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CFA Level II 2020 > Equity > Flashcards

Equity Flashcards

1
Q

Intrinsic Value

A

a calculated value determined through fundamental analysis (could differ from MV)

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2
Q

What to look for in the financial statement footnotes

A

a. Reclassifying gains and nonoperating income
b. Off-balance-sheet issues
c. Expense recognition
d. Accelerating of income
e. Amortization, depreciation, and discount rates

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3
Q

Absolute vs Relative Valuation Models

A

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)

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4
Q

Conglomerate discount

A

Purpose: investors apply a markdown for companies in multiple industries.

Because:

a. Internal capital inefficiency
b. Research valuation errors

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5
Q

How to Annualize a Return

A

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%

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6
Q

Equity Risk Premium

A

Rm - Rf

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7
Q

Required Return for a Stock

A

CAPM: RF + B(equity risk premium)

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8
Q

Gordon Growth Model Equity Premium

A

(D1 / P) + g - RF

Weakness:

  1. assumes stable growth rate
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9
Q

Gordon Growth Model Expected Return

A

(D1 / P) + g

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10
Q

Build Up Method for Required Return

A

RF + equity risk premium + size premium + specific company premium

Can be used for closely held companies

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11
Q

Types of Return

A

Geometric < Arith

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12
Q

What is Beta?

A

Systematic risk

Tends to drift towards 1

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13
Q

What is Adjusted Beta?

A

Blumes Adjusted Beta: (2/3 x beta) + (1/3 x 1)

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14
Q

What are Porter’s Five Forces?

A
  1. Threat of New Entrants
  2. Threat of Substitutes
  3. Bargaining Power of Buyers
  4. Bargaining Power of Suppliers
  5. Rivalry Among Existing Competitors
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15
Q

Strategy Industry Styles

A

Adaptive Less Predictable Less Malleable

Classical More Predictable Less Malleable

Shaping Less Predictable More Malleable

Visionary More Predictable More Malleable

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16
Q

Classical Industry Style

A

Goal is to optimize efficiency (Using Porters 5 forces is an example)

Industry Examples: Oil companies, household products, tobacco. auto

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17
Q

Adaptive Industry Style

A

have to react quickly to change.

Goal is to maximize flexibility

Industry Examples: Specialty retail, office electronics, construction materials, biotech

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18
Q

Shaping Industry Style

A

goal is to influence their environment (Software is a good example)

Look to define new markets and technologies

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19
Q

Visionary Industry Style

A

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

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20
Q

Economies of scale

A

occurs if costs decreases and sales increase

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21
Q

COGS Forecast

A

forecast COGS = (historical COGS / revenue) x (estimate of future revenue)

OR

(1 - gross margin)(estimate of future revenue)

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22
Q

Forecasting financing costs; net debt and net interest expense

A

Net debt = gross debt - cash/short-term securities

Net interest expense = gross interest expense - interest income - cash/short-term securities

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23
Q

ROIC

A

better than ROE since it compares different capital structures

ROIC = NOPLAT / (operating assets - operating liabilities)

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24
Q

When to use dividend discount models

A

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

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25
What is FCFF?
1. Purpose: cash that can be paid out to bondholders and shareholders 2. It is the cash after the firms buys/sell products, provides services, pay operating expenses, and makes short/long-term investments. 3. FCFF = firm value 4. discounted at the WACC 5. Can use when FCFE is negative
26
What is FCFE?
1. It is the cash available to common shareholders after funding capital requirements, working capital, and debt financing 2. FCFE is discounted at the required return on equity 3. FCFE is also **Equity value** = firm value - MV of debt 4. Use when capital structure is not volatile 5. Leverage affects FCFE
27
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
28
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
29
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
30
Leading and Trailing GGM
Leading GGM: D1 / r - g Trailing GGM: D0 x (1 + g) / r - g
31
GGM Assumptions
Assumptions: 1. Dividend is expected in 1 year and grow forever at a constant rate 2. Dividends related to earnings 3. G is less than r
32
PVGO
PVGO: V0 = E1 / R + PVGO
33
Justified leading P/E
Justified leading P/E = (1 - b) / r - g)
34
Justified trailing P/E
Justified trailing P/E = (1 - b) \* (1 + g) / r - g
35
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
36
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
37
H-Model
_D0 \* (1 + gL)_ + _D0 \* H \* (gS - gL)_ r - gL r - gL
38
GGM Required Return
D1 / P0 + g
39
Sustainable Growth Rate
SGR = b x ROE ROE = NI/SE OR Profit margin x asset turnover x financial leverage
40
DuPont
g = _(NI - dividends)_ \* _NI_ \* _sales_ \* _total assets_ NI sales total assets SH equity
41
FCFF/FCFE Formula breakdowns
1. Noncash Charges (NCC) Represents expenses that reduced NI but didn’t result in an outflow of cash They are Depreciation, Amortization, write-down/impairment 2. 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 3. Working Capital Investment (WCInv) ∆ in WC: current assets - current liabilities Dont include cash or NP 4. Interest Expense 5. Net borrowing: difference between short and long-term debt accounts
42
FCFF Formulas
## Footnote 1. FCFF Net Income = NI + NCC + [Int \* (1 - tax rate)] - FCInv - WCInc 2. FCFF EBIT = [EBIT \* (1 - tax rate)] + Dep - FCInv - WCinc 3. FCFF EBITDA = [EBITDA \* (1 - tax rate) + (Dep \* tax rate) - FCInv - WCInc 4. FCFF CFO = CFO + {Int \* (1 - tax rate)] - FCInv Note: EBITA is a poor proxy If Preferred Stock is there make sure to add back
43
FCFE Formulas
1. FCFE from FCFF = FCFF - Int(1 - tax rate) + net borrowing 2. FCFE from Net Income = NI + NCC - FCInv - WCInv + net borrowing 3. FCFE from CFO = CFO - FCInv + net borrowing Note: If Preferred Stock is there make sure to subtract
44
CFO
CFO = Net income + NCC - WCInv Then if you adjust for taxes it = FCFF Then add net borrowing it = FCFE
45
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
46
Single-Stage FCFE Model
(Same as FCFF) often used for international valuation with high inflation FCFE1 / r - g OR FCFE0 \* (1 + g) / r - g
47
P/E Ratio
**_Advantages:_** 1. widely used as a proxy for risk and growth 2. P/E differences are related to long-run stock returns **_Disadvantages:_** 1. earnings can be negative 2. volatile earnings hard to interpret 3. management can distort earnings
48
P/B Ratio
**_Advantages:_** 1. Can be used with negative earnings and bankruptcy 2. BV more stable than EPS 3. More appropriate for firms with liquid assets (e.g. finance, insurance, and banks) **_Disadvantages_**: 1. Does not reflect full economic value (e.g. human capital) 2. Difficult due to size differences 3. Management can distort BV
49
P/S Ratio
**_Advantages:_** 1. Good for distressed firms, mature, cyclical industries, and START UPS 2. Not easy to manipulate 3. Not as volatile as P/E **_Disadvantages_** 1. High sales does not mean high profits 2. Does not capture differences in cost structure
50
Justified P/B ratio
Justified P/B ratio = ROE - g / r - g
51
Justified P/S
Justified P/S = (Earnings/Sales) \* payout ratio \* (1 + g) / r - g
52
Justified P/CF
Justified P/CF = FCFE0 \* (1 + g) / r - g THEN divide by CF
53
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
54
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
55
Residual Income Per Share Formula
RI = EPS1 - (BVPSt-1 \* r) EPS = BVPS \* ROE
56
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
57
Single Stage RI valuation
Remember: 1. g = retention ratio \* ROE!!!!! 2. RI reverts to 0 over time 3. r is the **COST OF EQUITY** Also: 1 + r is the value now (instead of r - g)
58
RI implied growth rate
59
RI Strengths/weaknesses
**_Strengths:_** 1. Terminal value does not dominate the intrinsic value estimate 2. Applicable even without dividends or positive cash flow **_Weaknesses:_** 1. can be manipulated by management. 2. requires numerous and significant adjustments. 3. The models assume that the clean surplus relation holds
60
RI should be used when?
1. Firm pays no dividends 2. Expected cash flow is negative 3. TV forecast is highly uncertain 4. Evaluates managerial effectiveness
61
Clean surplus violations are
1. Pension adjustments 2. Operating leases 3. SPEs 4. AFS changes 5. Foreign currency G/L **Solution:** Calc ROE using comprehensive income (NI + ∆OCI)
62
Definitions of value
1. **Fair value:** used for tax purposes and financial reporting 1. Cash price based on free market and well-informed buyer/seller 2. **Market value:** used for appraisals (used for Real Estate) 1. Requires willing and informed seller/buyer, appraised value 3. **Investment value:** value specific to a buyer 1. Think about future cash flows, perceived risk, appropriate discount rates, financing costs, synergies 4. **Intrinsic value:** derived from investment analysis
63
What to use when valuing private companies?
1. Early stages = asset-based a. Assets - liabilities b. Lowest valuation. Used for poorly performing firms, REITS, intangible assets 2. Growth stage = income approach a. values a firm at the PV of future income 3. Mature = market value a. values a firm using price multiples based on recent sales
64
Discount for Lack of Control (DLOC)
Minority shareholders are at a disadvantage b/c they have less power DLOC = 1 - [1 / 1 + control premium]
65
Combining DLOC and DLOM
DLOC and DLOM = 1 - [(1 - DLOC)(1- DLOM)]
66
Market value added (MVA)
difference between l/t debt and equity and the BV of invested capital MV equity + MV of debt - total capital
67
Growth Rate of Dividends
(Latest Dividend / Beginning Dividend)^1 / n Then - 1 n = # of years between dividends
68
Capitalized Cash Method (CCM)
good when no comparables are available, stable growth expected
69
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
70
Capitalization rate
(WACC – Long-term growth rate)
71
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 %**
72
Residual Income Standard Formula
**NI - equity charge** NI also = EBIT - interest expense - income tax expense equity charge = equity capital \* cost of equity
73
RI Income with Persistance
BV0 + [(ROE - r)\*BV0] / 1 + cost of equity - w] w = persistence factor (assumption of a decreasing RI)
74
Justified Forward P/E
Is it P0 / E1 which = (1 - b) \* (r - g)

CFA Level II 2020 (13 decks)

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