Equity Valuation

Question 1

The reading defined intrinsic value as “the value of an asset given a hypothetically complete understanding of the asset’s investment characteristics.” Discuss why “hypothetically” is included in the definition and the practical implication(s).

Answer 1

knowledge of a stock’s investment characteristics is always incomplete. The practical consequences are that an investor can only estimate intrinsic value and active security selection carries the risk of making mistakes in estimating value

Question 2

Going concern assumption effect on valuing inventory

Answer 2

An inventory value under going concern assumption > inventory value under liquidation assumption

Question 3

Compare current price to estimated target price. `What you need to pay attention to?

Answer 3

Time horizon (1 year?)
Required rate of return (is it the same?)

Question 4

Accelerating the payment of expenses for acquired companies. Effects?

Answer 4

• decreases cash flows before the acquisition
• decreases earnings before acquisition because of the accelerated expense recognition
• -> value of the acquired firm will be lower

Question 5

which sources of perceived mispricing do active investment managers attempt to identify? (positive alpha)

Answer 5

The difference between the true (real) but unobservable intrinsic value and the observed market price contributes to the abnormal return or alpha which is the concern of active investment managers

Question 6

How does nonrecurring events (sale of fixed assets) affect valuation if they are not excluded?

Answer 6

Value would be upward biased.

Question 7

Intrinsic value =/= current market value

The least likely explanation for this?

Answer 7

The difference between intrinsic value and going concern value

Question 8

Stock price decreases after M&A. Most likely reason?

Answer 8

Conglomerate discount

Question 9

Positive return from “convergence of price” to intrinsic value occur if…

Answer 9

Expected return > required return

Question 10

Use geometrical mean over arithmetical mean. Impact on risk premium?

Answer 10

Geometrical mean will decrease the risk premium (geometrical mean < arithmetic mean)

Question 11

Factor included in Pastor Stambaugh model but not in Fama-French model?

Answer 11

Liquidity premium
The average liquidity premium for equity should be zero.
Less liquid assets should have a positive liquidity beta

Question 12

How to estimate beta for a PUBLIC company ?

Answer 12

Regress its returns against an equity market index.
Then adjust the estimated beta for beta drift (the observed tendancy of a computed beta to revert to a value of 1.0 over time)

Question 13

Country risk rating model

Answer 13

Estimate an equation for the equity risk premium for developed countries and the input in the equation the inputs for emerging markets

Question 14

How to see if there are economies of scale?

Answer 14

Look at the industry… look at the presented companies. If the costs relative to the revenues of the bigger companies are lower than those of smaller companies then we have economies of scale

Question 15

How to choose the forecast horizon ?

Answer 15

It should be related to the investment horizon

Question 16

Depreciation forecast based on sales - how to?

Answer 16

Forecast it as a constant % of sales, except if the company is expanding their assets then as an increasing % of sales

Question 17

Sustainable growth rate

Answer 17

SGR = RoE x retention rate

Or

SGR = RoE x (1 - div payout rate)

Question 18

Using a residual income model - when is it best suited?

Answer 18

No dividend payment
Negative cash flows over the forecast horizon
Transparent financial reporting and high earnings quality

Question 19

Justified leading P/E formula

Answer 19

Justified leading P/E = (1-b)/(r-g)

Question 20

RoE (dupont formula)

Answer 20

ROE = NI / Sales x Sales / Total Assets x Total Assets / Equity
= profitability x asset efficiency x leverage

Question 21

FCFE formula when we have debt / equity ratio given

Answer 21

FCFE = NI - (1-D)(FCInv - Dep) - (1-D)(WCinv)

Where D = debt ratio

(1-D) = the equity part

Question 22

FCFE from EBIT

Answer 22

1) FCFF = EBIT (1-T) + Dep - FCinv - WCinv
2) Compute the value of the firm
3) remove the debt
4 You obtained the value of equity

Question 23

PVGO (Present Value of Growth Opportunity)

Answer 23

PVGO = stock price - Earnings/cost of equity

= value of stock - value no growth

Question 24

FCFF (whole formula)

Answer 24

FCFF = NI + Depr + Int(1-T) + preferred dividends - FCInv -WCInv

Question 25

Value of equity from FCFF

Answer 25

FCFE = FCFF - Bonds - Preferred shares

= firm value - market value of debt and preferred stock

Question 26

Issue debt to repurchase common stock. Impact on FCFE and on FCFF?

Answer 26

Y1 - FCFE forecast will increase as FCFE = FCFF + net borrowing but afterwards it will decrease as there will be higher interest expenses

No impact on the FCFF!

Question 27

FCinv formula based on balance sheet

Answer 27

FCinv = ending net PP&E - beginning net PP&E + depr expense - gain on sale (+loss on sale)

Question 28

Gain on sale of PP&E ? Where in FCFF?

Answer 28

Goes in non cash charges