Equity valuation

Question 1

Module 20.1, LOS 20.a

In asset valuation, what are the potential mispricing sources (put in fotmula)?

Answer 1

IVanalyst − price = (IVactual − price) + (IVanalyst − IVactual)

Question 2

Module 20.1, LOS 20.a

Which value does the investor need to assess acqisition?

Answer 2

Investment value

Question 3

Module 20.1, LOS 20.e

What are the five elements of industry structure by Michael Porter?

Answer 3

1) Threat of new entrants in the industry.
2) Threat of substitutes.
3) Bargaining power of buyers.
4) Bargaining power of suppliers.
5) Rivalry among existing competitors.

Question 4

Module 20.1, LOS 20.e

What are the 3 most common strategies a company may employ in order to compete and generate profits?

Answer 4

1) Cost leadership
2) Product differentiation
3) Focus (employing one of the previous strategies within a particular segment of the industry in order to gain a competitive advantage)

Question 5

Module 20.1, LOS 20.g

What is a conglomerate discount and what are the possible reasons of such discount?

Answer 5

Conglomerate discount - investors apply a markdown to the value of a company that operates in multiple unrelated industries, compared to the value a company that has a single industry focus

Reasons:

1) Internal capital inefficiency
2) Endogenous (internal) factors (s.a. buying unrelated business to hide poor performance)
3) Measurement mistakes (or discount doesn’t exist)

Question 6

Module 20.1, LOS 20.h

Which valuation model does controlling interest imply?

Answer 6

Cash flow model since having a controlling interest allows to set dividend policies

Question 7

Module 20.1, LOS 20.c
What is the most relevant definition of value to use in an agreement between the owners of a private business regarding the price at which the owners can sell their ownership interest?

Answer 7

Fair market value

Question 8

Module 21.1, LOS 21.a

What is price convergance?

Answer 8

If the expected return is not equal to required return, there can be a “return from convergence of price to intrinsic value.
expected return = required return + (V(0) − P(0))/P(0)

Question 9

Module 21.1, LOS 21.b

According to Gordon growth model, how equity premium is calculated?

Answer 9

GGM equity risk premium = (1-year forecasted dividend yield on market index) + (consensus long-term earnings growth rate) − (long-term government bond yield)

Question 10

Module 21.1, LOS 21.b

According to Ibbotson-Chen (2003) model, how equity premium is calculated?

Answer 10

equity risk premium = [1+i]×[1+rEg]×[1+PEg]−1+Y−RF

i = [(1 + YTM of 20-year T-bonds) ÷ (1 + YTM of 20-year TIPS)] – 1

Question 11

Module 21.1, LOS 21.с

What is the formula of required return in Fama-French 3-factor model?

Answer 11

required return of stock j = RF + βmkt,j × (Rmkt − RF) + βSMB,j × (Rsmall − Rbig) + βHML,j × (RHBM − RLBM)

Question 12

Module 21.1, LOS 21.с

What is the formula of required return in Pastor-Stambaugh model?

Answer 12

required return of stock j = RF + βmkt,j × (Rmkt − RF) + βSMB,j × (Rsmall − Rbig) + βHML,j × (RHBM − RLBM) + βliquidity,j×(liquidity premium)

Question 13

Module 21.1, LOS 21.с

What are the determining factors of required return in Burmeister, Roll, and Ross model?

Answer 13

1) Confidence risk: unexpected change in the difference between the return of risky corporate bonds and government bonds.
2)  Time horizon risk: unexpected change in the difference between the return of long-term government bonds and Treasury bills.
 3) Inflation risk: unexpected change in the inflation rate.
4)  Business cycle risk: unexpected change in the level of real business activity.
5) Market timing risk: the equity market return that is not explained by the other four factors.

Question 14

Module 21.1, LOS 21.с

What is the formula of required return in build-up method?

Answer 14

required return = RF + equity risk premium + size premium + specific-company premium

Question 15

Module 21.1, LOS 21.с

For which companies the build-up method is usually applied?

Answer 15

Closely held companies where betas are not readily obtainable

Question 16

Module 21.1, LOS 21.с

For which companies the bond-yield plus risk premium method is usually applied?

Answer 16

Company with publicly traded debt

Question 17

Module 21.1, LOS 21.d

According to Blume method, what is the adjusted beta formula and why beta needs to be adjusted?

Answer 17

adjusted beta = (2/3 × regression beta) + (1/3 × 1.0)

Adjustment needed for beta drift - observed tendency of an estimated beta to revert to a value of 1.0 over time.

Question 18

Module 21.1, LOS 21.d
How to estimated beta for:
1) public companies?
2) thinly traded and non-public companies?

Answer 18

1) public companies - regression on market index returns + adjustment for beta drift
2) thinly traded and non-public companies - find beta as in 1) of similar but public company, unlever it, then lever back

Question 19

Module 21.1, LOS 21.e
What are the + and - of:
1) CAPM?
2) Multifactor model?
3) Build-up model?

Answer 19

1) CAPM
\+ simple, only 1 factor
- how to choose appropriate factor
- loww explanatory power
2) Multifactor model
\+ can have higher explanatory power
- more complex and expensive
3) Build-up model
\+simple 
\+can apply to closely held companies
-use historical values as estimates

Question 20

Module 22.1, LOS 22.d

What is the net debt?

Answer 20

Net debt is gross debt minus cash, cash equivalents, and short-term securities

Question 21

Module 22.2, LOS 22.f
What is the difference between ROIC and return on capital employed?
How each is calculated?

Answer 21

ROIC = net operating profit adjusted for taxes (NOPLAT) divided by invested capital (operating assets minus operating liabilities)

Return on capital employed - similar to ROIC but uses pretax operating earnings

Question 22

Module 22.2, LOS 22.l

What are the inflection points?

Answer 22

Inflection points—those instances when the future will not be like the past, due to change in a company’s or an industry’s competitive environment or to changes in the overall economy.

Question 23

Module 23.1, LOS 23.a

How to estimate equity risk premium with market data?

Answer 23

equity risk premium = one-year forecasted dividend yield on market index + consensus long-term earnings growth rate - long-term government bond yield

Question 24

Module 24.1, LOS 24.a

When FCFF is preferred rather than FCFE?

Answer 24

1) FCFE is negative and volatile and
2) leverage is relatively high
3) capital structure is volatile

Question 25

Module 24.2, LOS 24.c

How to estimate FCFF starting from NI? What is the general idea behind the formula?

Answer 25

FCFF = NI + NCC + [Int × (1 − tax rate)] − FCInv − WCInv

The idea is to calculate all CF available to both: shareholders and bonholdres after the firm pays all of it’s operation expances + taxes, makes investments.

NI includes operation CFs, so this part we take, some non-cash charges (like depr., this we take out), gains/losses from sale of long-term assets (already included in FCInv, so do not need - or will be double counted), interest paid to bondholders (remove it since it is available to bondholders), investments we need to add - they are real cash movements not reflected in NI.

Question 26

Module 24.2, LOS 24.c

In estimation of FCFF starting from NI, how to calculate FCInv?

Answer 26

FCInv = capital expenditures − proceeds from sales of long-term assets
capital expenditures = ending net PP&E − beginning net PP&E + depreciation

Question 27

Module 24.2, LOS 24.c

In estimation of FCFF starting from NI, how to calculate WCInv?

Answer 27

WCInv = delta in WC - cash, cash equivalents, notes payable, and the current portion of long-term debt

Question 28

Module 24.3, LOS 24.c

How to calculate FCFE starting with FCFF?

Answer 28

FCFE = FCFF − Int(1 − tax rate) + net borrowing

net borrowing = long- and short-term new debt issues − long- and short-term debt repayments

Question 29

Module 23.2, LOS 23.j

What is the approximation for H-model?

Answer 29

V(0) =D(0)×(1+gL)/(r−gL)+D(0)×Ts/2×(gS−gL)/(r−gL)

Question 30

Module 23.1, LOS 23.a

How to estimate equity risk premium with market data?

Answer 30

equity risk premium = one-year forecasted dividend yield on market index + consensus long-term earnings growth rate - long-term government bond yield

Question 31

Module 24.1, LOS 24.a

When FCFF is preferred rather than FCFE?

Answer 31

1) FCFE is negative and volatile and

2) leverage is relatively high

Question 32

Module 24.2, LOS 24.c

How to estimate FCFF starting from NI? What is the general idea behind the formula?

Answer 32

FCFF = NI + NCC + [Int × (1 − tax rate)] − FCInv − WCInv

The idea is to calculate all CF available to both: shareholders and bonholdres after the firm pays all of it’s operation expances + taxes, makes investments.

NI includes operation CFs, so this part we take, some non-cash charges (like depr., this we take out), gains/losses from sale of long-term assets (already included in FCInv, so do not need - or will be double counted), interest paid to bondholders (remove it since it is available to bondholders), investments we need to add - they are real cash movements not reflected in NI.

Question 33

Module 24.2, LOS 24.c

In estimation of FCFF starting from NI, how to calculate WCInv?

Answer 33

WCInv = delta in WC - excluding cash, cash equivalents, notes payable, and the current portion of long-term debt

Question 34

Module 24.3, LOS 24.c

How to calculate FCFE starting with FCFF?

Answer 34

FCFE = FCFF − Int(1 − tax rate) + net borrowing

Question 35

Module 24.3, LOS 24.c

How to calculate CFO starting with NI?

Answer 35

CFO = NI+NCC-WCInv

Question 36

Module 24.5, LOS 24.e

Describe method to forecast FCFE assuming some specific D/A ratio

Answer 36

FCFE = NI − [(1 − D/A) × (FCInv − Dep)] − [(1 − D/A) × WCInv]

Question 37

Module 24.5, LOS 24.g

How may dividends, share repurchases, share issues, and changes in leverage affect future FCFF and FCFE?

Answer 37

Dividends, share repurchases, share issues are CF uses -> no impact on FCFF and FCFE
leverage changes slightly impact FCFE - if debt is repayed in current period, FCFE will decrease now, and grow later through decreased interest payments

Question 38

Module 24.5, LOS 24.k

What are the two major mistakes in setting inputs for FCFE and FCFF forecasting?

Answer 38

1) growth rates choice

2) base year choice