Equity Flashcards
FCF
Net Fixed Capital Investment
Free Cash Flow to the Firm
Free Cash Flow to Equity
Value with each model
FCF
Inputs to Free Cash Flow
Common Noncash charges: + or - and location? I can do
- If decrease NI, then add back
- If increases NI, then subtract
Fcf
Net borrowing
FCF
Working Capital Investment
WCinv = (OCA - OCL)
- OCA/OCL is operating current assets/liabilities
- Part of CFO
- Direct relationship w/ liability acct ∆ (increase/decrease liability = same for WCinv)
- Opposite with asset acct ∆ (increase/decrease asset drives opposite in WCinv
Industry & Company Analysis
- Top down / bottrom up
- Segments disclosures
- What are calcs and considerations in revenue and expense forecasting?
Industry & Company Analysis
- What’s considering in Balance Sheet forecasting? (I/S- and non-I/S-related)
- Types of return on capital?
- Impacts on margins?
[mkt-based-valuations]
Price to Sales
- advantages/disadvantages
- calculation
- calculate justified ratio
- fundamental influences
- growth driver
Advantages
- Meaningful for distressed firms.
- Sales rev not easily manipulated.
- Not as volatile as P/E ratios.
- Useful for mature, cyclical, and zero-income (start-up) firms.
Disadvantages
- High sales do not necessarily mean high profits or cash flows.
- Doesn’t capture cost structure differences b/w firms.
- Rev recognition practices still distort sales.
Calc
- See slide. Note: E/S = profit margin, so we can also calculate (P0 / S0 ) = profit margin x justified trailing P/E
[mkt-based valuation]
P/E ratio
- pros/cons of use
- calculation
- calculate justified ratio
- fundamental influences
- Analyst adjustments?
- Normalized earning methods?
- P/E growth drivers?
- Pros/cons
- Pro - EPS primary driver of value, popular w/ investors, empirical research shows relation to avg stock returns long-term
- Con - zero or negative earnings issue, adjust book earnings req, mgmt control of accting
- While the price is always the market price of a share of stock, the analyst must determine the EPS. Analysts frequently use normalized EPS rather than EPS from the most recent financial statements. There are two methods of normalization:
mkt-based valuation
Price-to-CashFlow
- advantages/disadvantages
- calculation
- calculate justified ratio
- fundamental influences
- growth driver
Advantages:
- CF more difficult to manipulate.
- Price-to-CF more stable than P/E.
- Price-to-CF mitigates quality concerns of reported earnings.
Disadvantages
- Determining true cash flow from operations may be difficult.
- FCFE may be better than cash flow to the entire firm, but it’s also more volatile.
Calcs:
- P/CF: CF = NI + depreciation + amortization.
- P/CFO = NI + Dep + Other NCC - (Use of Cash: increase A / decrease L) + (source of cash: decrease A or increase L)
- Price-to-adjusted CFO (P/CFO)
- adjusted CFO = CFO + [(net cash interest outflow) × (1 – tax rate)].
- Price-to-FCFE:
- FCFE = CFO – FCInv + net borrowing.
- Price-to-EBITDA: EBITDA = earnings before interest, taxes, depreciation, and amortization.
Theoretically, FCFE is the preferred way to define cash flow. However, FCFE is also more volatile than traditional cash flow. EBITDA is a measure of cash flow to all providers of capital (i.e., both debt and equity). Hence, it may be better suited to valuing the entire firm rather than just the equity stake. Analysts typically use trailing cash flows when calculating price-to-cash-flow ratios.
mkt-based valuation
PEG Ratio (very testable)
- calc
- implications
- drawbacks
PEG = (P/E) / g (<strong><em><u>whole number!</u></em></strong> not decimal!)
Implications - calculates a stock’s P/E per unit of expected growth, so:
- Low PEG desirable, indicates undervaluation
- High PEG less attractive, indicates overvalued
Drawbacks
- differences in firm risk attributes
- differences in duration of growth
- linear relationship assumed b/w P/E and g, but this may actually be nonlinear
- calc uses g as WHOLE #!!!
Mkt-based valuation
Pricing multiples overall
- What are price multiples vs justified price multiples?
- What are the two methods for justifiying a price multuiple? (define each)
Price multiples: Price multiples are ratios of a common stock’s market price to some fundamental variable.
Justified price multiples: what the multiple should be if the stock is fairly valued.
- Actual multiple > Justified price multiple means stock overvalued (vice-versa)
- Two methods:
- Method of comparables is an average multiple of similar stocks in the same peer group. The economic rationale for the method of comparables is the Law of One Price, which asserts that two similar assets should sell at comparable prices
- Forecasted fundamentals: Ratio of DCF valuation (numberator) to fundamental variable (e.g. EPS).
mkt-based valuation
P/B ratio
- advantages/disadvantages
- calculation
- calculate justified ratio
- fundamental influences
- growth driver
Advantages:
- BV usually positive, even when earnings are negative.
- BV more stable than EPS.
- BV is good measure of net asset value (especially for firms such as financial institutions that hold liquid assets).
Disadvantages:
- Misleading when significant size differences b/w firms.
- BV influenced by accounting choices/conventions.
- Inflation/tech may drive large differences b/w BV and MV
Private companies
LOS 34.g Explain factors that require adjustment when estimating the discount rate for private companies.
Adjustments made for:
- size premium
- Debt availability and cost
- acquirer vs target
- projection risk
- life cycle stage
Private companies
LOS 34.h Compare models used to estimate required rate of return for private company equity
Private company equity required return models:
- CAPM
- Expanded CAPM
- Build-up method
[res income]
Residual income valuation
- strengths/limitations
- calculation (RI and valuation model)
- accounting challenges
Residual Income (RI) = NI - equity charge
- where:
- equity charge = equity capital x cost of equity
= (Bt-1) x (r)
Strengths
- Terminal value doesn’t dominate valuation equation (as with DDM and FCFE)
- Uses available accounting data.
- Useful w/ non-dividend-paying firms.
- Focuses on economic profits.
Limitations
- Accting manipulation by mgmt
- Accting data may need significant adjustments
- Assumes clean surplus relationship (i.e., ending BV = beginning BV + earnings – dividends)
Accounting Issues
There are many accounting issues associated with the residual income approach. Any accounting procedure that results in a direct charge to equity (e.g., foreign currency translation adjustments and some pension adjustments, etc.) will cause the residual income approach to break down. If the residual income model shows up on the exam, the most likely accounting issues that you will have to deal with involve balance sheet adjustments. Common balance sheet adjustments that you may have to allow for include the following:
- Changing inventory value from LIFO to current value.
- Capitalization of operating leases.
- Pension asset/liability issues.
- Goodwill.
On the exam, make the adjustments to the balance sheet and then calculate the value of the stock with the residual income method.
[Return Concepts]
Beta estimates for Public vs non-public/thinly traded firms
Return Concepts
- Build-up method
- Bond Yield + Risk Premium
- Country Spread model and risk rating model
- WACC
Return Concepts
CAPM
ERP
Forward-looking ERP
Return Concepts
How do you measure required return with:
- Multi-factor models?
- Fama-French?
- Pastor-Stambaugh?
- Artbitrage Pricing (BIRR version)?
Valuation: Application & Process
- Intrinsic Value (perceived mispricing)
- Going-concern assumptions
- Model selection criteria
Valuation - Applications & Process
- Absolute vs relative values
- Valuation process overview: 5 steps, what’s critical?
- Porter’s 5-Forces?
- Porter’s competitive strategy? (3-advantages)
- Uses of valuation
Residual Income
Estimating & Calculating Future Residual Income
Residual Income
RI definition, post, & pre-levered figures
Residual Income
RI Formula & Basic Valuation
RI
RI Strengths
RI
RI Limitations
LOS 30.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.
