Equity A&V Flashcards
Three different analysis: Technical analysis, behavioral finance, and fundamental equity analysis. we focus on fundamental analysis.
what is the definition of technical analysis?
The science of recording, usually in graphic form, the actual history of trading (price changes, volume of transactions, etc.) in a certain stock or in “the Averages” and then deducing from the pictured history the probable future trend.
Technical analysis look at price changes.
The example of technical analysis: Candlestick Charts
If the stock went up, the body is white, with the opening price at the bottom of the body and the closing price at the top. If the stock went down, the body is black, with the opening price at the top and the closing price at the bottom.
The wick illustrates the highest and lowest traded prices of a stock, and the body the opening and closing trades
if it is white with no wick, it indicates the stock straight up. —a bullish sign.
What is Behavioral Finance?
Applies scientific research on human and social cognitive and emotional biases to better understand economic decisions and how they affect market prices, returns and the allocation of resources
Fundamental Equity Analysis
we focus on this
Fundamental analysis of a business involves analyzing its financial statements and health, its management and competitive advantages, and its competitors and markets
Fundamental Factors for Analyzing Equity
–We should focus our time on here
Fundamental Factors:
- Demand for product or service
- Industry analysis
- Corporate strategy and management
- Growth potential and drivers
- Financial Statements
- Ratios to evaluate performance
The Capital StructureClaims on a Company’s Assets and Income
- Bonds (Debt):
- -Firm obligation to pay interest and principal
- -Lien against the assets of the company
- -Right to force bankruptcy
- Preferred Stock (Hybrid Equity/Debt):
- -Fixed dividend payment is common
- -Paid after debt but before common stock
*Common Stock (Equity):
–Ownership control through right to vote for board of directors
–No obligation to pay
–Right/Opportunity to share in profits of company
share profit with ownership
the asset would go to debt holder, then preferred stock, and then common stock, which are equity holders
Common Stock Characteristics
- Owners of the corporation:
- Right to share in profits
- Right to vote for board or directors
- Limited Liability (can only loose amount invested)
- Benefit from company’s earnings growth (upside potential)
- High Risk:
- Residual claim after debt, bondholders and preferred.
- If no profits, no return.
- If bankruptcy, can lose entire investment.
Common Stock Characteristics (continue)
*Dividends not deductible by Issuer
-Tax code favors debt
*Preemptive Rights
-maintain proportionate share of firm
(ventures + convertible PS to prevent diluted)
*Voting Rights
-Proxy
-Majority Voting
-Cumulative Voting
Ratio Analysis –Equity Perspective
Five most important charateristies
Five most imprtant charaties
1) Growth
- -Growth in Sales (Top Line) and Net Income ( (Bottom Line or earnings) Growth in sales in #1 to look at. (if sales goes up, + margin expansion up = good; if sales goes down, + margin expansion up, = hurt. eg. IBM)
- -Growth in Earnings per Share = annual % increase in EPS
- -PEG Ratio = P/E / Annual EPS growth
2) Value
- -Price Earnings Ratio = Price per share / EPS
- -Trailing and Forward P/Es
3) Profitability
- -Profit Margins (Gross, Operating and Net)
- -Margins expanding or contracting
- -EBITDA, EBIT and Net Income
- -Return on Assets, Equity and Capital
Ratio Analysis –Equity Perspective (continus)
Five most important charateristies
4) Risk (real estate is a little less risk)
–Measured by Beta (Market Risk) and Standard Deviation (Total Risk)
Operational risk: asset
Financial risk: leverage up -> B up
–Driven by Volatility in Sales, FCFs and Earnings
–Industry and company’s growth stage are factors
5) Income
–Dividend Yield
–Payout Ratio
–Impact on Growth
What else is important?
- is div growth?
- is div safe?
Valuing Common Stock or Total Enterprise?
- Common Stock (Equity)
- -Value driven by right to share in company’s Earnings
- -Earnings to equity are residual flow after debt-holders have been paid interest (e.g. Net Income or levered FCF)
- Enterprise: (EV)
–Includes value of both debt and equity
–Value is driven by total cash flow prior to making interest payments (e.g. EBITDA or unlevered FCF)
–Sometimes referred to as value of the firm
it is value of the whole firm
Valuing Common Stock or Total Enterprise? continu
–Depending on the valuation methodology, you may be solving for either Enterprise Value (EV) (step #1) or Equity value.
–To translate one valuation to the other, use the following equations:
* Equity value (step #2) = Enterprise Value – Market Value Debt + Cash
* Enterprise Value = Equity Value + Market Value Debt – Cash
Note: (Market Value Debt – Cash) is often referred to as Net Debt.
Determining Value
Value=∑_(t=0)^N▒(〖CFt/((1+r)^2)〗 )
* There are various methods for valuing common stock but most center around the same basic theme
–Determine cash flow
–Discount cash flow based on risk
(if it is stock, it is cf. but if you hold the stock forever, it would be the dividend.
if it is bond, it is compound and
Equity Cash Flow Alternatives
- Dividends
- Net Income or Earnings( –CF equity, equity valuation)
- EBITDA
- Un-levered FCF
- Levered FCF to equity (–CF to both debt and equity, EV )
- Adjusted FCF
Note: It is critical to define exactly what is incorporated in your CF number because this will determine what you are valuing. FCF to equity holders will value equity. CF to all investors (both debt and equity) will value the enterprise. Moreover, consider what adjustments have been made to CFs?
Valuation Discount Rate Alternative
(RRR: measure risk and discount for that risk)
In class excise
**After-tax WACC: (EV)
= [(1 – tax rate) x (before-tax cost of debt) x (debt/(debt+equity))]
+ [(cost of equity) x (equity/(debt+equity)
**CAPM from comparable firm: (Equity)
Kcs = Krf + beta * (Km-Krf)
Note: CAPM and P/E rates are best for equity valuations while the WACC makes more sense for total enterprise valuations because it incorporates the cost of debt and equity.
Common Stock Valuation Methods
- Multiples (EBITDA, Earnings, Sales)
- Constant Growth Models
- Discounted Free Cash Flow Methods
1) Valuing Equity Multiples Methods
- -Several Equity and Enterprise valuation methods are based on simple multiples of a firm’s sales, earnings, book value of assets, EBIT or Free Cash Flow.
- -Two of the more common methods include P/E ratio and the Enterprise Value/EBITDA multiple
- -The advantage of using a multiple method is its easy to calculate and comps are usually market driven
Valuing Equity with Multiples Price/Earnings Ratio
(Share Price/ Earning Per Share)=P/E
EPS * P/E = Share Price
Net Income * P/E = Total Equity Value
Note: When valuing a new company or venture, use the P/E ratio from a comparable (“comp”) publicly traded company to determine the equity value.
Valuing Equity with Multiples Price/Earnings Ratio (continue)
Art: What is the appropriate multiple (P/E) to trade at?
Science: Calculate the most accurate Earnings estimate.
Valuing Equity with Multiples Price/Earnings Ratio (continue)
What determines/drives P/E Ratios?
- Potential Growth in Earnings (ROE x RR)
- Risk/Volitility in Sales, Earnings, FCF, etc
- Risk Free interest rates
- Position in Business/Economic Cycle (P/E vs Forward P/E)
Valuing Equity with Multiples Price/Earnings Ratio Example
Next year’s Projected Net Income = $10 ml
Comp P/E = 20
Total number of Shares Issued = 2 ml
Total Value of Equity = $10 ml x 20 = $200 ml
Price per Share = ($10ml x 20) / 2ml = $100
Valuing Equity with MultiplesEnterprise Value/EBITDA Ratio
(EV/EBITDA)*EBITDA =Entreprise Value
To solve for Equity Value use formula:
Enterprise Value – Market Value Debt + Cash = Equity Value
Per Share Value = Equity Value / # of shares outstanding
Note: EV/EBITDA Multiples are typically derived from industry averages, recent comparable transactions in the market, or company’s with similar risk profiles.
Valuing EquityEV/EBITDA Multiple Example
Next year’s Projected EBITDA = $5 ml Comp EV/EBITDA Multiple = 8 Market Value Debt = $10 ml Cash on B/S = $2 ml Total number of Shares Issued = 500K Enterprise Value = $5 ml x 8 = $40 ml Equity Value = $40ml - $10ml + $2ml = $32 ml Per Share Price = $32 ml / 500K = $64
2) Valuing EquityGrowth Based Models
- -Growth based models are essential valuing a company as a growing perpetual annuity
- -The flow being valued can be dividends, earnings, or free cash flow
- -Works best for less volatile, high dividend stocks
- -Is often used to determine a company’s terminal value in Discounted FCF models
Dividend Growth Model
- -Estimate the venture’s next Dividend, sustainable growth rate and required rate of return on common stock
- -Plug estimates into Dividend Growth Model and solve for share value
- -Multiply share value by number of shares to determine the firm’s total equity value
Note: If share buybacks are done regularly, some analyst will add an average annual buyback number with the dividend to get a total amount of cash given to equity.
Dividend Growth Model- formula
Vcs = D1 / (Kcs -g)
Where:
D1= D0 * (1+g)
g=ROE *r
Kcs = Required rate of return on common stock
Kcs > g By assumption to get a positive value
Example: Dividend Growth Model (Common Stock Valuation)
Gilliland Motor, Inc. paid a $3.75 dividend last year. At a constant growth rate of 6%, what is the value of the common stock if the investors require a 20% rate of return?
Vcs = D1 / (Kcs -g)
=3.75 *(1+0.06)/ (20% -6%) =3.975/0.14 = 28.39
Measuring Growth?
Method #1
g = ROE x r
Where:
g = growth in common stockholders investment in the firm.
ROE = return on equity
r = profit retention rate or plow back rate
d = dividend payout ratio = (1 – r)
Example –Measuring Growth
Given that a firm’s return on equity is 24% and management plans to retain 60% of earnings for investment purposes, what will be the firm’s growth rate?
g = ROE x r
=0.24* 0.6 = 0.144=14.4%
Measuring Growth?
Example
Axel Co. had earnings per share of $5.00 five years ago. This year their EPS was $10.00. They expect their growth to continue as before. What will their growth rate be?
(Hint: This is a PV problem, compute I/Y.)
**Method #2
Base growth off a combination of long term industry growth rate and GDP growth rate
Method #3 Determine the historical growth rate in company’s earnings Answer to the example: N=5, PV=-5, FV=10, PMT=0 CPT i/y = 14.8698%
Growth Based Modelsusing Earnings or FCF
Value CS (common stock) = Earnings or Levered FCF / (RRR – g)
Where:
Value CS = Intrinsic Value of Common Stock
Earnings or FCFs = Next period’s after-tax Earnings or FCFs
RRR = Required Rate of Return for Equity Investors
g = Sustainable growth in Earnings
Key Drivers Determining Value
- The 3 key drivers to equity value are:
- -Profitability: Free Cash Flow or Earnings
- -Equity investors Required Rate of Return (i.e. the discount rate)
- -Future Growth in Earnings or Free Cash Flow
- After investors and analysts estimate current FCF or Earnings, 2 key factors remain which can significantly impact corporate value. What is the correct
- -Required Rate of Return on Equity (i.e. the discount rate)?
- -Future growth in FCFs or Earnings?
Impact of Changes in
Growth and RRR
Example:
You estimated KPD Corporation FCFs per share for next year at $1. FCF is expected to grow at a constant rate of 8% annually. If your required rate of return on KPD equity is 20%, what is your valuation of KPD stock?
2nd
If your required rate of return on KPD equity is 12%.
If KPD Corporation goes through a restructuring and convinces investors that KPD’s risk has fallen and a 12% required rate of return on equity is now appropriate, what is KPD’s new valuation?
3rd
Due to the restructuring, KPD’s investor’s now feel a growth in FCF has risen from 8% to 10%. What is KPD’s new valuation?
Vcs = D1 / (Kcs -g)
value 1/ (20%-8%) =$8.33
2nd 1/ ( 12%-8%) =$25
3rd 1/ (12%-10%)= $50
the grow is what investors proceed what it is to be.
Factors Impacting Investor’s Perception
of Required Rate of Return (i.e. Risk)
Measured by volatility in stock price: Beta Kcs = Krf + beta * (Km-Krf) -Volatility in earnings -Cyclicality of Industry -Capital Structure -Liquidity and Credit strength -Confidence in management (track record) -Other risks (sovereign, foreign exchange, etc.)
Factors Impacting Investor’s Perception
of Potential Growth in Earnings
- -Industry growth rate
- -Company’s ability to gain market share
- -Management’s focus on growth and earnings
- —Capex and R&D
- —Introduction of new products and services
- —Divestitures of slow growth businesses
- —Value added acquisitions
- —Dividend policy (g = ROE x r)
- -Trends in Profit Margins
- -Capacity to raise capital
3) Equity ValuationDiscounted Unlevered FCF Model
1) Project unlevered FCFs for period in which reasonable growth rates and other financial factors can be estimated (e.g. 5 years) and PV these FCFs using the firm’s WACC
2) Estimate the residual or terminal value at the beginning of year 6 by using an annuity like valuation (e.g. FCF6 / WACC - g) and then PV this residual value
3) Add the FCF PVs and the residual value PV to get total Enterprise Value
4) Subtract PV of debt and add Cash on the B/S to Enterprise Value to determine shareholder’s Equity Value
5) Divide Equity Value by number of common shares outstanding to calculate Value Per Share.
Equity Valuation Discounted Unlevered FCF Model
Excel on "Discounted Cash Flow Anaysiss for Hawaiian Electric Company Sales EBITDA' Less: Depreciation EBIT Less: Taxes @ 7% Tax-effected EBIT
Plus Depreciation
Less: Maintenance capital expenditures
+/- changes in working capital
Unlevered cash flow
Asian Equities: Factors to consider
- -Estimating Growth and RRR
- -Risk free interest rate environment
- -Beta as measure of market risk
- -Country and currency risk
- -Ownership Impact
- -Differences in Accounting (Depreciation methods)
- -Tax Rates on equity investments
- -Differences in M&A valuations
