Equity Flashcards
Intrinsic Value
a calculated value determined through fundamental analysis (could differ from MV)
What to look for in the financial statement footnotes
a. Reclassifying gains and nonoperating income
b. Off-balance-sheet issues
c. Expense recognition
d. Accelerating of income
e. Amortization, depreciation, and discount rates
Absolute vs Relative Valuation Models
Absolute valuation models:
valuation based solely on investment characteristics, not outside firms
a. Dividend discount models
b. FCF,
c. RI
Valuation Models:
determining value in relation to the value of other assets (e.g. P/E)
Conglomerate discount
Purpose: investors apply a markdown for companies in multiple industries.
Because:
a. Internal capital inefficiency
b. Research valuation errors
How to Annualize a Return
To annualize the return
Formula: (1 + r)^t - 1
Example: (for 1% in 1 month):
(1 + 0.01)^12 - 1 = 0.1268 or 12.68%
Equity Risk Premium
Rm - Rf
Required Return for a Stock
CAPM: RF + B(equity risk premium)
Gordon Growth Model Equity Premium
(D1 / P) + g - RF
Weakness:
- assumes stable growth rate
Gordon Growth Model Expected Return
(D1 / P) + g
Build Up Method for Required Return
RF + equity risk premium + size premium + specific company premium
Can be used for closely held companies
Types of Return
Geometric < Arith
What is Beta?
Systematic risk
Tends to drift towards 1
What is Adjusted Beta?
Blumes Adjusted Beta: (2/3 x beta) + (1/3 x 1)
What are Porter’s Five Forces?
- Threat of New Entrants
- Threat of Substitutes
- Bargaining Power of Buyers
- Bargaining Power of Suppliers
- Rivalry Among Existing Competitors
Strategy Industry Styles
Adaptive Less Predictable Less Malleable
Classical More Predictable Less Malleable
Shaping Less Predictable More Malleable
Visionary More Predictable More Malleable
Classical Industry Style
Goal is to optimize efficiency (Using Porters 5 forces is an example)
Industry Examples: Oil companies, household products, tobacco. auto
Adaptive Industry Style
have to react quickly to change.
Goal is to maximize flexibility
Industry Examples: Specialty retail, office electronics, construction materials, biotech
Shaping Industry Style
goal is to influence their environment (Software is a good example)
Look to define new markets and technologies
Visionary Industry Style
Follows a “build it and they will come” approach. Very risky
i. Must have adequate resources and be long-term
Industry examples: food products, gas utilities, aerospace and defense, media, and insurance
Economies of scale
occurs if costs decreases and sales increase
COGS Forecast
forecast COGS = (historical COGS / revenue) x (estimate of future revenue)
OR
(1 - gross margin)(estimate of future revenue)
Forecasting financing costs; net debt and net interest expense
Net debt = gross debt - cash/short-term securities
Net interest expense = gross interest expense - interest income - cash/short-term securities
ROIC
better than ROE since it compares different capital structures
ROIC = NOPLAT / (operating assets - operating liabilities)
When to use dividend discount models
i. Company has a history of dividend payments
ii. Dividend policy is clear and related to the earnings of the firm
iii. Perspective from a minority shareholder
What is FCFF?
- Purpose: cash that can be paid out to bondholders and shareholders
- It is the cash after the firms buys/sell products, provides services, pay operating expenses, and makes short/long-term investments.
- FCFF = firm value
- discounted at the WACC
- Can use when FCFE is negative
What is FCFE?
- It is the cash available to common shareholders after funding capital requirements, working capital, and debt financing
- FCFE is discounted at the required return on equity
- FCFE is also Equity value = firm value - MV of debt
- Use when capital structure is not volatile
- Leverage affects FCFE
When to use FCFF and FCFE
i. Firms that do not have a dividend history or one that is not related to earnings
ii. When free cash flow is related to earnings
iii. Perspective from a controlling shareholder
Residual Income Definition
Purpose: earnings that exceeds the required return
Can be applied to negative free cash flow and non-dividend paying firms.
Firms must have high quality reporting
One and Two Period DDM Valuation
One Period DDM: V0 = D1 + P1 / 1 + R
Two Period DDM: V0 = D1 / (1 + R) + D2 + P2 / (1 + R)²
Leading and Trailing GGM
Leading GGM: D1 / r - g
Trailing GGM: D0 x (1 + g) / r - g
GGM Assumptions
Assumptions:
- Dividend is expected in 1 year and grow forever at a constant rate
- Dividends related to earnings
- G is less than r
PVGO
PVGO: V0 = E1 / R + PVGO
Justified leading P/E
Justified leading P/E = (1 - b) / r - g)
Justified trailing P/E
Justified trailing P/E = (1 - b) * (1 + g) / r - g
GGM Strengths and Weaknesses
Strengths
i. Is applicable to stable, mature, dividend-paying firms.
ii. Is easily communicated
Weaknesses
i. Valuations are very sensitive to estimates of g & r
ii. Cannot use for non-dividend-paying stocks
iii. Unpredictable growth patterns would be difficult
Growth Phases and Models to Use
a. Initial growth phase:
i. rapidly increasing earnings, no dividends, heavy reinvestment
ii. Use three-stage model
b. Transition phase:
i. dividends increasing but at a slower rate
ii. Use two-stage or H model
c. Mature phase:
i. earnings grow slowly and payout ratios are stable
ii. Use GGM
H-Model
D0 * (1 + gL) + D0 * H * (gS - gL)
r - gL r - gL
GGM Required Return
D1 / P0 + g
Sustainable Growth Rate
SGR = b x ROE
ROE = NI/SE
OR
Profit margin x asset turnover x financial leverage
DuPont
g = (NI - dividends) * NI * sales * total assets
NI sales total assets SH equity
FCFF/FCFE Formula breakdowns
- Noncash Charges (NCC)
Represents expenses that reduced NI but didn’t result in an outflow of cash
They are Depreciation, Amortization, write-down/impairment - Fixed Capital Investment (FCInv)
FCInv = ∆ of gross PP&E
OR ∆ in net PP&E + depreciation
Make sure to subtract any long-term assets that were sold
- Working Capital Investment (WCInv)
∆ in WC: current assets - current liabilities
Dont include cash or NP
- Interest Expense
- Net borrowing: difference between short and long-term debt accounts
FCFF Formulas
- FCFF Net Income = NI + NCC + [Int * (1 - tax rate)] - FCInv - WCInc
- FCFF EBIT = [EBIT * (1 - tax rate)] + Dep - FCInv - WCinc
- FCFF EBITDA = [EBITDA * (1 - tax rate) + (Dep * tax rate) - FCInv - WCInc
- FCFF CFO = CFO + {Int * (1 - tax rate)] - FCInv
Note: EBITA is a poor proxy
If Preferred Stock is there make sure to add back
FCFE Formulas
- FCFE from FCFF = FCFF - Int(1 - tax rate) + net borrowing
- FCFE from Net Income = NI + NCC - FCInv - WCInv + net borrowing
- FCFE from CFO = CFO - FCInv + net borrowing
Note: If Preferred Stock is there make sure to subtract
CFO
CFO = Net income + NCC - WCInv
Then if you adjust for taxes it = FCFF
Then add net borrowing it = FCFE
Single-Stage FCFF Model
(same as GGM) used for stable mature firms
Formula: FCFF1 / WACC - g
OR
FCFF0 * (1 + g) / WACC - g
Assumptions: FCFF grows at a constant rate
g < WACC
Single-Stage FCFE Model
(Same as FCFF) often used for international valuation with high inflation
FCFE1 / r - g
OR
FCFE0 * (1 + g) / r - g
P/E Ratio
Advantages:
- widely used as a proxy for risk and growth
- P/E differences are related to long-run stock returns
Disadvantages:
- earnings can be negative
- volatile earnings hard to interpret
- management can distort earnings
P/B Ratio
Advantages:
- Can be used with negative earnings and bankruptcy
- BV more stable than EPS
- More appropriate for firms with liquid assets (e.g. finance, insurance, and banks)
Disadvantages:
- Does not reflect full economic value (e.g. human capital)
- Difficult due to size differences
- Management can distort BV
P/S Ratio
Advantages:
- Good for distressed firms, mature, cyclical industries, and START UPS
- Not easy to manipulate
- Not as volatile as P/E
Disadvantages
- High sales does not mean high profits
- Does not capture differences in cost structure
Justified P/B ratio
Justified P/B ratio = ROE - g / r - g
Justified P/S
Justified P/S = (Earnings/Sales) * payout ratio * (1 + g) / r - g
Justified P/CF
Justified P/CF = FCFE0 * (1 + g) / r - g
THEN divide by CF
PEG Formula
Disadvantages
P/E ratio / g
Lower the better
Disadvantages:
Relationship between P/E and g is not linear
Doesn’t account for risk
Enterprise Value (EV)
Enterprise Value (EV) = MV of common stock + MV of preferred equity + MV of debt - cash and investments
Be able to rearrange!
Useful for comparing companies with different financial leverage
Disadvantages: if WC increases EBITDA will be overstated
Residual Income Per Share Formula
RI = EPS1 - (BVPSt-1 * r)
EPS = BVPS * ROE
Economic Value Added (EVA)
AKA
Economic Profit
Purpose: measures the value added for shareholders
Formula: NOPLAT - (WACC * total capital)
OR
[EBIT x (1 - t)] - $WACC
Single Stage RI valuation
Remember:
- g = retention ratio * ROE!!!!!
- RI reverts to 0 over time
- r is the COST OF EQUITY
Also: 1 + r is the value now (instead of r - g)
RI implied growth rate
RI Strengths/weaknesses
Strengths:
- Terminal value does not dominate the intrinsic value estimate
- Applicable even without dividends or positive cash flow
Weaknesses:
- can be manipulated by management.
- requires numerous and significant adjustments.
- The models assume that the clean surplus relation holds
RI should be used when?
- Firm pays no dividends
- Expected cash flow is negative
- TV forecast is highly uncertain
- Evaluates managerial effectiveness
Clean surplus violations are
- Pension adjustments
- Operating leases
- SPEs
- AFS changes
- Foreign currency G/L
Solution: Calc ROE using comprehensive income (NI + ∆OCI)
Definitions of value
-
Fair value: used for tax purposes and financial reporting
- Cash price based on free market and well-informed buyer/seller
-
Market value: used for appraisals (used for Real Estate)
- Requires willing and informed seller/buyer, appraised value
-
Investment value: value specific to a buyer
- Think about future cash flows, perceived risk, appropriate discount rates, financing costs, synergies
- Intrinsic value: derived from investment analysis
What to use when valuing private companies?
- Early stages = asset-based
a. Assets - liabilities
b. Lowest valuation. Used for poorly performing firms, REITS, intangible assets
- Growth stage = income approach
a. values a firm at the PV of future income - Mature = market value
a. values a firm using price multiples based on recent sales
Discount for Lack of Control (DLOC)
Minority shareholders are at a disadvantage b/c they have less power
DLOC = 1 - [1 / 1 + control premium]
Combining DLOC and DLOM
DLOC and DLOM = 1 - [(1 - DLOC)(1- DLOM)]
Market value added (MVA)
difference between l/t debt and equity and the BV of invested capital
MV equity + MV of debt - total capital
Growth Rate of Dividends
(Latest Dividend / Beginning Dividend)^1 / n
Then - 1
n = # of years between dividends
Capitalized Cash Method (CCM)
good when no comparables are available, stable growth expected
Excess earnings method (EEM)
Excess earnings method (EEM): excess earnings over required return
Allows for WC, FC, and intangible assets to use different discount rates.
Used for small firms with significant intangible assets
Capitalization rate
(WACC – Long-term growth rate)
Breaking down Debt-to-Equity Ratio
D/E / (1 + D/E)
Example: Debt to equity of 0.3
0.3 / (1 + 0.3) = 23.08%
That is the debt %
Residual Income Standard Formula
NI - equity charge
NI also = EBIT - interest expense - income tax expense
equity charge = equity capital * cost of equity
RI Income with Persistance
BV0 + [(ROE - r)*BV0] / 1 + cost of equity - w]
w = persistence factor (assumption of a decreasing RI)
Justified Forward P/E
Is it P0 / E1 which = (1 - b) * (r - g)
