Equity Valuation Flashcards
Intrinsic Value & Valuation Methods (Absolute vs Relative)
Intrinsic Value: Actual intrinsic value is the value of asset given all info
Analyst intrinsic value will use the info they have available and come up with a value for the equity and the market will price the asset as it sees fit
Analyst IV - Price is the possible gain to be made on the asset if the analyst is right, which can be expanded to (Analyst IV - Actual IV) + (Actual IV - Price)
Going concern is the assumption that the firm will continue to operate
Equity valuation can be approached in two ways:
Absolute Valuation: Uses inputs and forms a model from financials
Relative Valuation: Uses ratios to compare firms like P/E, P/CF, P/S
Porter’s Five Industry Forces & Quality of Earnings Issues
Porters 5 Forces:
1) Threats of new entries into industry
2) Threat of substitutes
3) Bargaining power of buyers
4) Bargaining power of suppliers
5) Rivalry among existing competitors
Quality of Earnings Issues:
1) Accelerating or Premature income recognition
2) Reclassifying gains and non-operating income
3) Expense recognition and losses (looks for wrongly capitalizing)
4) Amort, Depreciation, and Discount Rate changes
5) Off balance sheet issues (Operating leases)
Holding Period Return & Equity Risk Premium (Gordon Growth Model & Ibbotson-Chen)
Holding Period Return = (Price_1 + CF_1)/Price_0 - 1
If required rate of return < expected return than the security is undervalued
Equity risk premium = Required rate of return on equity - Risk free rate
To estimate equity risk premium can use historical estimates (easy to calc but use old data), forward looking (need to be updated periodically), macroeconomic (need to be for established markets) or survey (easy to collect but opinions vary.
Gordon Growth Model: Price = Div_1/(Required rate of return - growth), P=D_1/r-g
Ibbotson-Chen: Equity risk premium is based on 3 main factors in short term: expected inflation, real growth, and P/E growth. In long term P/E growth goes to 0 so we are focusing on nominal growth (combo of real growth and inflation)
Equity risk premium = ((1 + expected inflation) (1 + real growth) (1 + P/E growth) + D_1/P_0 - Risk free rate
Required Rate of Return Models (CAPM, Multifactor, Fama-French) & Beta
CAPM: Required rate of return = Rf + (equity risk premium * beta)
Multifactor Model: Required return = Rf + Risk Premium_1 + Risk Premium_2 + …
Fama-French: Focuses on 3 risk premiums which are market risk premium, small cap risk premium, and value risk premium. Take risk free rate and betas of each premium to get your required return.
Required return = Rf + Beta of Market * (Required return Market - Rf) + Beta of Small Cap * (Required Small Cap Return - Required Large Cap Return) + Beta of Value * (Required High Value Return - Required Low Value Return)
Pastor-Stambaugh model adds liquidity to the Fama French model
Blume Method Adjusted Beta = 2/3 * Regular Beta + 1/3 to correct for trend to 1
To estimate beta of stock you can find a comparable and unlever the comparable so that capital structure is not in play and then relever the beta to get estimated beta given the company you are estimating capital structure
Forecasting Revenues, Expenses, Balance Sheet, Return on Invested Capital (ROIC) and Long Term Growth Consideration
Revenues:
Bottom Up (start with individual company level), Top Down (start with macro level), Hybrid (mixed)
Growth based on GDP: Growth is a factor of GDP, take GDP * Growth factor to get your revenue growth level
Market Based Approach: If you own 15% of market and it sells 100 than you will sell 15
Expenses:
COGS are variable, R&D and overhead are steady in short term, SG&A depends largely on sales increases, and economies of scale drive costs down
If input costs are up than COGS go up and amount that can be passed onto consumer depends on elasticity of demand
Tech improvements can lead to productivity increases but can also increase subs and even cause cannibalization in the industry
Interest expense depends on debt level and rate, net interest is Paid - Received on your own cash/interest bearing instruments
Balance Sheet:
Current BS items (AP, AR) are estimated using income statement items (Sales, expenses)
PP&E is estimated using capital expenditures
Return on Invested Capital (ROIC): If high return forecast than you either have a competitive advantage or there is an error in forecast
Assess long term growth rate at inflection points as terminal value estimate is largely based on this growth rate
Discounted Cash Flow Methods (DDM, FCF, RI) & Cost of Equity
Dividend Discount Model (DDM): Estimates value based on dividends that are paid out
Used when there is a dividend history, dividend policy is consistent and related to earnings, and you are a minority shareholder
Free Cash Flow (FCF): Two versions (FCFF & FCFE), estimates FCF for the firm
Used when no stable dividend policy, dividend policy is unrelated to earnings, FCF is profitable and you are controlling shareholder
Residual Income (RI): Amount earned in excess of required earnings
Used when firm has no dividend history, FCF is negative, and firm has good accounting to be able to estimate the RI
Value of the firms equity = BV + PV(All future Residual Incomes)
All DCF Methods need Future CFs to discount, usually the discount rate will be equal to the cost of equity which can be found via CAPM, Multifactor Model (Fama-French), or Building Up Model. One exception is FCFF will use WACC at the discount rate
Multiperiod Dividend Discount Models (Gordon Growth, Two Stage, H-Model)
Gordon Growth Model: Dividends will grow at a constant rate forever
P_0 = D_1/r-g
Price today = Next period dividend/(required return - growth)
P_0 = Earnings_1/r + PV of growth opportunities works as well
A firm may have low earnings but a high price due to a high PV of growth opportunities within the firm, firm would be expected to grow
Two Stage Growth: Temporary period of high growth followed by a period of low growth forever. Take the two periods of growth individually and combine the two to get the value. Low growth will be calced via traditional GGM. PV(Divs in high growth) + PV(Divs in low growth)
H-Model: Similar to Two Stage Growth except drop from high to low is not immediate, it takes time and the decline is linear. To calc the value of a firm with an H-Model you can break down into traditional GGM and the high growth period.
P_0 = D_1/r-g_L + D_0 * H * (g_H - G_L)/r-g_L
Price Today = Div tomorrow/ required return - low growth + Div today * Time/2 * (high growth % - low growth %)/required return - low growth
H is time/2 and time is the amount of time that the decline takes, think of it like a triangle
Required Rate of Return & Sustainable Growth Rate
Required Rate of Return = D_1/P_0 + g, simple algebra to calc this
Sustainable Growth Rate = Retention Ratio * ROE, if the firm make 10% on there equity and always retains 75% than the sustainable growth rate will be 7.5%
ROE can be broken down using DuPonts analysis into
NI/Sales * Sales/Assets * Assets/Equity
Profit Margin * Asset Turnover * Financial Leverage
Free Cash Flow Firm (FCFF)
Free Cash Flow Firm (FCFF): Cash available to all firms investors after buying/selling products, providing services, paying operating expenses, and making investments.
Use FCF when no dividend payment, firm is a takeover target, bad dividend policy
FCFF from NI: FCFF = NI + Depr + (interest * (1-tax rate) - FC_Inv - WC_Inv
FCFF from EBIT: FCFF = (EBIT * (1-tax rate)) + Depr - FC_Inv - WC_Inv
FCFF from EBITDA: FCFF = (EBITDA * (1 - tax rate) + (Depr * Tax) - FC_Inv - WC_Inv
FCFF from CFO: FCFF = CFO + (interest * (1-tax)) - FC_Inv
FC_Inv = Net investment in fixed capital
WC_Inv = Net investment in working capital
FCFF is not affected by div payments, share buyback/issuance or leverage
FCFF Valuation = FCFF_1/WACC - g, use WACC as cost of capital because computing CF for the entire firm
Free Cash Flow Equity (FCFE)
Free Cash Flow Equity (FCFE): Cash available to common stockholders after funding capital requirements, working capital needs, and debt financing costs
FCFE from FCFF: FCFE = FCFF - (interest *(1 - tax rate)) + Net Borrowing
FCFE from NI: FCFE = NI + Depr - FC_Inv - WC_Inv + Net Borrowing
FCFE from CFO: FCFE = CFO - FC_Inv +Net Borrowing
FCFE from Debt Ratio: FCFE = NI - (1-DR) * (FC_Inv - Depr) - ((1 - DR) * WC_Inv)
Dividends, share buybacks/issuance do not affect FCFE but leverage does slighlt due to Net Borrowing
FCFE Valuation = FCFE_1/r-g
For 2-stage valuation find value of high growth CF and the low growth CF
Justified Price Multiples, P/E Ratio, P/B Ratio, PEG Ratio
Justified Price Multiples: What price multiple should be if fiarly priced, if actual < justified than undervalued
Price to Earnings Ratio (P/E): Most common ratio since earnings drive value
- Disadvantages: Negative earnings make P/E useless, volatility can be tough to interpret and management can manipulate earnings somewhat
- Analysts can normalize EPS via historical average or average ROE over last period
- Justified Leading P/E = P_0/E_1 = 1 - Retention Rate/r-g
- Justified Trailing P/E = P_0/E_0 = (1 - Retention Rate) (1+g)/r-g
- Leading takes into account that there was growth already, trailing needs to project that growth
- If payout rate is up than retention rate down and P/E up, if r up than P/E down, if g up than P/E up
PEG Ratio: PEG = P/E/g, if high PEG relative than overvalued, if low PEG than undervalued
Price to Book (P/B): Price/BV per share, BV per share is common equity, no preferred
- Adv: Positive even when EPS is negative, stable, and BV is good representation for firms with liquid assets
- DisAdv: Misleading if firm size differs
- Justified P/B Ratio = ROE-g/r-g, increases with ROE up or if ROE to r spread goes up
Use trailing ratio for all ratios except P/E leading
Justified P/S, P/CF & Method of Comparables
Justified Price/Sales Ratio = (E_0/S_0) * (1 - retention rate) * (1+g)/r-g
- Adv: Meaningful to all firms even if in distress, sales not easily manipulated, not volatile, and good for mature, cyclical, and start up firms
- DisAdv: High sales does not equal high profits or CF, does not take cost structure into account
- Can also be calced by Justified P/S = Net Profit Margin * Justified Trailing P/E because your earnings will be your Sales * Profit Margin
- Increase as Profit Margin goes up or growth goes up
- Calced as trailing ration
Price to CF Ratios: CF is most difficult to manipulate, more stable and will show true quality of earnings but tough to determine CF and FCFE is most useful but volatile
- Price/CF, CF = NI + Depr + Amort
- Price/FCFE, FCFE = CFO - FC_Inv + Net Borrowing
- Price/Adjusted CFO = CFO + ((net cash interest outflow) * (1 - tax))
- Price/EBITDA
- Want to use FCFE but more volatile, EBITDA is for the whole firm
Method of Comparables: Comparing a firms ratios to the benchmark to see if it is overvalues or undervalued, if firms ratios are higher than benchmark than overvalued, if lower than undervalued. Make sure to compare apples to apples
Residual Income (RI)
Residual Income: Looks at economic profit of firm, recognizes NI doesn’t factor in cost of equity.
RI = NI - (Equity Capital * Cost of equity), equity capital is the current BV of equity, use beginning year BV of equity when calcing end of year RI (think of it as what equity was used to generate the NI this year)
Residual Income breaks value of firm into current value of equity and PV of all future RI
Value_0 = B_0 + (RI_1/(1+r)^1) + (RI_2/(1+r)^2) + … need to make sure to discount back the RI properly
RI can also be calced as the excess return over r, RI = (ROE - r) (BV beginning year equity), how much excess return did you get per unit of equity * all of your equity units
Single stage model, constant growth, V_0 = B_0 + (ROE - r) * B_0/r-g, if constant growth than you can plug RI into the numerator, V_0 = B_0 + RI/r-g
Strengths of RI: Terminal value is not main driver of value, takes estimation risk out of equation, uses accounting data, no div needed and good for negative FCF firms
Weaknesses of RI: Accounting data can manipulated, some adjustments are needed to make sure that there is a clean surplus relationship in place (Ending BV = Beginning BV + Earnings - Div)
RI Adjustments: Need to make sure equity is clean, Inventory that is LIFO needs to be current value, operating leases need to be accounted for, Pension adjustments, CTA, and goodwill need to be cleaned up
Multi-Stage RI: Same as other models, need to estimate the high growth period out and discount back and then use the constant growth model onward. Some models will adjust depending on how strong competitive advantage is, and if RI will go to zero, stay constant, or go the industry average
Private Firm Valuation Reasons (Transaction, Compliance, Litigation) & Approaches (Income, Market, Asset)
Private firms valuation is based on potential, management, financial info, taxes and lifestage
Reasons for private valuation:
Transaction: VC financing, IPO, sale of firm, bankruptcy, management comp
Compliance: Required financial reporting and tax reporting
Litigation: Value needed for lawsuit, damage claims, lost profit claims or divorce
Income Approach to Valuation: PV of future income, alot of assumptions
- Free Cash Flow Assumption: PV of future CFs to firm
- Capitalized CF Approach: Uses GGM with cap rate (r-g) as denominator and CF or earnings as numerator
- Excess Earnings Approach: Earnings in excess of required return, part of these earnings can be attributed to intangible assets
Market Approach:
Public Company Comparable: Use a public company that has a known value and find you value by plugging in your ratios
Public Company Transaction: Model your value after an actual transaction that happened
Prior Transaction: Use a prior transaction from your own firm to figure out the value
Asset Based Approach: Value is Assets - Liabs, really only used in liquidations
Normalizing Earnings, Strategic Buyer, Discount Rate Estimation, CAPM Limitations & Control and Marketability
Normalizing Earnings: Excluding nonrecurring and unusual items (personal expense & tax related). Also remove company owned real estate revenues/expenses and put a rent charge on the income statement because we want to know what the firm is making from the operations of the business, not because the owner owns a building and they make money via renting it out
Strategic Buyer: Makes a purchase with synergies in mind, non-strategic buyer is just buying for a good deal
Discount Rate Estimation Variables: Size Premium added to the discount rate for small firms, private firms usually have access to less and most costly, acquirer should use targets WACC in calcing value not their own to avoid overpaying for firm, projection risk is risk that you have less info on the firm due to being private and their may be inexperienced management which causes discount rate to go up, lifestage of a firm needs to be taken into consideration as it is tough to judge what a proper discount rate for a very new firm is
CAPM Limitations: CAPM needs beta and often times beta is not easy to get or estimate, if wrongly estimated can largely mess up the estimate of a firm
Control and Marketability: Control and Marketability (liquidity of shares) adds value to a position and will increase the price, minority shareholder and lack of marketability (not as liquid shares) will cause a price to be discounted
