Equity

Question 1

What is the formula for the difference between the analyst’s estimate of intrinsic value and the current market price?

Answer 1

IVanalyst - Price = (IVanalyst - IVactual) + (IVactual - Price)

Question 2

When is investment value used?

Answer 2

When the company in question is being acquired.

Question 3

Are conglomerates more likely to be value at a premium or a discount?

Answer 3

A discount.

Question 4

What is the formula for calculating Equity Risk Premium using the GGM model?

Answer 4

ERP = (d/P) + g - r

Question 5

What will be the effect of using arithmetic average vs geometric average for historical equity returns when estimating equity risk premium?

Answer 5

Arithmetic average will be higher, so equity risk premium will be higher.

Question 6

What will be the effect of using short-term treasury bill rate vs longer-term bond rates when estimating equity risk premium?

Answer 6

Short-term treasury bill rate will be lower, so equity risk premium will be higher.

Question 7

For a public company, how can a beta be estimated?

Answer 7

A beta can be estimated by regressing historical returns and then adjusting for beta drift.

Question 8

What is the formula for adjusted beta?

Answer 8

Adjusted Beta = (Beta x 2/3) + 1/3

Question 9

What does the country spread model do?

Answer 9

It takes a developed market return and adds an emerging market premium.

Question 10

What does the country risk rating model do?

Answer 10

It estimates an equation for developed equity risk premium and then uses this and EM inputs to estimate an EM equity risk premium.

Question 11

What is the formula for sustainable growth rate (SGR)?

Answer 11

SGR = ROE x Retention Ratio

Question 12

What are the formulas for valuing the long-term growth and short-term growth stages of a H-Model?

Answer 12

Long-Term V = d1/r-gL

Short-term V = (d0 x n/2 x (gS-gL)) / r - gL

Question 13

What is the formula for justified leading P/E?

Answer 13

Payout Ratio / r - g

Question 14

What is the formula for justified trailing P/E?

Answer 14

Payout Ratio x (1+g) / r - g

Question 15

What is the formula for residual income?

Answer 15

RI = (ROE - r) x B0

or

RI = NI - (B0 x r)

Question 16

What is the formula for the single-stage residual income model?

Answer 16

V0 = B0 + ((ROE - r) x B0) / r -g

Question 17

If there is expected to be no residual income after time T, how do you calculate terminal value?

Answer 17

Terminal Value = RI at time T / 1 +r

Question 18

What is the formula for the value of a stock a declining RI?

Answer 18

V0 = RI at time T / t + r - w

Question 19

What will be the effect on ROE and Book Value of incorrectly capitalising expenditures?

Answer 19

They will be overstated.

Question 20

What is the formula for valuing a firm under the Excess Earnings Method (EEM)?

Answer 20

EEM = Fixed Assets + Working Capital + Residual Income

Question 21

What is an alternative method of estimating required return when no comparable public companies are available?

Answer 21

When there are no comparable public companies there will be no comparable betas to use, so the build-up method is used.

Question 22

Under what circumstances can CAPM be used to estimate required return of a private firm?

Answer 22

If the firm is of similar size and specific risk to a public company.

Question 23

When is a control premium added?

Answer 23

When the investor is a strategic buyer.

Question 24

What is the formula to calculate DLOC from control premium?

Answer 24

DLOC = 1 - (1 / Control Premium)

Question 25

What multiple should you use for a highly cyclical firm?

Answer 25

Normalised Price-Earnings

Question 26

What is the formula for valuation that includes PVGO?

Answer 26

V = (E1/ r) + PVGO

Question 27

What is the formula for justified Price/ Book?

Answer 27

Justified P/B = (ROE-g) / r-g

Question 28

What is the formula for justified Price/Sales?

Answer 28

Justified P/S = EBIT Margin (1+g) / r-g

Question 29

What is the formula for Market Value Added (MVA)?

Answer 29

MVA = Market Value - Book Value

Question 30

Which discount rate is residual income discounted at?

Answer 30

Cost of equity.

Question 31

What is the formula for real growth rate?

Answer 31

Real Growth Rate = 1 + g / 1 + i

Question 32

When capital structure is simple and stable, what is the preferred valuation method - FCFF or FCFE?

Answer 32

FCFE, as it is easier to calculate.

Question 33

How do repurchases and share issues affect FCFF and FCFE?

Answer 33

They do not. Only new debt issue affects FCFE.

Question 34

What is the formula for cash flow from operations?

Answer 34

CFO = NI + Depr - NWCInv

Question 35

What is included in the Pastor Stormbaugh model that is not included in the Fama-French model?

Answer 35

A liquidity premium.

Question 36

What is the formula for expected dividend based on the target payout model?

Answer 36

Expected Dividend = Increase in Earnings * Target Payout Ratio * 1/n

Question 37

Does dividend policy affect required return on equity?

Answer 37

Yes - an unstable dividend policy will increase required return on equity.

Question 38

What is a better representation of capital available to all stakeholders - EBITDA or NI?

Answer 38

EBITDA, as it is pre-interest.

Question 39

Would a risk premium based on a public company be too high or too low for a private company?

Answer 39

Too high.

Question 40

What does sustainable growth rate assume with regards to capital structure?

Answer 40

When earnings are retained, more debt is issued in order to keep capital structure constant.

Question 41

When establishing the capital structure of a company, do you use market values or book values of debt and equity?

Answer 41

Market values. Note: If debt is trading at par, then MV = BV.

Question 42

What does the residual income model assume will happen to return on equity in the long run?

Answer 42

Competition will drive it down to the cost of capital, as competition will mean that supernormal earnings cannot be earned in the long run.