Equity Valuation Flashcards

Question

**Build-Up Method** for required return on equity

Answer 1

For private companies may we would also include a size risk premium

Answer 2

**BYPRP cost of equity** = YTM on the company's long term debt + Risk premium * For companies with publicly traded debt, this can be a **quick approximation** * For overseas markets, a **country premium** to the developed market equity premium can be added

Answer 3

* Assumes firm has established **optimal (_target_) capital structure** * Use **market** values, not book values (Equity & Debt)

Answer 4

**Key is to be consistent:** * Nominal cash flows need nominal discount rate * Real cash flows need real discount rate **_REAL EXLUDES INFLATION_**

Answer 5

* **Top-down** approach – start with a forecast for the economy and then narrow the forecasts to sector, industry and then finally stock. Two approaches: * Growth relative to GDP. Forecast GDP growth and from here estimate how this may effect a company's sales * Market growth and market share. Forecast how the market will grow and then consider how the company's market share will change * **Bottom-up** approach – starts with the individual company and makes forecasts. From here it is possible to aggregate up forecasts to provide industry, sector and even economy-wide forecasts. Examples include: * Time series regression * Return on capital * Capacity based forecasts (e.g. 'like for like' sales used in retailing) * **Hybrid** approach – combines elements of both

Answer 6

* Analysis of costs is just as important as revenue but unfortunately disclosure regarding costs is often less detailed * Need to understand breakdown of costs i.e. **variable vs. fixed.** Variable costs will tend to move as a percentage of revenue growth whereas fixed costs may grow at their own rate * **Economies of scale**? Gross and operating margins tend to be positively correlated with sales growth when economies of scale are present. Contributing factors: * Greater bargaining power with suppliers * Lower costs of capital * Lower per unit advertising expenses

Answer 7

Direct costs of producing the goods sold by a company. This amount includes the cost of the materials and labor directly used to create the good. It excludes indirect expenses, such as distribution costs and sales force costs. * Typically the biggest category of cost so even a small error can have a large impact on forecasted profits * Historical data on COGS and in particular as a percentage of sales, is often a good starting point when considering a forecast number (suffer from a **time lag**) * Must also consider the impact of **hedging** − Assume COGS doubles and a company can pass through 100% of this rise to its customers – what happens to the profit margin? − Lets assume sales are 100 and COGS are 30 giving us a gross profit margin of 70% (70/100). Now lets increase COGS to 60 and sales to 130. Our gross margin has now fallen to 53.8% (70/130). − To prevent this negative impact on profitability many companies hedge against input prices rises * **Competitor analysis** can also be useful

Answer 8

Direct and indirect selling expenses and all general and administrative expenses (G&A) of a company. SG&A, also known as SGA, includes all the costs not directly tied to making a product or performing a service. * Unlike COGS, SG&A do not have such a direct relationship with sales * Using historical data and also benchmarking against competitors will help with forecasting SG&A

Answer 9

1. Financial expenses include **interest expense generated by debt** 2. **Driven by the level of debt and interest rates** 3. Disclosure about the debt maturity profile will help forecast to what extent new debt will be required

Answer 10

* Statutory tax rate – the tax rate applied to the company's domestic tax base * Effective tax rate – derived from income statement * Cash tax rate – actual amount of tax paid relative to pre-tax income • The main focus when income statement modelling is effective and cash tax rates but applied to normalized income

Answer 11

* Some items will flow directly from the income statement (retained earnings) whereas other lines such as accounts receivables and inventory will be closely linked to the income statement projections * A common way to model working capital is to use working capital ratios. For example, we can forecast inventory by applying an inventory turnover rate for forecasted COGS. * Working capital projections can also be modified by both top-down and bottom-up considerations * Long-term assets such as **PP&E** are less directly tied to the income statement. **Maintenance capital expenditure** will be similar to but higher than depreciation due to the presence of inflation in the economy. **Growth capital expenditure** will require a judgement by the analyst regarding likely expansion plans * Lastly we need to forecast the **capital structure**. Historical analysis and management strategy is a good starting place.

Answer 12

* gives a sense of how well a company is using its capital to generate profits * Where **invested capital** is usually defined as _operating assets less operating liabilitie (NonCurrent Assets + Cash + WC (Current Asstes without Cash - Current Liab without financing ...)_ Can either take an opening figure or average for year * A better measure of performance than ROE since it is **unaffected by the degree of financial leverage** * A similar measure is return on capital employed (ROCE) which is essentially ROIC before tax. Useful when comparing difference companies in different tax jurisdictions.

Answer 13

* Dermines a company's profitability and the efficiency the capital is applied. A **higher ROCE implies a more economical use of capital** * A similar measure is return on capital employed (ROCE) which is essentially **ROIC before tax**. Useful when comparing difference companies in different tax jurisdictions.

Answer 14

* Changing price levels can significantly affect the accuracy of forecasts * The impact from inflation on future company performance will vary from company to company due to difference in competitive advantage and industry structure * If the product's **demand is relatively price inelastic** then its **revenues will benefit from inflation** * **Cost inflation will depend upon the scope for substituting alternative inputs** * Analysing international companies means adjusting for the geographic mix of its operations when incorporating inflation predictions * Foreign exchange rate movements can also be a source of price changes

Answer 15

* Technological developments have the capacity to significantly change the economics of an industry * Assumptions need to be made about the impact of such developments − Will this just **cannibalize** existing products or will it create a **new segment in the market?** * Important to analyse such developments using scenario and sensitivity analysis

Answer 16

* The choice of **forecast time horizon depends upon**: * Investment strategy for which the stock is being considered * Cyclicality of the industry * Horizon needs to be long enough to allow the company to reach a level of sales and profitability that is consistent with mid-cycle i.e. normalized earnings * Analyst's own preferences * Company specific factors * **Terminal value** * Take care when using historical valuation guidelines. Past multiples may not always be consistent with future multiples * Long term growth rate is always difficult to estimate * Regulations and technological change can dramatically impact terminal values.

Answer 17

[CF] -\> eingeben -\> [NPV] \> I eingeben (enter) \> [Downarrow] = NPV

Answer 18

Assumptions: * Dividends grow at a constant rate forever * r \> g

Answer 19

Fixed-rate preferred stocks are **valued as perpetuity**

Answer 20

_Learn by hard_ **If PVGO = 0, it does not necessarily mean no growth in dividends** **If PVGO = 0, then ROE = r** Company has no growth prospects \> No +ve NPV of Projetcs ; ROE is not greater than required return (**r**) \> Should pay out all Earnings as dividends \> Earnings will be constant (Assuming constant ROE) \> **Value as Perpetuity: [Po = E1 / r]**

Answer 21

* **Strengths**: * Applicable to stable, mature, dividend-paying firms * Easily applied to indices * Straightforward, easily understandable * Can be used to compute: * Implied growth * Implied rate of return * PVGO * Justified P/E * Useful component in multi-stage models * Weaknesses: * Extremely sensitive to inputs * Not appropriate for non-paying dividend stocks or stocks with unpredictable growth patterns * Share repurchases: Often less predictable than dividends. Analysts might want to estimate total distributions rather than just dividends

Answer 22

High-growth followed by stable growth Example: Compute each Dvidend + Terminal value and PV back

Answer 23

Decline in the growth rate is a gradual process (linear)

Answer 24

1. Calculate first two dividends in years of supernormal growth 2. Calculate H-Model linear decline plus Terminal value (longterm growth rate) 3. PV back with CF function (Div1 + Div2 + P2)

Answer 25

* **Strengths** * Value can be derived under a varied number of divided scenarios * Can be used forwards (i.e. derive value), or backwards (i.e. deriveimplied rates of return and growth rates) * Easy to use with spreadsheet modelling * Model forces analysts to examine their assumptions * **Weaknesses** * Sensitive to inputs * H-model is only an approximation, and cannot be used for an exact valuation - Not appropriate if the short-term high growth rate is significantly different from the normal long-term growth rate, or if there is a long period of linear decline

Answer 26

g = RR + ROE \>\> DuPont \>\> **g = PRAT**

Answer 27

* Cash available to **ALL investors** (debt + equity \> WACC) * Discounted using WACC

Answer 28

1. Cash available to **stock holders** ( Just equity \> discount using **C_E**) 2. Discounted using cost of equity

Answer 29

**When to use free cash flow models:** * Company does not pay a dividend * Dividend is unsustainable * Free cash flows can be forecast for a reasonable period of time and align with company's profitability **FCFE** more appropriate than DDM when considering a **control perspective**, i.e. valuing takeovers * Controlling interest gives owner the ability to direct cash flows * Non-controlling interest gets dividends at the board's discretion **FCFF** more appropriate than FCFE if company has high and/or unstable leverage or if FCFE is negative

Answer 30

**FCFF** = NI + NCC + INT(1 - Tax rate) - FC Inv - WC Inv\* \*Note: Investment in working capital excludes cash and marketable securities **FCFE** = NI + NCC - FC Inv - WC Inv + _Net borrowing_ *(New cash from new debt - debt repayments)*

Answer 31

**FCFF** = CFO\* + INT(1 - Tax rate) - FC Inv **FCFE** = CFO\* - FC Inv + Net Borrowing \*Classification of interest expense may vary between U.S GAAP and IFRS CFO already accounts for movements in AccPay, AccReceiv, Inventory --\> WC Invt.

Answer 32

**FCFE** = FCFF - INT(1 - tax rate) + Net borrowing

Answer 33

FCFF = **EBIT**(1-t) + NCC - FC Inv – WC Inv FCFF = **EBITDA**(1-t) + DEPR(t) + Other NCC - FC Inv - WC Inv

Answer 34

**FCFE** = Net Income - (1 - Debt Ratio)\*(Capex - Depreciation + Working Capital) DR = Debt / Total Assets

Answer 35

* Financial statements discrepancies * Advantages of free cash flow valuations * Useful where company does not pay dividends * Useful if dividends very variable * Valuation comes from a control perspective# * Cash flows not included in free cash flow: Dividends, share issuance and repos (these are uses of FCF) * EBIT/EBITDA should not be used as a proxy to FCF * Complicated capital structures: Preferred stock (treat as debt

Answer 36

For countries with volatile inflation levels FCF may be calculated on a real basis = discounted using a **real discount rate** ## Footnote **Real discount rate:** Country return (real) x% +/- Industry Adjustment x% +/- Size Adjustment x% +/- Leverage Adjustment x% **= Required rate (real) xx%**

Answer 37

Integrating environmental, social and governance (ESG) factors in valuation models can have a material impact on valuation 1. **Quantitative** ESG factors e.g. effect of a projected environmental fine on cash flows is pretty easy to integrate into models 2. **Qualitative** ESG factors are harder to incorporate into valuation models * One approach is to add a risk premium to the cost of equity * Often relies on analyst judgment

Answer 38

P/E is affected by the level of inflation and the ability of the company to pass inflation onto customers: * The **higher the level of inflation**, the **lower the P/E** (holding pass-through rate constant) * The **lower the pass-through rate**, the **lower the P/E (**holding inflation level constant)

Answer 39

**Advantages** * Uses earnings, therefore intuitively appropriate * Widely recognized * Empirical evidence (low P/E stocks may outperform) **Disadvantges**: * Negative earnings * Volatile earnings * Accounting policies Items to consider: Nonrecurring components of EPS − Generally excluded − Usually use underlying earnings (excluding nonrecurring items) as better reflect future earnings outlook − Diluted EPS better than basic • Effects of cyclicality − Impact of business cycle should be accounted for using normalized earnings − Normalized earnings • Historical average method (arithmetic mean of EPS) • Average ROE method (BVPS x Average ROE = EPS) • Accounting policies • Zero earnings gives an undefined P/E

Answer 40

* Inverse of P/E * Measures amount of EPS that a currency unit will purchase * Negative P/E is meaningless * Useful ranking measure in situations involving negative or zero earnings − High earnings yield: Cheap security − Low earnings yield: Expensive

Answer 41

Advantages * BV usually positive * BV more stable than earnings * BV equate to NAV if liquid assets * Useful for firms expected to go out of business * Empirical research Disadvantages * Non-physical assets not recognized * Accounting policies * BV uses historical information

Answer 42

**Advantages** * Sales usually positive * Sales difficult to manipulate * P/S less volatile than P/E * Useful for mature, cyclical and zero-income stocks * Empirical research **Disadvantages** * Growth in sales does not necessarily mean a growth in profit * No accounting for cost structure * Manipulation possible

Answer 43

**Advantages** * Difficult to manipulate * More stable than P/E * Empirical research **Disadvantages**: * Definition of CF varies CF = Net income + Depreciation/Amortization Adjusted CFO = CFO + Net interest charge

Answer 44

**Advantages** * Useful for comparing firms with differences in financial leverage * EBITDA unaffected by depreciation/amortization * EBITDA usually positive **Disadvantages:** * EBITDA not cash * FCFF better measure than EBITDA as takes account of capex

Answer 45

**Advantages** * Key part of total return * Not as risky as capital appreciation component **Disadvantages** * Ignores capital appreciation * Dividends paid now displace future cash flow

Answer 46

**International valuation considerations** * Differences in accounting methods, cultures, economic conditions, risk and growth opportunities **Momentum indicators** * Earnings surprise * Reported earnings - Expected earnings * Standardized unexpected earnings (SUE) * Earnings surprise / Standard deviation of previous surprises * Relative strength (RTSR) indicators * Performance of stock relative to benchmark or to its own historic performance * As indicator assumes pattern of returns either persists or reverses * Often expressed relative to 1

Answer 47

Net income takes into account explicit operational costs but not implicit cost (return required by shareholders) = From accounting profit \> **economic profit** **RI =** **NI** - ( r \* Equity) **RI =** **NOPAT** [EBIT (1-t) // NI+ Interest (1-t)] - (WACC \* Total Capital)

Answer 48

**NOPAT** = EBIT (1 - t) = NI+ Interest (1-t) = (S - COGS - SG&A - D)(1 - t) **RI** = NOPAT - (WACC \* Total Capital)

Answer 49

* R&D expenses should be capitalized and amortized * Eliminate deferred taxes – only cash taxes are recognized * Convert LIFO to FIFO (add LIFO reserve to assets (and therefore also to capital) and any increase in LIFO reserve to NOPAT) * Treat operating leases as capital leases * Adjust for non-recurring items

Answer 50

If **ROE \> r** then Residual income positive If **ROE = r** then RI is zero; Value of business = Bookvalue Residual income is driven by returns in excess of the cost of equity in addition to current book value • Consistent with dividend discount model but more value recognized up front • A stock's justified P/B ratio is directly related to expected future residual income • The residual income model is therefore related to Tobin's q = Market value of debt and equity / Replacement cost of total assets

Answer 51

1. **Accounting profit vs. EVA** * A firm may be making an accounting profit but an EVA (economic) loss * Positive EVA implies economic profit (firm is a wealth creator) * Negative EVA implies economic loss (firm is a wealth destroyer) * Accounting profits (and ROE) may not be the best indicator of firm's true economic performance 1. **Valuation considerations**: If a firm is expected to earn persistently negative EVA, its value should fall 2. **Market Value Added** * MVA = Market value of company - Total adjusted capital (book value) * MVA = Present value of future EVA

Answer 52

**Advantages** * Valuation is less dependent on terminal values (distant forecasts) * Based on existing accounting data * Company does not have to pay dividend * CF can be negative or unpredictable * Emphasizes economic profits (vs. accounting profits) **Disadvantages** * Accounting data can be manipulated * Requires significant adjustments to accounting data * Clean surplus rule must hold (changes in book value flow income statement; B1 = B0 + NI - DIV)

Answer 53

**Most appropriate** when: * No dividend or unpredictable dividend * Free cash flows are negative * Terminal values are difficult to forecast **Least appropriate** when: * Clean surplus is violated * Book value or ROE is difficult to forecast

Answer 54

P/B ratio \* Book value at end of year 2 Price = 20 B₂= 10 =\> **(P-B)** = 20 - 10 = 10 =\> **PV** = 10 / (1+r)² Add PV of TV to single stage model

Answer 55

RI in year 2 = RI in year 3 (constant = no growth) \>\> **Perpetuity: RI / r** \>\> PV back \>\> Add as PV of TV to single stage model

Answer 56

If the persistence rate is 1 or 100% then this formula becomes a perpetuity (1+r**-1**) \>\> once calculated TV \>\> PV back to add to single model

Answer 57

**Investment Value**: What it is worth to an individual investor

Answer 58

**Value of its component parts** * Fair value of the net assets. − Also called the cost approach * Considered to be the least effective valuation method * May be appropriate for valuing REITs and closed ended companies

Answer 59

**Multiples based approach**