Equity valuation

Question 1

• Liquidation value

Answer 1

what the assets would bring if sold separately, net of the company’s liabilities.to be used if the company’s business model is NOT SUSTAINABLE

Question 2

DDM valuation theory

Answer 2

for mature and profitable firms, not in a fast-growing economy, for large, diversified portfolios like the S&P 500.
* To be used if:
o The firm has a dividend history.
o The dividend policy is consistent and related to earnings. Stesso payout ratio negli anni
o The perspective is that of a minority shareholder.  se mi divide divento minority

Dividend si ottiene anche come = par value * dividend rate

• 4 versions of the multiperiod DDM:
• the Gordon growth model,
• 2-stage growth model,
• H-model, and
• 3-stage growth model–> usual for tech companies (forte crescita, crescita media e poi stabile

Question 3

FCF valuation theory

Answer 3

• FCF valuation is appropriate when the following characteristics exist:
  o NO stable dividend policy.
  o Dividend NOT related to earnings.
  o The firm’s FCF is related to profitability.
  o The perspective is that of a controlling shareholder.

Question 4

RI valuation theory

Answer 4

amount of earnings >investor’s required earnings.
RI=economic profit.
* difficult to apply –>requires an in-depth analysis of accruals.
* The RI method is most appropriate under the following conditions:
o NO dividend history.
o The firm’s FCF is negative.
o It is a firm with transparent and high-quality accounting

Question 5

build up method

Answer 5

add a risk premium to the firm’s bond yield.–> better for private firms

Question 6

V with DDM (gordon g)

Answer 6

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

Question 7

PV growth opportunities

Answer 7

E1/r+PVGO

• appropriate for mature, stable firms.
• The limitations:
  o Valuations are very sensitive to estimates of r and g.
  o The model assumes that the firm is paying dividends now
  o Unpredictable growth patterns from some firms make using the model difficult.

Question 8

H-model

Answer 8

((D0(1+gl))/(r-gl))+((D0H*(gs-gl))/(r-gl))

linear decrease

Question 9

Sustainable growth rate=g

Answer 9

bROE
b = retention rate
𝑛𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛∗𝑟𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒∗(𝑠𝑎𝑙𝑒𝑠𝐵𝑉𝑒𝑞𝑢𝑖𝑡𝑦)
(NI/sales)((1- payout ratio))*(sales/BVequity)

Question 10

FCFF

Answer 10

NI + Dep + (int* (1-tax rate)) – Fcinv – delta WC inv
CFO + (int * (1-tax rate)) - FCinv

dove CFO = NI +dep - delta wcinv

o FCFF better than FCFE for business cyclical company and for company with a changing capital structure

Question 11

FCFE

Answer 11

FCFF – (int * (1-t)) + net borrowing
Dove: net borrowing = debt issues – debt repayment = liabilities t0 – liabilities (t-1)
NI – (1 – DR) * (FCInv – Dep) – (1 – DR) * delta WCinv
Dove
DR = target debt-to-asset ratio
FCINV =CAPEX = end fixed assets – beginning fixed assets + depreciation

Better with stable capital structure

Question 12

Equity risk premium—> Grinold

Answer 12

[DY + ΔP/E + i + G + ΔS] – rf
dy= dividend yield
I = inflation forecast
g = real gdp growth rate
delta s = expected change in shares outstanding

Question 13

V0 with FCFF

Answer 13

FCFF1 / (WACC – g)

Question 14

V0 with FCFE

Answer 14

FCFE1 / (r-g)

Question 15

Justified leading P/E

Answer 15

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

Earnings affected by different acocunting standards - not good to value companies internationally

Question 16

Justified trailing P/E

Answer 16

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

Question 17

Justified Dividend Yield

Answer 17

D0/P0=((r-g))/(1+g)

Question 18

PEG ratio

Answer 18

(P/E)/g

Question 19

Justified P/B

Answer 19

((ROE-g))/((r-g))

o Book value is usually positive, even when earnings are negative.
o Book value is more stable than EPS.
o Book value is an appropriate measure of net asset value (especially for firms such as financial institutions that hold liquid assets).
* The disadvantages of the P/B ratio include the following:
* P/Bs misleading if significant size differences between firms.
* BV is influenced by accounting choices/conventions.

Question 20

Justified P/S

Answer 20

(((E0/S0)(1-b)(1+g))/(r-g))-→E0/S0*P0/E0

o The ratio is meaningful even for distressed firms.
o Sales revenue is not easily manipulated.
o P/S ratios are not as volatile as P/E ratios.
o P/S ratios are particularly useful in valuing mature, cyclical, and zero-income (start-up) firms.
* The disadvantages of using the P/S ratio include the following:
o High sales do not necessarily mean high profits or cash flows.
o The P/S ratio does not capture differences in the cost structure between firms.
o Revenue recognition practices still distort sales.

Question 21

V0 with RI

Answer 21

Bo+((RI1/(1+r)+RI2/(1+r)^2 +⋯))
B0+((ROE-r)B0)/(r-g)
B0+((ROE-r)B0)/(1+r-w)

dove w persistence factor between 0 e 1
o the more sustainable the competitive advantage and the better the industry prospects, the higher the persistence factor.

Question 22

RIt

Answer 22

Net income – Equity charge
Dove Equity charge = equity capital * cost of equity
NI - (r(BVt-1)
(ROE-r)(BVt-1)
BV = Book value of equity

• Residual income is expected to drop immediately to zero.
• Residual income is expected to decline to a long-run average level consistent with a mature industry.
• Residual income is expected to decline over time as ROE falls to the cost of equity (in which case residual income is eventually zero)

Question 23

Clean surplus relationship

Answer 23

BV(t0)= (BV(t-1)) + EPS - div

The clean surplus relationship is violated if gains or losses, like
- unrealized changes in the fair value of some financial instruments(FVOCI),
- foreign currency translation adjustments,
- certain pension adjustments,

bypass the income statement and are charged directly to equity.

Question 24

EVA

Answer 24

NOPAT − $WACC

Question 25

NOPAT

Answer 25

EBIT × (1 − t)

Question 26

MVA (market value added)

Answer 26

market value of (total) capital− book value of capital

Question 27

DLOC –> discount for lack of control

Answer 27

1-(1/(1+control premium))

Question 28

Total discount with dloc e dlom

Answer 28

1-((1-DLOC)(1-DLOM))

Question 29

Private firms

Answer 29

o Private firms also typically have more concentrated ownership of its equity.
o Private firms have higher cost of debt and lower debt-capacity

Question 30

• Approaches to Private Company Valuation

Answer 30

o Income approach.  pv of its expected future income
o Market approach.  price multiples based on recent sales of comparable assets.
o Asset-based approach.  Values a firm’s assets minus its liabilities

Question 31

size premiums

Answer 31

often added to the discount rates for small private companies