Equity - Free Cash Flow Valuation Flashcards by Zach Laux

Holding Period Return (HPR)

[(P1+CF1) / P0] - 1

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Required Return = risk-free return + Beta*Equity Risk Premium

…

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Gordon Growth Model Equity Risk Premium

= (1-year forecasted dividend yield on market index) + (consensus LT earning growth rate) - (LT government bond yield)
= D1/P + g - RLT

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Supply Side Equity Risk Premium (Macroeconomic Model). Example Ibbotson-Chen

Equity risk premium = [1+i][1+rEg][1+PEg] - 1 + Y - Rf
= [1+expected inflation][1+expected real growth in EPS][1+expected change in P/E ratio] - 1 + Expected yield - Expected risk-free return

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Risk Premium = Factor Sensitivity * Factor risk premium

Typically calculated for the macroeconomic models

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Fama-French Macroeconomic model

= Rf + Betamkt(Rmkt-Rf) + Betasmb(Rsmall-Rbig) + Betahml*(Rhbm-Rlbm)
= Risk free rate + (Return on a value weighted market index-risk free rate) + (A small cap return premium equal to the average return on small cap portfolios - average return on large-cap portfolio) + (A value return premium equal to the average return on a high book-to-market portfolio - the average return on low book-to-market portfolios)

*baseline betas are all 0, except Betamkt = 1

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Pastor-Stambaugh model vs Fama-French Model

Pastor Stambaugh model adds a liquidity factor to the Fama-French Model

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Blume method

Adjusted Beta = 2/3*regressionBeta + 1/3

Betax,unlevered = Betax * [1/(1+Debt/Equity)]
BetaA = Betax,unlevered * [1 + (DebtA/EquityA)]

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Weight Average Cost of Capital

WACC = Md(1-t)rd + Me*re

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Forecast COGS

=(Historical COGS / Revenue) * Estimate of future revenue

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Projected Inventory

Forecasted COGS / Inventory turnover

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Project A/R

=DSO * (forecasted sales/365)

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Return on invested capital

ROIC = Net operating profit after tax / (operating assets - operating liabilities)

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One Period Dividend Discount Model

V0 = (D1+P1) / (1+r)

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Multi-period Dividend Discount Model

V0 = D1/(1+r) + D2/(1+r)^2 +…+Dn/(1+r)^n

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Gordon Growth Model

= D0*(1+g) / (r-g) = D1 / (r -g)

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Present Value of Growth Opportunities

V0 = PVGO + (E1/r)

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Justified Leading P/E

P0/E1 = (D1/E1) / (r-g) = (1-b) / (r-g)

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Justified Trailing P/E

P0/E0 = ([D0(1+g)]/E0) / (r-g) = [(1-b)(1+g)] / (r-g)

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Value of perpetual shares

= Dp / rp

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Two Stage DDM

{[D0 + (1+gs)^t]/(1+r)^t} + {[D0 (1+gs)^n(1+gl)]/[(1+r)^n*(r-gl)]}

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H-Model

V0 = [D0(1-gl)]/(r-gl) + [D0H*(gs-gl)] / (r-gl)

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Sustainable Growth Rate

= retention ratio (b) * ROE = g

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ROE

= (net income/sales) * (sales/Total Assets) * (Total Assets / Shareholders Equity)

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PRAT Model

SGR = P(profit margin) * R(retention ratio) * A(asset turnover) * T (financial leverage)

Bond Yield Model

Required return = YtM on LT bonds + risk premium

Country Spread Model

Accounts for FX rate risk by using the difference in bond yields

Country risk rating model

Begins with model of a developed country , the modifies the model with risk premiums from a developing country to derive a total emerging market risk premium

Unlevering Beta takes out the company-specific risk and isolates the market risk

...Relever nonpublic or thinly traded public entities

Liquidation Value

= current market value of assets - current market value of liabilities

Including the historical returns biases the equity risk premium upwards due to the survivorship bias

...

Build up Method calculation for risk premium

required return = Rf + equity risk premium + size premium + specific company premium Use build up method for closely held companies

Beta is the level of systematic risk

...

Conditions if there exists economies of scale

1) Big Firm OM > Small Firm OM 2) COGS%/Revenue of Big Firm > COGS%/Revenue of smaller firm 3) SGA%/Revenue of Small Firm < SGA%/Revenue of Big Firm

Cash Tax Rate

Total Tax / Revenue

Total dividend (using Retained Earnings)

= REbeg + Net Income - REend

If the growth rate of a company's dividend is too high, readjust the growth rate of the dividend to the growth rate of GDP.

...

Use the residual income method, if the firm ...

If the firm does not pay dividends, or has negative cash flows over the forecasted period.

1-b vs. b

``` (1-b) = dividend payout ratio b = retention rate ```

Current dividend

= EPS * payout ratio

Sustainable growth rate

= ROE * retention rate

Dividend discount models

define cash flow as the dividends to be received by shareholders

Free Cash Flow to the Firm

defined as the cash flow generated by the firms current operations that is in excess of the capital investment required to sustain the firm's current productive capacity.

Free Cash Flow to Equity

Cash available to stockholders after funding capital requirement and expenses associated with debt financing.

Residual Income models

Define the amount of earnings during the period that exceeds the investor's required return.

Retention ratio (b)

= (earnings - dividends) / earnings

Dupont Formula

ROE = (net income / shareholders' equity)*(net income / sales)*(sales/total assets)*(total assets/shareholders' equity) Then, since SGR = g = ROE * (1-b) g = [(net income - dividends)/net income] * (net income/sales)*(sales/Total assets) *(total assets/ shareholders' equity)

PRAT Model

Sustainable growth rate (SGR) = g = Profit Margin (P) * Retention Ratio (R) * Asset Turnover (A) * Financial Leverage (T)

FCFE = Net Income - (FCinv-Depreciation) - WCinv + net borrowing

...

FCFE = Net Income - (1-DR)*(FCinv - Dep) - (1-DR)*WCinv where, DR = target debt to asset ratio

...

FCFF = EBIT(1-t) + Depreciation -FCinv - WCinv

...

Enterprise Value

= Firm value - cash & ST investments

Use FCFE in most cases, except:

1) capital structure is volatile 2) company has FCFE < 0 3) Significant debt is outstanding

FCFF = net income + NCC + [Interest Expense*(1-t)] - FCinv - WCinv

...

FCFF = CFO + [Interest Expense*(1-t)] - FCinv b/c CFO = Net income + NCC - WCinv

...

FCFE = FCFF - [Interest Expense*(1-t)] + net borrowing

...

FCFE = CFO - FCinv + Net borrowing

...

FCFF = [EBITDA*(1-t)] + (Depreciation*t) - FCinv - WCinv

...

Incremental FCinv

(Capital Expenditures - Depreciation) / (Change in Sales)

Incremental WCinv

Change in WC / Change in Sales

Two stage FCFF

[FCFFt/(1+WACC)^t] + {[FCFFn+1 / (WACC-g)] * [1/(1 + WACC)^n]}

Trailing P/E

market price per share / EPS over previous 12 months

Leading P/E

Market price per share / Forecasted EPS for next 12 months

Book value of equity

= (Total assets - Total liabilities) - preferred equity

Normalize EPS by

ROE * BVPS

Justified trailing P/E

[(1-b)*(1+g)] / (r-g)

Justified leading P/E

(1-b) / (r-g)

Yardeni Model

CEY = CBY - K*LTG + Error | Current Earnings Yield = Current Moody's A rated bond yield - constant*5year consensus earnings g.r.

P/E - to - earnings growth (PEG)

= (P/E)/g

Enterprise Value

= Market value of common stock + Market value of preferred equity + Market value of debt + minority interest - cash and investments

Earnings surprise

= reported EPS - expected EPS

Standardized unexpected earnings

SUE = Earnings surprise / standard deviations of earnings surprise

Justified P/B Ratio

(ROE - g) / (r-g)

Justified P/S Ratio

[(E/S) * (1-b) * (1+g)] / (r-g)

Justified P/CF Ratio

[FCFE * (1+g)] / (r-g)

Justified Dividend Yield

(r-g) / ( 1+g)

Trailing P/E

(P/S) / net profit margin

Leading P/E

Trailing P/E / (1+g)

Expected growth in dividend and earnings

= ROE * (1-payout ratio)

g = retention rate * E/S * Sales/Assets * Assets/Shareholders' Equity

...

g = retention rate * E/S * Sales/Assets * Assets/Shareholders' Equity

...

Residual Income

= Earnings - (r * Bt-1) | = (ROE-r) Bt-1

Single Stage Residual Income Valuation

V0 = B0 + [(ROE-r)/(r-g) * B0]

Residual Income

= Net Income - Equity Charge = Net Income - (Equity Capital * Cost of Equity Capital) OR = Net Operating Profit - Capital Charge = Net Operating Profit - Equity Charge - Debt Charge =NOPAT - (Equity Capital * Cost of Equity) - (Debt Capital*Cost of Debt*(1-t))

Retention Ratio (b)

= (EPS - Dividend) / EPS

ROE = EPS / BVPS

...

Residual Income is the book value of the firm plus the present value of the firms' economic profits.

RI is used to measure goodwill impairment, management effectiveness and equity value.

Firms making more aggressive accounting decisions will report higher book values and lower future earnings

...

Value of intangibles

= [RI * (1+g)]/(discount rate of intangibles - growth of residual income)