes and any material changes.
– V(B)2: They must use reasonable judgment in identifying factors important to investment decisions and include these in communications.
– V(B)3: Members and Candidates must distinguish between fact and opinion in their analyses and recommendations.

5- Standard V(C): Record Retention
– Members and Candidates must develop and maintain records to support their investment-related communications, analysis, and actions.

Question 26

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Quiz - Understanding Mispricing: Difference Between Intrinsic Value and Market Price
1- Overview of the Question
The question asks which source of perceived mispricing active investment managers attempt to identify, based on Statement 2. The goal is to determine the difference that leads to mispricing concerns.

2- Correct Answer
A: Intrinsic value and market price.

3- Explanation

1- Understanding Mispricing:
– Mispricing occurs when there is a gap between the true intrinsic value of a security and its market price.
– Active managers aim to capture positive alpha by identifying and exploiting this gap.

2- Why A is Correct:
– 1- Intrinsic value refers to the “true” but unobservable value of a security, determined through fundamental analysis.
– 2- Market price is the observable price at which the security is traded in the market.
– 3- Mispricing results from the gap between true intrinsic value (unobservable) and the market price. This is the foundation of alpha generation for active managers.

3- Why B is Incorrect:
– 1- The estimated intrinsic value is an analyst’s subjective approximation of the true intrinsic value.
– 2- While analysts may use estimates to identify potential mispricing, the mispricing itself arises from the deviation between true intrinsic value and market price, not from the estimated value.

4- Why C is Incorrect:
– 1- Comparing intrinsic value and estimated intrinsic value highlights potential analyst errors, which is unrelated to the mispricing active managers exploit.
– 2- This does not address the gap between true intrinsic value and market price, which is the focus of the question.

Answer

A

Key Takeaways
– Mispricing refers to the difference between intrinsic value and market price.
– Active managers aim to exploit this gap to generate positive alpha.
– True intrinsic value is unobservable, but its deviation from market price is the foundation of mispricing analysis.
– Answer A reflects this relationship, making it the correct choice.Key Takeaways
– Mispricing is defined as the gap between intrinsic value (unobservable) and market price (observable).
– Active investment managers generate positive alpha by identifying and exploiting this gap.
– The correct answer, A, reflects this relationship, while B and C misinterpret the focus of mispricing.

Question 27

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Quiz - Understanding Measures of Value: Relevance for Core Equity Fund
1- Overview of the Question
The question asks which measure of value is most relevant for the core equity fund described in Statement 4, focusing on companies expected to generate significant future free cash flows from core operations.

2- Correct Answer
C: Going-concern value.

3- Explanation

1- Understanding Going-Concern Value:
– Going-concern value reflects a company’s ability to continue operating and generating future cash flows.
– For companies in a core equity fund, future free cash flow from operations is a primary consideration, making this measure of value most relevant.

2- Why C is Correct:
– 1- The fund focuses on financially sound companies with sustainable business operations and the ability to generate future free cash flows.
– 2- The emphasis on future operations aligns directly with the going-concern value, which assumes the company will continue to operate indefinitely.

3- Why A is Incorrect:
– 1- Liquidation value is the value realized by selling off a company’s assets, assuming operations cease.
– 2- This measure is not relevant for well-capitalized companies with strong future cash flow prospects, as they are not expected to be liquidated.

4- Why B is Incorrect:
– 1- Investment value is specific to a particular investor and reflects unique factors such as synergies or investor-specific objectives.
– 2- While investment value may be used in certain contexts, it is not the focus for selecting companies in a core equity fund based on their general ability to generate future cash flows.

Question 28

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Market prices reflect the expectations of investors about the future performance of companies. The analyst can evaluate the reasonableness of the expectations implied by the market price by comparing the market’s implied expectations to his own expectations. This process assumes a valuation model, as discussed in the text.

Question 29

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Quiz - Appropriateness of Asset-Based Valuation for Companies
1- Overview of the Question
The question asks which company in Exhibit 1 is most appropriate for an asset-based valuation approach, based on Lacroix’s notes.

2- Correct Answer
B: NCF.

3- Explanation

1- Understanding Asset-Based Valuation:
– Asset-based valuation is most suitable for companies whose value is closely tied to their tangible assets, such as natural resource companies.
– The value is determined by applying the current market price of commodities to the proven reserves of the company, with adjustments for extraction costs.

2- Why B is Correct (NCF):
– 1- NCF is a pure-play natural resource company, deriving revenues from commodities such as iron, copper, zinc, and nickel.
– 2- Its assets can be valued using an asset-based approach by assessing the market price of its reserves and applying necessary discounts for extraction.

3- Why A is Incorrect (FTK):
– 1- FTK, a forest products company, also derives a significant portion of revenue from media operations, which are intangible in nature.
– 2- The mixed nature of FTK’s revenue sources makes asset-based valuation less appropriate.

4- Why C is Incorrect (PSH):
– 1- PSH is a manufacturing company involved in machinery and industrial operations, which rely heavily on operational profitability rather than tangible asset valuation.
– 2- Asset-based valuation is generally inappropriate for such companies.

Question 30

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Quiz - Identifying Overvalued Stocks Based on Holland’s Criteria
1- Overview of the Question
The question asks which company or companies from Exhibit 1 are most likely to be considered overvalued according to Holland’s criteria.

2- Correct Answer
A: FTK only.

3- Explanation

1- Holland’s Overvaluation Criteria:
– A stock is overvalued if its P/E ratio is at least two standard deviations above the mean index P/E ratio.
– The mean index P/E ratio is 8.50, and the standard deviation is 0.20.
– The overvaluation threshold is calculated as:

Threshold = Mean P/E + (2 × Standard Deviation) = 8.50 + (2 × 0.20) = 8.90.
2- Calculating P/E Ratios for the Stocks:
– 1- PSH:

Share Price = Market Value ÷ Shares Outstanding = $620m ÷ 15m = $41.33.
P/E Ratio = Share Price ÷ EPS = $41.33 ÷ $4.96 = 8.33.
Below the threshold, not overvalued.
– 2- FTK:

Share Price = Market Value ÷ Shares Outstanding = $1,240m ÷ 38m = $32.63.
P/E Ratio = Share Price ÷ EPS = $32.63 ÷ $3.64 = 8.96.
Above the threshold, overvalued.
– 3- NCF:

Share Price = Market Value ÷ Shares Outstanding = $900m ÷ 20m = $45.00.
P/E Ratio = Share Price ÷ EPS = $45.00 ÷ $5.15 = 8.74.
Below the threshold, not overvalued.
3- Why A is Correct:
– FTK is the only stock with a P/E ratio above the overvaluation threshold of 8.90.

4- Why B is Incorrect:
– NCF’s P/E ratio is 8.74, below the threshold. It is not overvalued.

5- Why C is Incorrect:
– PSH and NCF both have P/E ratios below the threshold. FTK is the only stock meeting the overvaluation criteria.

Question 31

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Quiz - Identifying Companies Likely to Reflect a Conglomerate Discount
1- Overview of the Question
The question asks which company is most likely to have a share price reflecting a conglomerate discount, based on the provided information.

2- Correct Answer
A: FTK.

3- Explanation

1- Understanding Conglomerate Discounts:
– A conglomerate discount is applied when a company operates in multiple, unrelated sectors.
– Investors may perceive that conglomerates allocate capital less efficiently or fail to capture synergies compared to companies focused on a single sector.

2- Why A is Correct (FTK):
– 1- FTK derives 30% of its revenues from a media division, which is unrelated to its primary business of forest products.
– 2- This diversification across unrelated sectors makes FTK more likely to experience a conglomerate discount, as investors may view its capital allocation as inefficient.

3- Why B is Incorrect (NCF):
– NCF is a natural resource company with revenues tied to mining operations (iron and non-ferrous metals).
– It does not operate in unrelated sectors, making a conglomerate discount unlikely.

4- Why C is Incorrect (PSH):
– PSH is a manufacturing company producing machinery with applications in various industries.
– While the products are used across diverse sectors, PSH itself is not involved in multiple, unrelated businesses.

Question 32

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5.2 Discount Dividend Valuation

Answer

A

– 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.
– Calculate and interpret the value of a common stock using the dividend discount model (DDM) for single and multiple holding periods.
– Calculate the value of a common stock using the Gordon growth model and explain the model’s underlying assumptions.
– Calculate the value of non-callable fixed-rate perpetual preferred stock.
– Describe strengths and limitations of the Gordon growth model and justify its selection to value a company’s common shares.
– Calculate and interpret the implied growth rate of dividends using the Gordon growth model and current stock price.
– 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.
– Calculate and interpret the justified leading and trailing P/Es using the Gordon growth model.
– Estimate a required return based on any DDM, including the Gordon growth model and the H-model.
– Evaluate whether a stock is overvalued, fairly valued, or undervalued by the market based on a DDM estimate of value.
– Explain the growth phase, transition phase, and maturity phase of a business.
– Explain the assumptions and justify the selection of the two-stage DDM, the H-model, the three-stage DDM, or spreadsheet modeling to value a company’s common shares.
– Describe terminal value and explain alternative approaches to determining the terminal value in a DDM.
– Calculate and interpret the value of common shares using the two-stage DDM, the H-model, and the three-stage DDM.
– Explain the use of spreadsheet modeling to forecast dividends and to value common shares.
– Calculate and interpret the sustainable growth rate of a company and demonstrate the use of DuPont analysis to estimate a company’s sustainable growth rate.

Question 33

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Broad Steps in Discounted Cash Flow (DCF) Analysis

1- Defining Cash Flows
– Identify the appropriate cash flows for valuation (e.g., dividends, free cash flow to equity, or free cash flow to the firm).

2- Forecasting Cash Flows
– Project the future cash flows based on assumptions about the company’s growth, profitability, and other key factors.

3- Choosing a Discount Rate Methodology
– Determine the appropriate discount rate to use, such as the cost of equity or the weighted average cost of capital (WACC).

4- Estimating a Discount Rate
– Calculate the specific discount rate that reflects the riskiness of the cash flows and the company’s cost of capital.

Dividend Discount Models (DDMs)
– In cases where dividends are considered the appropriate measure of cash flows, DCF models are referred to as Dividend Discount Models (DDMs).

Question 34

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Streams of Expected Cash Flows

Stocks can be valued using different streams of cash flows: dividends, free cash flows, or residual income. This section focuses on dividends.

1- Dividends Overview
– Stock investors typically receive returns in the form of dividends.
– Earnings not distributed as dividends are reinvested earnings, expected to improve the company’s profitability over time.
– Dividends are generally less volatile than earnings, making dividend discount models (DDM) less sensitive to short-term earnings fluctuations and better suited for estimating long-term intrinsic value.

2- Reasons for Dividend Policies
– Companies may choose not to pay dividends:
— If they are unprofitable and lack cash to distribute.
— If they are highly profitable but prefer to reinvest cash into operations for growth.
– In recent decades, dividend-paying companies have declined as share repurchases have become more common.

3- Valuing Non-Dividend-Paying Companies
– DDM can still be used to value companies not currently paying dividends if future dividend timing and amounts are predictable.
– However, forecasting future dividends for non-dividend-paying firms is challenging.

4- Conditions for Using DDM
The DDM is most appropriate when:
– The company pays dividends.
– The dividend policy aligns with the company’s profitability.
– The investor holds a non-control perspective (e.g., minority shareholder).

Question 35

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Non-Control Perspective

1- Definition
– Investors with a non-control perspective are content to passively receive dividends rather than actively influencing a company’s dividend policies or decision-making.

2- Relevance
– This perspective is typical of minority shareholders who do not seek to alter corporate policies but rely on management’s judgment regarding dividend distributions.

Answer

A

Key Takeaways
– The non-control perspective aligns with valuation approaches like the Dividend Discount Model (DDM), which assumes dividends are the primary return to investors.
– Investors focus on receiving dividends as a reflection of the company’s profitability and policy decisions.

Question 36

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Free Cash Flows

A company’s cash flows are generated and utilized through operations, investments, and financing activities. For a going concern, cash flows are essential for reinvestment and new investments. Different measures of cash flows include:

1- Types of Cash Flows
– Cash Flow from Operations (CFO): Cash generated through day-to-day activities, including buying and selling products or services.
– Free Cash Flow to the Firm (FCFF): Cash flows available to all capital providers (bondholders and stockholders).
— Calculated as CFO minus capital expenditures.
– Free Cash Flow to Equity (FCFE): Cash flows available to shareholders only.
— FCFE ≈ FCFF - debt payments + funds raised from new debt issues.

2- When to Use Cash Flow-Based Valuation Models
Cash flow-based models, such as those using FCFF or FCFE, are most appropriate when:
– The company is not dividend-paying.
– The company pays dividends that differ significantly from FCFE.
– Projected free cash flows align with the company’s profitability.
– The investor holds a control perspective or views the company as a potential merger target.

3- Limitations of Free Cash Flow Models
– Intense capital demands: Free cash flow models may undervalue companies reinvesting all cash flows into projects.
– Choice between FCFF and FCFE:
— FCFF is preferred when significant changes in capital structure are expected.
— FCFE is specific to shareholders and may not account for lender-related cash flows.

Answer

A

FCFE = CFO - FC_INV + Net debt (Net borrowing)

Question 37

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Residual Income

1- Definition
– Residual income represents a company’s earnings in excess of the investors’ required return on common stock.
– The required rate of return reflects the opportunity cost for investors compared to other investments with equivalent risk.
– Stock Value Calculation:
— A stock’s value is determined as:
—- Book value per share + Present value of expected future residual earnings.

2- Applications of Residual Income Models
– This approach can be used for both dividend-paying and non-dividend-paying stocks.
– It focuses on profitability relative to opportunity cost.

3- When to Use the Residual Income Approach
This method is especially suitable when:
– The company does not pay dividends (as an alternative to free cash flow models).
– The company has negative expected free cash flows.

Answer

A

Key Takeaways
– Residual income provides a flexible valuation method that accounts for profitability exceeding required returns.
– It is particularly valuable for non-dividend-paying companies or firms with insufficient or negative free cash flows.

Question 38

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Dividend Policies and Rationales

1- Reasons for Not Paying Dividends
– Companies may refrain from paying dividends due to:
— Lack of profitability: They have no cash to distribute.
— Profitability with reinvestment focus: Highly profitable companies may choose not to pay dividends to retain cash for reinvestment in growth opportunities.

2- Rationale for Paying Dividends
– Mature, profitable companies often pay consistent dividends because:
— They have limited investment opportunities.
— Returning cash to shareholders is viewed as a better use of funds.

Question 39

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Example: Calculating Residual Income

1- Scenario
– Shareholders’ initial investment: $150 million.
– Required rate of return: 6%.
– Company earns: $10 million during the year.

2- Calculations
– Required Return:
— $150 million × 6% = $9 million.

– Residual Income:
— $10 million (earnings) − $9 million (required return) = $1 million.

3- Conclusion
– Residual income represents the economic gain to shareholders, in this case, $1 million, which is the surplus after meeting the required return on investment.

Question 40

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Residual Income Model

1- Formula for Stock’s Value
– Stock’s value = Book value per share + Present value of expected future residual earnings.

2- Book Value Per Share
– Calculated as:
— Common stockholders’ equity ÷ Number of common shares outstanding.

Question 41

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Expression for a Single Holding Period

1- Formula for Stock Value over One-Year Holding Period
– “V0 = (D1 + P1) ÷ (1 + r)^1”.

2- Explanation of Variables
– D1: Dividend received at the end of the holding period.
– P1: Selling price of the stock at the end of the holding period.
– r: Required rate of return.

Question 42

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Expression for Multiple Holding Periods

1- Formula for Stock Value Over Multi-Year Holding Period
– “V0 = T∑_t=1 (Dt ÷ (1 + r)^t) + (Pn ÷ (1 + r)^n)”.

2- Explanation of Variables
– Dt: Dividends received at the end of period t.
– Pn: Selling price of the stock at the end of the holding period (n years).
– r: Required rate of return.
– n: Total number of holding periods.
– t: Time period for each dividend payment, ranging from 1 to n.

Question 43

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Dividend Discount Model (DDM) for Infinite Dividends

1- Overview of the Concept
– The DDM calculates the value of a stock as the present value of all future dividends. If dividends are assumed to continue indefinitely, the following formula applies.

2- Formula
– Infinite Dividend Discount Model formula:
— “V0 = ∞∑_t=1 [Dt ÷ (1 + r)^t]”

3- Explanation of Variables
– V0: Current value of the stock.
– ∞∑_t=1: Summation from t=1 to infinity.
– Dt: Dividend expected in time period t.
– r: Required rate of return or discount rate.

4- Simplifications to the DDM
– Because forecasting infinite dividends is challenging, two common simplifications are used:
— 1- Assume future dividends follow a growth pattern:
—- Examples: Constant growth, two-stage growth, or three-stage growth.
— 2- Forecast a finite number of dividends and a terminal value:
—- The forecast horizon depends on the predictability or visibility of earnings.

Question 44

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Gordon Growth Model

1- Overview of the Concept
– The Gordon Growth Model assumes that dividends grow at a constant rate indefinitely. This allows the calculation of a stock’s present value based on the growth of future dividends.

2- Formula
– Gordon Growth Model formula:
— “V0 = [D0(1 + g) ÷ (r - g)] = [D1 ÷ (r - g)]”

3- Explanation of Variables
– V0: Present value of the stock.
– D0: Dividend paid in the current period.
– D1: Dividend expected in the next period (D1 = D0(1 + g)).
– r: Required rate of return.
– g: Constant dividend growth rate.

4- Assumptions and Conditions
– The model assumes that the required rate of return (r) is greater than the growth rate (g), ensuring a finite value. If r ≤ g, the value of the stock would be infinite or undefined.
– Both r and g should reflect long-term expectations for accuracy. Small changes in these parameters can lead to significantly different valuations.

5- Suitability
– The model is most appropriate when:
— Dividends exhibit a stable and predictable growth pattern.
— The relationship between profitability and dividends is consistent.

Question 45

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Example: Gordon Growth Model

1- Problem Description
– A company’s most recent quarterly dividend (D0) is $0.24. Dividends are expected to grow at a constant rate of 5% per year (g = 0.05). The required return on equity (r) is 7% (0.07).
– Calculate the stock’s current value (V0) using the Gordon Growth Model.

2- Solution
– First, calculate the annualized dividend for the next period (D1):
— “D1 = D0(1 + g)”
— “D1 = (4 × 0.24)(1.05)”
— “D1 = 1.05”.

– Then, use the Gordon Growth Model formula to find the present value (V0):
— Formula: “V0 = D1 ÷ (r - g)”
— Calculation: “V0 = 1.05 ÷ (0.07 - 0.05)”
— Result: “V0 = 50.40”.

Question 46

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Example: Noncallable Fixed-Rate Perpetual Preferred Stock

1- Problem Description
– A noncallable 5% fixed-rate perpetual preferred stock has a par value of $25 per share. The required return on this issue (r) is 5.7% (0.057).
– Estimate the value of this issue (V0).

2- Solution
– Calculate the annual dividend (D1):
— Formula: “D1 = Dividend rate × Par value”
— Calculation: “D1 = 0.05 × 25”
— Result: “D1 = 1.25”.

– Use the valuation formula for a perpetual stock:
— Formula: “V0 = D1 ÷ (r - g)”
— Substitution: “V0 = 1.25 ÷ (0.057 - 0)”
— Result: “V0 = 21.93”.

Question 47

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The Links Among Dividend Growth, Earnings Growth, and Value Appreciation

1- Overview of the Concept
– The Gordon growth model assumes a constant, proportional relationship between earnings and dividends, driven by a fixed payout ratio.

2- Key Relationships
– “g” represents both the dividend growth rate and the rate of capital appreciation.
– The stock’s forward dividend yield, expressed as “D1 ÷ P0”, remains constant.
– This constancy arises because both dividends and price grow at the same rate (“g”).

Question 48

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Share Repurchases

1- Overview of the Concept
– Share repurchases are becoming increasingly popular in developed markets and are often used alongside or in place of cash dividends. They have distinct features compared to cash dividends.

2- Key Features of Share Repurchases
– Share repurchases reduce the number of shares outstanding.
– Corporations feel a stronger commitment to maintaining dividend rates compared to share repurchase levels.
– Cash dividends are predictable in both amount and timing, while share repurchases are opportunistic and harder to predict.
– Share repurchases should have no impact on ongoing shareholders if the repurchases are made at market prices.

Question 49

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Present Value of Growth Opportunities (PVGO)

1- Overview of the Concept
– The value of a stock can be expressed as the sum of two components: the value without earnings reinvestment and the present value of growth opportunities (PVGO). This separates the value derived from growth from the baseline no-growth value.

2- Formula
– Present value of the stock: “V0 = (E1 ÷ r) + PVGO”
— Where:
— V0: Current stock value.
— E1: Earnings per share expected in the next period.
— r: Required rate of return.
— PVGO: Present value of future growth opportunities.

3- Explanation of Components
– (E1 ÷ r): Represents the no-growth value per share, assuming constant EPS (E1) indefinitely without reinvestment.
– PVGO: Reflects the net present value of projects where earnings are reinvested, assuming returns exceed the opportunity cost of funds.

4- Key Implications
– Earnings growth influences shareholder wealth.
— If earnings return exceeds the opportunity cost (r), shareholder wealth increases as value is generated from positive NPV projects.
— Conversely, growth with returns below the cost of funds reduces value.

Answer

A

Key Takeaways
– PVGO highlights the importance of reinvestment decisions and their impact on shareholder value, distinguishing between no-growth intrinsic value and growth-driven value.

Question 50

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Price-to-Earnings Ratio (P/E) and PVGO

1- Overview of the Concept
– The present value of growth opportunities (PVGO) is a key driver of a company’s valuation. Companies without positive NPV projects are considered no-growth companies and should distribute all earnings as dividends. PVGO reflects the value of potential growth opportunities or real options.

2- Formula for P/E Ratio with PVGO
– “P0 ÷ E1 = (1 ÷ r) + (PVGO ÷ E1)”

3- Explanation of Variables
– P0: Current stock price.
– E1: Expected earnings in the next period.
– r: Required rate of return.
– PVGO: Present value of growth opportunities.

4- Key Insights
– The formula separates the P/E ratio into two components:
— (1 ÷ r): Represents the P/E ratio of a no-growth company.
— (PVGO ÷ E1): Reflects the contribution of growth opportunities to the P/E ratio.
– Growth opportunities are valuable when the projects offer returns exceeding the cost of capital, while no-growth companies derive value only from existing earnings.

Answer

A

Key Takeaways
– PVGO helps distinguish between intrinsic value from earnings and value added by growth opportunities.
– The P/E ratio highlights the proportion of a company’s valuation attributable to growth.

Question 51

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Example: Calculating PVGO and Percentage of Market Value Attributable to Growth

1- Problem Overview
– A company’s earnings per share (E1) is expected to be $0.85. The required rate of return (r) is 9.25%, and the current price of the stock (P0) is $18.60. The task is to determine what percentage of the stock’s market value is attributable to growth opportunities.

2- Formula and Solution
– Step 1: Calculate the no-growth value per share.
— “No-growth value = E1 ÷ r = 0.85 ÷ 0.0925 = 9.19”

– Step 2: Use the equation to find PVGO.
— “P0 = No-growth value + PVGO”
— “18.60 = 9.19 + PVGO”
— “PVGO = 9.41”

– Step 3: Calculate the percentage of market value attributable to growth.
— “Percentage = PVGO ÷ P0 = 9.41 ÷ 18.60 ≈ 51%”

3- Conclusion
– 51% of the stock’s market value is derived from growth opportunities, while the remaining 49% is attributable to current earnings without growth.

Question 52

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Price-to-Earnings (P/E) Ratios Derived from the Gordon Growth Model

1- Overview of the Concept
– The Gordon growth model can be used to calculate the justified P/E ratio and determine the implied earnings growth rate from the stock price. P/E ratios can be calculated on a leading (forward) or trailing basis.
– Leading P/E uses forecasted earnings (E1), while trailing P/E uses the most recent earnings (E0).

2- Formulas (DDM)
– Leading (Justified forward) P/E ratio:
— Formula: “Leading P/E = P0 ÷ E1 = D1 ÷ E1 ÷ (r - g) = (1 - b) ÷ (r - g)”
— Explanation: “b” represents the retention rate, and (1 - b) is the dividend payout ratio.

– Trailing P/E ratio:
— Formula: “Trailing P/E = P0 ÷ E0 = D0(1 + g) ÷ E0 ÷ (r - g) = (1 + g)(1 - b) ÷ (r - g)”
— Explanation: “D0” is the dividend for the current period, and growth (g) adjusts dividends to the next period.

3- Explanation of Variables
– P0: Current stock price.
– E0: Current earnings per share.
– E1: Forecasted earnings per share.
– D0: Current dividend.
– D1: Expected dividend (D1 = D0(1 + g)).
– b: Retention rate.
– (1 - b): Dividend payout ratio.
– r: Required rate of return.
– g: Growth rate of dividends.

Answer

A

Key Insights
– Higher retention rates (b) lead to lower P/E ratios, assuming other factors remain constant.
– The P/E ratio is highly sensitive to differences between “r” and “g.”
– Trailing P/E ratios are typically higher than leading P/E ratios due to the adjustment for growth (1 + g).

Question 53

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Gordon Growth Model: Estimating the Required Rate of Return

1- Overview of the Concept
– The Gordon Growth Model can be rearranged to calculate a stock’s required rate of return (r) by solving for it. This approach uses dividend expectations, the stock’s price, and the growth rate of dividends.

2- Formula
– Formula for the required rate of return: — “r = (D1 ÷ P0) + g”

3- Explanation of Variables
– r: Required rate of return.
– D1: Expected dividend in the next period.
– P0: Current stock price.
– g: Constant dividend growth rate.

4- Application and Assumptions
– The formula assumes that dividends grow at a constant rate (g) indefinitely.
– It also assumes that the relationship between dividends, stock price, and growth remains consistent over the long term.

Question 54

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Multistage Growth Phases

1- Overview of the Concept
– The Gordon Growth Model’s assumption of a single constant growth rate is often unrealistic. Many companies experience growth in distinct stages: growth, transition, and maturity.

2- Growth Phase
– Companies in this phase exhibit high growth and profit margins.
– Free cash flows are often negative due to high investment needs.
– Dividends are typically minimal or nonexistent.

3- Transition Phase
– Growth slows as competition increases, and profit margins decrease.
– Capital requirements decline, resulting in positive free cash flows and growing dividends.

4- Mature Phase
– Investments earn returns equivalent to the opportunity cost of capital.
– Growth rates stabilize, and dividend payout ratios become predictable.
– Companies in this phase are best suited for valuations using the Gordon Growth Model.

Question 55

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Two-Stage Dividend Discount Model

1- Overview of the Concept
– This model assumes a company experiences a short-term phase of supernormal growth, denoted by gs, before transitioning to a long-term stable growth phase, denoted by gL.
– The total value of the company today (V0) includes the present value of dividends during the high-growth phase and the present value of the terminal value at the end of the high-growth period.

2- Formula for Present Value of the Stock (V0)
– Formula:
— “V0 = T∑_t=1 [D0(1 + gs)^t ÷ (1 + r)^t] + [Vn ÷ (1 + r)^n]”
– Where the terminal value (Vn) is:
— “Vn = [D0(1 + gs)^n(1 + gL)] ÷ (r - gL)”

3- Explanation of Variables
– V0: Present value of the stock.
– D0: Dividend paid in the current period.
– gs: Short-term growth rate during the high-growth phase.
– gL: Long-term stable growth rate after the high-growth phase.
– r: Required rate of return.
– T∑_t=1: Summation for dividends during the high-growth phase (t=1 to n).
– Vn: Terminal value at the end of the high-growth period.

4- Terminal Value Approaches
– The terminal value can be calculated using the Gordon Growth Model or estimated through a price multiple.
– The Gordon Growth Model assumes dividends grow at gL indefinitely.

5- Applicability
– This model is suitable for companies with a temporary phase of high growth, such as firms with expiring patents or first-mover advantages.
– More complex models can incorporate different discount rates for cash flows during different phases.

Answer

A

Key Takeaways
– The two-stage dividend discount model divides the valuation into a high-growth phase and a mature phase.
– The terminal value (Vn) significantly influences the valuation, especially for longer high-growth periods.
– The model uses a single discount rate (r) across all cash flows unless adapted for varying rates.

Question 56

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Valuing a Non-Dividend-Paying Company

1- Overview of the Concept
– The two-stage method can be applied to value a company that does not currently pay dividends. In this case, dividends are assumed to be zero during the initial period, simplifying the valuation process.

2- Key Considerations
– The primary challenge is predicting when the company will initiate dividends and estimating the initial dividend amount.

Question 57

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Example: Two-Stage Dividend Discount Model Starting with Zero Dividends

1- Problem Setup
– A company currently pays no dividends.
– It will begin paying an annual dividend of $2.00 in five years.
– After dividends begin, they are expected to grow at a rate of 5% per year.
– The required rate of return is 11%.

2- Objective
– Estimate the current stock value using the two-stage dividend discount model.

3- Solution and Formula
– Two-Stage Dividend Discount Model formula:
— “V0 = [Dn+1 ÷ ((1 + r)^n * (r - g))]”

4- Substitution and Calculation
– Inputs:
— Dn+1 = $2.00 (first dividend payment).
— r = 11% or 0.11 (required rate of return).
— g = 5% or 0.05 (growth rate after dividends start).
— n = 5 years (time until first dividend payment).

– Calculation:
— “V0 = 2.00 ÷ [(1.11)^4 * (0.11 - 0.05)] = 2.00 ÷ (1.4641 * 0.06) = 21.96”

Question 58

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Example: Basic Two-Stage Dividend Discount Model (DDM)

1- Problem Setup
– Two analysts, Samuel Laviolette and Catherine Blanc, use the two-stage growth model to value Bloemfontein Minerals (BFM).
– Key inputs:
— BFM just paid an annual dividend of €0.80, based on €2.00 of earnings per share.
— A new mineral discovery allows the company to increase its dividend by 15% annually for the next three years.
— BFM’s managers will maintain a 40% payout ratio over the long run.
— Investors require a 9% return on BFM shares.

– Laviolette uses the Gordon growth model for terminal value with a 6% long-term growth rate.
– Blanc applies a 13.5 trailing P/E ratio to terminal earnings.

2- Formula and Solution
– Both analysts calculate the value of dividends over the next three years:
— “Dividend Value = [(0.80)(1.15)/(1.09)] + [(0.80)(1.15)^2/(1.09)^2] + [(0.80)(1.15)^3/(1.09)^3] = 2.674”

– Laviolette’s terminal value (Vn):
— Formula: “Vn = [(0.80)(1.15)^3(1.06)] / (0.09 - 0.06)”
— Substitution: “Vn = 42.990”
— Present value of Vn: “42.990 / (1.09)^3 = 33.194”
— Total value: “2.674 + 33.194 = 35.87”

– Blanc’s terminal value (Vn):
— Formula: “Vn = [(0.80)(1.15)^3 / 0.40] * 13.5”
— Substitution: “Vn = 41.064”
— Present value of Vn: “41.064 / (1.09)^3 = 31.656”
— Total value: “2.674 + 31.656 = 34.38”

Question 59

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H-Model

1- Overview of the Concept
– The H-model is an enhancement of the basic two-stage model. It assumes a smoother transition from a period of high growth (supernormal growth) to a long-term growth rate by gradually decreasing the growth rate over a specified time period.
– The model uses all inputs from the two-stage model but adds a variable, H, to represent the half-life of the supernormal growth period, which spans 2H years.

2- Formula
– H-model formula:
— “V0 = [D0(1 + gL) ÷ (r - gL)] + [D0H(gS - gL) ÷ (r - gL)]”

3- Explanation of Variables
– V0: Present value of the stock.
– D0: Current dividend per share.
– gS: Initial high (supernormal) growth rate.
– gL: Long-term sustainable growth rate.
– r: Required rate of return.
– H: Half-life of the supernormal growth period (H = half the number of years for the transition).

4- Key Characteristics and Suitability
– The H-model provides an approximate value for discounting future dividends when a company transitions gradually to a long-term growth rate.
– It is not suitable when the supernormal growth period is long or when there is a significant difference between gS and gL, as the approximation becomes less accurate in such cases.

Question 60

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H-Model

1- Overview of the Concept
– The H-model is an enhancement of the basic two-stage model. It assumes a smoother transition from a period of high growth (supernormal growth) to a long-term growth rate by gradually decreasing the growth rate over a specified time period.
– The model uses all inputs from the two-stage model but adds a variable, H, to represent the half-life of the supernormal growth period, which spans 2H years.

2- Formula
– H-model formula:
— “V0 = [D0(1 + gL) ÷ (r - gL)] + [D0H(gS - gL) ÷ (r - gL)]”

3- Explanation of Variables
– V0: Present value of the stock.
– D0: Current dividend per share.
– gS: Initial high (supernormal) growth rate.
– gL: Long-term sustainable growth rate.
– r: Required rate of return.
– H: Half-life of the supernormal growth period (H = half the number of years for the transition).

4- Key Characteristics and Suitability
– The H-model provides an approximate value for discounting future dividends when a company transitions gradually to a long-term growth rate.
– It is not suitable when the supernormal growth period is long or when there is a significant difference between gS and gL, as the approximation becomes less accurate in such cases.

Answer

A

Key Takeaways
– The H-model addresses the abrupt transition issue in the two-stage model by introducing a gradual change in growth rates.
– It offers a simpler, approximate approach to valuation compared to more complex models.

Question 61

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Example: Two-Stage Dividend Discount Valuation using the H-Model

1- Problem Setup
– Bloemfontein Minerals (BLM) has the following inputs:
— Most recent annual dividend (D0): €0.80.
— Dividends are initially expected to grow at 15% and then decline linearly to a long-term growth rate of 6% over three years.
— Required rate of return (r): 9%.

2- Formula Application
– H-Model formula:
— “V0 = [D0(1 + gL) ÷ (r - gL)] + [D0H(gS - gL) ÷ (r - gL)]”
— Substituting the values:
— “V0 = [(0.80)(1.06) ÷ (0.09 - 0.06)] + [(0.80)(1.5)(0.15 - 0.06) ÷ (0.09 - 0.06)]”

3- Solution Steps
– First Component: “0.80(1.06) ÷ (0.09 - 0.06) = 28.27”.
– Second Component: “0.80(1.5)(0.15 - 0.06) ÷ (0.09 - 0.06) = 3.60”.
– Summing both components: “V0 = 28.27 + 3.60 = 31.87”.

4- Explanation of Results
– The estimated current stock value using the H-Model is €31.87.
– The H-Model valuation is lower compared to the basic two-stage model because the H-Model assumes that growth rates decline linearly rather than remaining constant during the high-growth phase.

Answer

A

The “H” represents half the time (in years) over which the dividend growth rate declines from its initial high growth rate to the long-term stable growth rate.

Therefore: 3/2 = 1.5

Question 62

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Three-Stage Dividend Discount Models (DDMs)

1- Overview of the Concept
– The three-stage DDM is designed to model a company’s dividend growth through three distinct phases, capturing various growth patterns over time.

2- Versions of the Three-Stage DDM
– 1- General Version:
— Assumes three distinct stages of growth, with each stage having a constant growth rate.

– 2- H-Model-Like Version:
— The growth rate in the middle stage declines linearly to the mature growth rate in the third stage.
— The second and third stages resemble an H-Model structure.

Question 63

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Example: Three-Stage Dividend Discount Model with Declining Growth Rates in Stage 2

1- Problem Statement
– A company’s most recent annual dividend is €0.80, with the following growth expectations:
— Dividends are expected to grow at 15% annually for the next three years (Stage 1).
— Dividends will transition to a long-term growth rate of 4% (Stage 3), declining linearly over ten years during Stage 2.
— The required rate of return (r) is 8%.

2- Solution Steps

Stage 3 (Terminal Value):
– Formula for terminal value (V3):
— “V3 = [D3(1 + gL) ÷ (r - gL)] + [D3 * H * (gs - gL) ÷ (r - gL)]”
— Where:
— D3 = Dividend at the end of Stage 1.
— gL = Long-term growth rate (4%).
— gs = Growth rate at the end of Stage 1 (15%).
— H = Half-life of transition (10 ÷ 2 = 5).

Calculations for V3:
— D3 = 0.80 * (1.15)^3 = 1.157.
— V3 = [1.157 * (1.04) ÷ (0.08 - 0.04)] + [1.157 * 5 * (0.15 - 0.04) ÷ (0.08 - 0.04)] = 48.36.

Total Value (V0):
– Formula:
— “V0 = Σ {Dt ÷ (1 + r)^t} for t = 1 to n + V3 ÷ (1 + r)^n.”
— Summing dividends for Stage 1 and Stage 3’s discounted terminal value:
— V0 = [0.80(1.15) ÷ 1.08] + [0.80(1.15)^2 ÷ (1.08)^2] + [0.80(1.15)^3 ÷ (1.08)^3] + [48.36 ÷ (1.08)^3].

Final Calculation:
— V0 = 41.12.

Question 64

Q

Estimating a Required Return Using Any DDM

1- Overview of the Concept
– Dividend Discount Models (DDMs) can be rearranged to estimate the required rate of return (r) implied by a stock’s current price. Different DDMs require different methods to solve for r.

2- Formula for Required Return

Gordon Growth Model:
– Formula: “r = (D1 ÷ P0) + g”
— D1: Dividend expected in the next period.
— P0: Current stock price.
— g: Constant dividend growth rate.

H-Model:
– Formula: “r = [(D0 ÷ P0) * (1 + gL + H(gs - gL))] + gL”
— D0: Most recent annual dividend.
— P0: Current stock price.
— gL: Long-term dividend growth rate.
— gs: Short-term dividend growth rate.
— H: Half-life of the transition period (e.g., H = n ÷ 2 for n years).

3- Application to Other Models
– For complex models, such as multi-stage DDMs, iterative calculations or computational tools may be required to estimate r.

Answer 18

A

– Compare the free cash flow to the firm (FCFF) and free cash flow to equity (FCFE) approaches to valuation.
– Explain the ownership perspective implicit in the FCFE approach.
– Explain the appropriate adjustments to net income, earnings before interest and taxes (EBIT), earnings before interest, taxes, depreciation, and amortization (EBITDA), and cash flow from operations (CFO) to calculate FCFF and FCFE.
– Calculate FCFF and FCFE.
– Describe approaches for forecasting FCFF and FCFE.
– Explain how dividends, share repurchases, share issues, and changes in leverage may affect future FCFF and FCFE.
– Compare the FCFE model and dividend discount models.
– Evaluate the use of net income and EBITDA as proxies for cash flow in valuation.
– Explain the use of sensitivity analysis in FCFF and FCFE valuations.
– Explain the single-stage (stable-growth), two-stage, and three-stage FCFF and FCFE models and justify the selection of the appropriate model given a company’s characteristics.
– Estimate a company’s value using the appropriate free cash flow model(s).
– Describe approaches for calculating the terminal value in a multistage valuation model.
– Evaluate whether a stock is overvalued, fairly valued, or undervalued based on a free cash flow valuation model.

Answer 19

A

Key Takeaways
– FCFF evaluates the firm’s entire cash-generating capacity, while FCFE is tailored for equity holders.
– The choice between FCFF and FCFE depends on the company’s leverage and the stability of its capital structure.

Answer 20

A

Key Takeaways
– MV(Debt) and MV(Equity) must reflect current market values, not book values.
– WACC reflects the firm’s blended cost of capital and is used to discount FCFF to derive firm value.

Answer 21

A

Key Takeaways
– FCFF and FCFE models differ in discount rates (WACC for FCFF, r for FCFE) and what they value (firm vs. equity).

Answer 22

A

In the WACC, ALWAYS use Market Values, not Book values !!!

Answer 23

A

Key Takeaways
– The formula adjusts net income to reflect cash flows available to both debt and equity holders by accounting for non-cash items, capital expenditures, and changes in working capital.
– FCFF is crucial for valuing the firm as it represents cash flows available to all capital providers.

Answer 24

A

Key Takeaways
– When CFO is available, computing FCFF becomes simpler as adjustments for non-cash charges and working capital are pre-accounted for.
– The formula aligns cash flows to reflect availability to all capital providers by reconciling operating activities with financing and investing activities.

Answer 25

A

Key Takeaways
– IFRS offers more flexibility in classifying cash flows, allowing companies to better align classifications with the nature of their business.
– US GAAP provides stricter guidelines, ensuring uniformity but limiting flexibility.

Answer 26

A

Exercise: FCFF and FCFE Calculations from the Uses of Free Cash Flow

1- Calculate FCFF
– Formula:
— “FCFF = ΔCash + Int(1 - t) - New borrowing + Dividends paid + Share repurchases”

– Calculation:
— ΔCash = 108.92
— Int(1 - t) = 14.00 × (1 - 0.3) = 9.8
— New borrowing = -21.22
— Dividends paid = 0.00
— Share repurchases = 0.00

FCFF = 108.92 + 9.8 - 21.22 + 0.00 + 0.00 = 97.5

2- Calculate FCFE
– Formula:
— “FCFE = ΔCash + Dividends paid + Share repurchases”

– Calculation:
— ΔCash = 108.92
— Dividends paid = 0.00
— Share repurchases = 0.00

FCFE = 108.92 + 0.00 + 0.00 = 108.92

Answer 27

A

Key Takeaways
– Calculating FCFF and FCFE from uses provides a consistency check with the sources of cash flow.
– FCFF addresses both debt and equity transactions, while FCFE is limited to equity-related cash flows.

Answer 28

A

Key Takeaways
– Sales-based forecasts consider historical relationships between expenditures and sales, offering more precision.
– The target debt ratio allows for more nuanced FCFE calculations, assuming adjustments to capital structure.

Answer 29

A

Key Takeaways
– Free cash flow models offer greater flexibility than DDMs, especially for companies with inconsistent dividend policies or growth-focused reinvestments.
– EBITDA, while sometimes used as a proxy for FCFF, requires adjustments for depreciation, working capital, and tax effects for accurate free cash flow analysis.

Answer 30

A

Key Takeaways
– Real terms and adjusted discount rates are vital for international valuation under volatile inflation conditions.
– Sensitivity analysis identifies the most impactful variables in equity valuation and helps mitigate uncertainty in financial models.

Answer 31

A

Key Takeaways
– The two-stage FCFF model is more complex than dividend discount models, accommodating varying growth rates.
– Proper estimation of growth rates, WACC, and terminal value is critical for accurate valuation.

Answer 32

A

ESG Considerations in Free Cash Flow Models

1- Impact of ESG on Valuation
– Environmental, Social, and Governance (ESG) factors can materially influence valuations in free cash flow models.

2- Quantitative vs. Qualitative Factors

Quantitative Factors:
– Examples: Expected environmental fines or penalties.
– These factors are straightforward and can be easily incorporated into valuations.

Qualitative Factors:
– More challenging to model.
– One approach is to adjust the cost of equity by including a risk premium to account for ESG risks.
– This requires significant judgment and subjective evaluation.

Answer 33

A

Key Examples of Nonoperating Assets:
– Excess cash and marketable securities.
– Non-current investments in stocks and bonds.
– Land held for investment.
– Pension surplus.

Answer 34

A

Key Takeaways:
– Always exclude cash and notes payable from the calculation of working capital changes.
– Include only operational current assets and liabilities that are directly tied to the company’s operations.
– The correct answer, A (€35 million), aligns with these principles.

Answer 35

A

Key Takeaways
– Dividends and share repurchases are allocations of FCFE, not components of its calculation.
– Grenier was wrong to claim that a share repurchase would reduce FCFE.
– The correct answer, B, reflects that FCFE remains unaffected by share repurchases.

Answer 36

A

– Contrast 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.
– Calculate and interpret a justified price multiple.
– Describe rationales for and possible drawbacks to using alternative price multiples and dividend yield in valuation.
– Calculate and interpret alternative price multiples and dividend yield.
– Calculate and interpret underlying earnings, explain methods of normalizing earnings per share (EPS), and calculate normalized EPS.
– Explain and justify the use of earnings yield (E/P).
– Describe fundamental factors that influence alternative price multiples and dividend yield.
– Calculate and interpret a predicted P/E, given a cross-sectional regression on fundamentals, and explain limitations to the cross-sectional regression methodology.
– Calculate and interpret the justified price-to-earnings ratio (P/E), price-to-book ratio (P/B), and price-to-sales ratio (P/S) for a stock, based on forecasted fundamentals.
– Calculate and interpret the P/E-to-growth (PEG) ratio and explain its use in relative valuation.
– Calculate and explain the use of price multiples in determining terminal value in a multistage discounted cash flow (DCF) model.
– Evaluate whether a stock is overvalued, fairly valued, or undervalued based on comparisons of multiples.
– Evaluate a stock by the method of comparables and explain the importance of fundamentals in using the method of comparables.
– Explain alternative definitions of cash flow used in price and enterprise value (EV) multiples and describe limitations of each definition.
– Calculate and interpret EV multiples and evaluate the use of EV/EBITDA.
– Explain sources of differences in cross-border valuation comparisons.
– Describe momentum indicators and their use in valuation.
– 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.

Answer 37

A

[Finding Variables in the Forward P/E Example]

1- Variable: EPS_forecasted (Next Four Quarters)
– Explanation: To calculate EPS for the next four quarters, sum the forecasted quarterly EPS from the table. This includes the current quarter (March 31, 20X5) and the next three quarters (June 30, September 30, and December 31, 20X5).
– Example Calculation:
— EPS_forecasted = 0.00 (March) + 0.04 (June) + (-0.05) (September) + 0.14 (December) = 0.13.

2- Variable: EPS_NTM (Next Twelve Months)
– Explanation: Calculate EPS over the next 12 months using a weighted average of the current fiscal year (20X5) and the next fiscal year (20X6) based on time proportions.
— 8 months of the 20X5 EPS = (8 ÷ 12) * 20X5 EPS.
— 4 months of the 20X6 EPS = (4 ÷ 12) * 20X6 EPS.
– Example Calculation:
— 20X5 EPS: 0.01 × (8 ÷ 12) = 0.0067.
— 20X6 EPS: 0.30 × (4 ÷ 12) = 0.10.
— Total EPS_NTM = 0.0067 + 0.10 = 0.1067.

3- Variable: EPS_fiscal-year (Next Fiscal Year)
– Explanation: Use the annual forecasted EPS for 20X6 from the table.
– Example Calculation:
— EPS_fiscal-year = 20X6 EPS = 0.30.

4- Variable: Price (Stock Price)
– Explanation: The stock price is given in the example as $25.30 (as of May 7, 20X5).

Answer 38

A

Key Takeaways
– Use forward P/E to focus on future earnings, while trailing P/E reflects past performance adjusted for growth.
– The formulas provide insights into the valuation based on fundamental drivers such as growth, dividends, and retention.

Answer 39

A

Key Takeaways
– While useful, this method faces challenges in stability and multicollinearity.
– Analysts often prioritize studying the relationship between stock prices (or returns) and economic variables over direct P/E multiple relationships.

Answer 40

A

Key Takeaways
– Peer-company and industry multiples provide a framework for assessing relative valuation but require adjustments for specific company characteristics and growth expectations.

Answer 41

A

Key Takeaways
– The Fed Model assesses valuation relative to Treasury yields but omits growth and risk factors.
– The Yardeni Model improves upon this by integrating earnings growth expectations, offering a more comprehensive view of market valuation.

Answer 42

A

Key Takeaways
– Historical P/E provides a baseline by referencing a company’s historical valuation trends.
– Cross-country comparisons highlight the influence of inflation and macroeconomic factors on P/E ratios. The formula accounts for inflation-adjusted earnings growth and real return expectations.

Answer 43

A

Key Takeaways
– P/E ratios simplify the calculation of terminal values in DDMs by leveraging growth, return, and comparables.
– The choice of approach depends on the availability of reliable market data and the assumptions about growth and required returns.

Answer 44

A

Key Takeaways
– Basic EPS focuses on actual shares outstanding, while diluted EPS accounts for the dilutive effects of potential shares from other securities.
– Adjustments in diluted EPS ensure comparability by reflecting the potential dilution’s impact on earnings per share.

Answer 45

A

Key Takeaways
– Historical Average EPS is simple but may not account for changes in company size or structure.
– Average ROE considers company size through the book value per share, offering a more dynamic approach to normalizing earnings.

Answer 46

A

Key Takeaways
– P/B is a valuable metric for evaluating companies but must be interpreted alongside its limitations.
– The stability of BV and its limitations (e.g., unrecorded intangible assets) must be considered in analysis.

Answer 47

A

Key Takeaways
– Accurate adjustments to book value improve the reliability of P/B ratio analysis.
– Awareness of accounting methods is crucial for meaningful comparisons and insights.

Answer 48

A

Key Takeaways
– The Gordon growth model emphasizes the relationship between ROE, growth, and the required rate of return.
– The residual income model highlights the role of future residual earnings in determining justified P/B.
– A higher justified P/B indicates better stock valuation fundamentals.

Answer 49

A

Key Takeaways
– The P/S ratio is a useful alternative valuation measure when earnings or book value data are unreliable.
– Its limitations, such as ignoring cost structures and profitability, require careful interpretation alongside other metrics.

Answer 50

A

Key Takeaways
– The P/S ratio derived from the Gordon growth model links sales to profitability, growth, and required returns.
– Higher profit margins and growth rates result in higher justified P/S ratios, while a higher required return lowers the ratio.

Answer 51

A

Key Takeaways
– The P/B ratio is effective for valuing financial asset-based companies but is less reliable for firms with significant non-financial assets.
– Understanding the basis of asset valuation (historical cost vs. market value) is essential when analyzing P/B ratios.

Answer 52

A

Key Takeaways
– P/CF is a reliable alternative to earnings-based metrics but requires careful consideration of how cash flow is defined.
– Differences in accounting practices and the choice of cash flow measure (e.g., FCFE vs. operating cash flow) can significantly impact the ratio’s interpretation.

Answer 53

A

Key Takeaways
– CFO is a reliable measure of ongoing operations but requires adjustments for cross-company comparisons.
– FCFE is most closely tied to valuation but is more volatile.
– EBITDA serves as a proxy for cash flow but omits important cash outflows, like taxes and interest.

Answer 54

A

Key Takeaways
– The justified P/CF ratio reflects the relationship between growth, required return, and cash flow.
– Comparables-based valuation requires care when cash flows are negative, and alternative cash flow measures may be needed.

Answer 55

A

Key Takeaways
– Dividend yield is a useful valuation metric, emphasizing income stability.
– It should be used alongside other metrics, as it does not account for total equity returns or company reinvestment potential.

Answer 56

A

Key Takeaways
– Trailing Yield focuses on historical dividend payments, providing a backward-looking measure.
– Leading Yield is forward-looking, incorporating expected changes in dividend payments.
– Investors should use both measures to assess a stock’s dividend performance and growth potential

Answer 57

A

Key Takeaways
– Dividend yield is a valuable metric for assessing return and safety but requires adjustment for growth and payout sustainability.
– Comparables analysis should consider company-specific factors like payout and leverage ratios.

Answer 58

A

Key Takeaways
– EV/EBITDA is a versatile valuation metric, especially for leveraged companies, but it has limitations in reflecting true cash flows.
– Alternative measures like FCFF should be considered for a more accurate valuation.

Answer 59

A

Key Takeaways
– EV accounts for both equity and debt, making it suitable for leveraged companies.
– The EV/EBITDA multiple is influenced by growth, efficiency, and funding costs.
– TIC provides another perspective when cash holdings distort EV comparisons.

Answer 60

A

Key Takeaways
– EV multiples are versatile and adjust for capital structure differences.
– EV/S is a useful alternative to P/S, especially for industries where debt plays a significant role in financing.
– Nonfinancial denominators allow for industry-specific valuations, such as EV/proven reserves in the energy sector.

Answer 61

A

Key Takeaways
– International valuation requires careful adjustments to align accounting standards.
– Cash flow-based multiples are more reliable for cross-country comparisons due to their reduced sensitivity to accounting rule differences.
– P/E, P/B, and EV/EBITDA multiples should be interpreted cautiously in global contexts.

Answer 62

A

Key Takeaways
– Momentum indicators, such as earnings surprise, highlight trends and deviations from expectations.
– Positive earnings surprises may indicate a company’s potential to deliver higher returns, serving as a leading indicator for future performance.

Answer 63

A

Key Takeaways
– SUE accounts for earnings surprise volatility, making it valuable for cross-company or time-series analysis.
– Relative strength identifies performance trends, with higher RS values signaling momentum and lower values indicating lagging performance.

Answer 64

A

Key Takeaways
– The harmonic mean is an effective method for averaging multiples while minimizing the effect of outliers.
– Using multiple valuation indicators reduces reliance on a single metric, improving decision accuracy.
– Investors should be cautious of biases like look-ahead bias and use screening to refine their investment universe.

Answer 65

A

Key Takeaways
– Forward P/E ratios can be misleading or meaningless when earnings are expected to be negative, as these result in a negative ratio.
– Earnings yields are more robust and provide meaningful comparisons in all scenarios, making them preferable in such cases.
– The correct answer, C, identifies the limitation of forward P/E ratios.

Answer 66

A

Key Takeaways
– The PEG ratio provides a quick, simplified measure of valuation relative to growth, but its reliance on a linear relationship may oversimplify real-world scenarios.
– For more accurate valuation, models like the DDM, which account for nonlinear dynamics, should be considered.

Answer 67

A

Key Takeaways
– When using P/B ratios, be cautious of distortions caused by share repurchases or issuances.
– The P/B ratio is a more reliable valuation tool for assessing long-term value, especially in cyclical industries or during periods of earnings volatility.

Answer 68

A

Key Takeaways
– P/E ratios can provide insights into valuation, but results may differ depending on whether the comparison is to a benchmark or historical average.
– In this example, the stock appears undervalued relative to the index but overvalued relative to its historical fair value.

Answer 69

A

– Calculate and interpret residual income, economic value added, and market value added.
– Describe the uses of residual income models.
– Calculate the intrinsic value of a common stock using the residual income model and compare value recognition in residual income and other present value models.
– Explain fundamental determinants of residual income.
– Explain the relation between residual income valuation and the justified price-to-book ratio based on forecasted fundamentals.
– Calculate and interpret the intrinsic value of a common stock using single-stage (constant-growth) and multistage residual income models.
– Calculate the implied growth rate in residual income, given the market price-to-book ratio and an estimate of the required rate of return on equity.
– Explain continuing residual income and justify an estimate of continuing residual income at the forecast horizon, given company and industry prospects.
– Compare residual income models to dividend discount and free cash flow models.
– Explain strengths and weaknesses of residual income models and justify the selection of a residual income model to value a company’s common stock.
– Describe accounting issues in applying residual income models.

Answer 70

A

Key Takeaways
– Residual income provides a more accurate measure of value creation by incorporating the cost of equity.
– It is particularly useful for evaluating whether a company is earning above its required rate of return.
– RI models are valuable for equity valuation and assessing goodwill impairment.

Answer 71

A

Key Takeaways
– EVA focuses on economic profit after accounting for the cost of capital and requires adjustments to financial data.
– MVA evaluates value creation by comparing market and book values.
– These metrics are critical for assessing performance and aligning management incentives.

Answer 72

A

Key Takeaways
– The residual income model is particularly useful for valuing companies with inconsistent or no dividend payouts.
– It integrates the cost of equity, emphasizing whether the company is adding value beyond its equity capital costs.
– The RI model highlights the importance of current book value and future earnings in valuation.

Answer 73

A

Key Takeaways
– The RI model is useful for valuing companies with inconsistent or no dividend payments but stable book value or earnings.
– Clean surplus accounting ensures the consistency of residual income computations.
– The RI model incorporates book value and profitability, linking them directly to intrinsic valuation.

Answer 74

A

Key Takeaways
– The residual income model connects P/B ratios to fundamental drivers like ROE, growth, and required return, emphasizing the importance of profitability relative to equity costs.
– Tobin’s q extends this analysis to total capital, making it useful for assessing overall asset efficiency and valuation.

Answer 75

A

The terminal value of residual income often approaches zero because the ROE approaches the cost of equity.

Answer 76

A

Key Takeaways
– The multistage RI model balances short-term earnings with assumptions about terminal value and persistence.
– Proper estimation of the persistence factor (ω) is critical to accurately valuing companies with varying residual income sustainability.
– Book value forms a strong base for valuation, complemented by future residual income forecasts.

Answer 77

A

Key Takeaways
– The RI model is particularly useful for valuing firms with inconsistent cash flows or no dividends.
– However, care must be taken to ensure the reliability and accuracy of accounting inputs.
– Clean surplus violations or improper cost-of-capital assumptions can undermine its effectiveness.

Answer 78

A

Key Takeaways
– The RI model is ideal for firms with limited or irregular dividends, negative cash flows, or when terminal value forecasts are uncertain.
– It is less suitable in cases of accounting inconsistencies or when key metrics like ROE and book value lack stability.

Answer 79

A

Key Takeaways
– All these models calculate intrinsic value as the present value of future returns, with specific applications based on company characteristics.
– The choice of model depends on dividend stability, cash flow predictability, and the firm’s capital structure.
– In theory, all models should yield consistent intrinsic values when used under equivalent assumptions.

Answer 80

A

Key Takeaways
– The accuracy of the residual income model depends on clean surplus accounting; violations can lead to valuation errors.
– Adjustments to book value and income are necessary to reflect comprehensive financial performance.

Answer 81

A

Key Takeaways
– Accurate valuations require adjustments for fair value, particularly for off-balance sheet items and intangible assets.
– Analysts should be vigilant about non-recurring items and aggressive accounting practices to avoid distorted valuations.
– Harmonization of international standards (e.g., IFRS) facilitates global comparability of valuation models.

Answer 82

A

Key Takeaways
– Proper adjustments to book value and net income are crucial for accurate residual income valuation.
– Clean surplus violations can distort the model, necessitating additional adjustments to maintain consistency.
– The balancing effect between book value and future earnings ensures that differences in accounting practices do not significantly alter intrinsic valuation.

Answer 83

A

Key Takeaways
– Excluding non-recurring charges like restructuring expenses is essential for accurate forecasts in residual income valuation.
– Valuations should focus on recurring items to capture a firm’s sustainable earnings potential.

Answer 84

A

Key Takeaways
– Multistage residual income models effectively account for fading residual income over time.
– Persistence factors (ω) capture the expected decay in residual income contributions beyond a certain period.
– Accurate book value, earnings projections, and cost of equity are critical for reliable valuations.

Answer 85

A

Key Takeaways
– Residual income is a critical measure of value added to equity beyond its cost.
– Accurate calculation requires understanding book value changes due to earnings and dividends.
– In this example, the RI for 20X8 is $2.97

Answer 86

A

Key Takeaways
– The justified P/B ratio reflects the relationship between the return on equity, sustainable growth rate, and required return on equity.
– A higher ROE relative to r increases the P/B ratio, while a higher g reduces it.
– In this example, the justified P/B ratio is calculated to be 2.96.

Answer 87

A

Key Takeaways
– The intrinsic value of the equity is calculated as $33.52 per share.
– The share price of $29.83 is below the intrinsic value, indicating the stock is undervalued.
– This valuation demonstrates the importance of the residual income model in assessing equity values beyond earnings-based approaches.

Answer 88

A

Key Takeaways
– A higher retention rate contributes to a greater intrinsic value due to its effect on both growth rate and book value.
– The relationship between dividend payouts and intrinsic value is crucial in evaluating equity under the residual income model.

Answer 89

A

– Contrast important public and private company features for valuation purposes.
– Describe uses of private business valuation and explain key areas of focus for financial analysts.
– Explain cash flow estimation issues related to private companies and adjustments required to estimate normalized earnings.
– Explain factors that require adjustment when estimating the discount rate for private companies.
– Compare models used to estimate the required rate of return to private company equity (for example, the CAPM, the expanded CAPM, and the build-up approach).
– Explain and evaluate the effects on private company valuations of discounts and premiums based on control and marketability.
– Explain the income, market, and asset-based approaches to private company valuation and factors relevant to the selection of each approach.
– Calculate the value of a private company using income-based methods.
– Calculate the value of a private company using market-based methods and describe the advantages and disadvantages of each method.

Answer 90

A

Key Considerations
– Each purpose requires specific expertise, such as compliance knowledge for financial reporting or legal experience for dispute resolution.
– Discrepancies in valuation may arise depending on the objective (e.g., tax valuation vs. acquisition valuation).

Answer 91

A

Key Takeaways
– Valuing private companies often requires additional adjustments to financial statements to ensure accuracy.
– Analysts rely on normalization techniques to present a clearer picture of private company performance.]

Answer 92

A

Key Takeaways
– Normalization ensures private company financials are comparable to public companies by adjusting for non-economic items and anomalies.
– Separate treatment of real estate ensures accuracy in reflecting operational performance.]

Answer 93

A

Key Takeaways
– Cash flow estimation for private companies requires adjustments to account for ownership intent, uncertainty, and potential management biases.
– Probability-weighted scenarios can improve the accuracy of cash flow projections under varying conditions.]

Answer 94

A

Key Takeaways
– Discount rates for private companies are influenced by size premiums, higher debt costs, and projection uncertainties.
– Proper adjustments are essential to avoid mispricing during valuations.

Answer 95

A

Key Takeaways
– CAPM serves as the baseline for estimating equity cost but is insufficient for private companies with unique risks.
– Expanded CAPM and the build-up method provide more flexibility for valuing small, private entities or those with industry-specific risk factors.

Answer 96

A

Key Takeaways
– Strategic buyers often pay more due to synergy potential, while financial buyers prioritize fundamentals.
– DLOC and DLOM reflect control and liquidity limitations, affecting valuation significantly.

Answer 97

A

Key Takeaways
– DLOC adjusts for the absence of control, while DLOM addresses limited liquidity.
– Combined discounts often apply to non-controlling interests using multiplicative rather than additive methods.

Answer 98

A

Key Takeaways
– The multiplicative approach ensures accurate combined discounts.
– Total discounts reflect compounded effects of DLOC and DLOM.

Answer 99

A

Key Takeaways
– Valuations decline from strategic control (highest) to non-controlling, non-marketable minority interest (lowest).
– DLOC and DLOM represent significant reductions in value for minority and illiquid positions.

Answer 100

A

Key Takeaways
– Free cash flow valuation incorporates cash flow projections for both lenders and shareholders.
– The choice between income, market, or asset-based methods depends on the company’s stage, operations, and size.

Answer 101

A

Key Takeaways
– CCM assumes a constant growth rate in FCFF or FCFE.
– Valuation results depend on accurate inputs for growth, WACC, tax rates, and reinvestment proportions.
– Intrinsic equity value is derived by adjusting enterprise value for debt or directly capitalizing FCFE.

Answer 102

A

Key Takeaways
– EEM is ideal for valuing intangible assets in small firms or unique cases.
– Required returns are higher for intangible assets due to their risk and illiquidity.
– Total enterprise value includes all tangible and intangible assets at their fair market values.

Answer 103

A

Key Takeaways
– The excess earnings method complements other approaches by focusing on intangible asset valuation.
– Valuation precision depends heavily on subjective inputs, making it a less definitive method.
– It provides another data point to refine the estimated valuation range.

Answer 104

A

Key Takeaways
– Market-based approaches leverage external comparisons to provide realistic valuation estimates.
– The availability and comparability of relevant market data are critical to the accuracy of this approach.

Answer 105

A

Key Takeaways
– The guideline public company method is useful for leveraging the valuation metrics of publicly traded peers.
– Adjustments for differences in leverage, taxation, and control premiums ensure a more accurate valuation for private companies.
– Careful selection of comparable public companies and accurate adjustments are critical for the method’s reliability.

Answer 106

A

Key Takeaways
– GTM uses acquisition multiples to value private companies, requiring adjustments for uncertainty and comparability.
– The prior transaction method is most relevant for minority equity valuations but is limited by the availability and relevance of historical data.
– Both methods rely heavily on accurate adjustments for synergies, contingent payments, and transaction timing to provide reliable valuations.

Answer 107

A

Key Takeaways
– When a firm anticipates a major shift in leverage, FCFF is preferred over FCFE as it mitigates the influence of leverage on valuation.
– The FCFF approach allows for a clearer representation of the firm’s intrinsic value under an expected new capital structure.