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CFA Level 2 > Equity Valuation > Flashcards

Equity Valuation Flashcards

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1
Q

Intrinsic value

How it occurs
Possible sources of mispricing (Formula)

A
  • Value of the asset given a hypothetically complete understanding of the asset’s investment characteristics
  • A mispricing occurs where the market price differs from the intrinsic value
  • Active investment managers aim to generate a positive excess risk-adjusted return i.e. a positive Alpha
  • Two possible sources of mispricing:
  1. Genuine mispricing
  2. Our estimate compared to I. Value = error in analysts estimate
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2
Q

Going-concern value / Liquidation value

A
  1. Going-concern: Valuation under the assumption that the company will continue its business activities in the foreseeable future
  2. Liquidation: Value if the company was dissolved and its assets sold individually

The difference between going concern value and liquidation value consists of intangible assets and goodwill

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3
Q

Fair market value / Investment value

A
  1. Fair market value: The price at which an asset would change hands between a willing buyer and a willing seller
  2. Investment value: The value to a specific buyer taking into account potential synergies and based on investor’s requirements and expectations (That has a potetnial much bigger value to me)
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4
Q

Applications of equity valuation

A
  • Stock selection
  • Inferring market expectations
  • Corporate event analysis such as mergers, divestitures etc.
  • Fairness opinions
  • Business strategy analysis
  • Shareholder communication
  • Private equity valuation
  • Share based payment
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5
Q

The valuation process steps

A
  1. Understand the business
    1. Industry analysis (5 forces etc.)
    2. Competitive position (5 forces etc.)
    3. Information from regulatory filings, press releases etc.
    4. Analysis of financial reports (Ratios etc)
  2. Forecast performance
    1. ​Economic forecast (top-down vs. bottom-up)
    2. Forecast sales, earnings, cash flow (quantitative)
    3. Financial statement analysis (including footnotes and adjustments)
    4. Qualitative factors (management, quality of earnings, disclosures)
  3. Select valuation model
  4. Estimate intrinsic value
  5. Make investment recommendation
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6
Q

Quality of earnings analysis

A

Covered in FRA

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7
Q

Valuation models

A
  1. Absolute valuation models: Specifies intrinsic value
  • Present value models:
    • Dividend discount model
    • Discounted cash flow models
    • Residual income models
    • Asset-based models
  1. Relative valuation models: Method of comparables
  • Multiples: assume that comparison asset is fairly valued
    • Price-to-earnings
    • Price-to-sales
    • Price-to-book value
    • Price-to-cash flow
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8
Q

Valuation / Model selection criteria

A
  • Consistent with economics of the business
  • Availability and quality of data
  • Purpose of the valuation

Other issues:

  • Control premiums: Ability to influence management and operations adds value to majority ownership
  • Marketability discounts: Non-publicly traded companies are more difficult to value and ultimately sell
  • Liquidity discounts: Thinly traded securities are more difficult to value and may be more risky than issues with greater liquidity
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9
Q

Realized vs. Expected Holding period return

A
  • The selling price PH and the dividend DH are only known at the end of the holding period i.e. a realized holding period return
  • If the future sale price and dividend are estimated, this would give an expected holding period return

The investor’s expected rate of return has two components

  • The required return
  • A return from the price converging to its intrinsic value
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10
Q

Required / Expected return

Definition

3 apporaches

A

The minimum level of expected return that an investor requires given the asset’s riskiness

The required / expected return on equity = Three popular approaches:

  1. CAPM
  2. Multifactor models (Fama-French)
  3. Build-up method
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11
Q

Expected (ex ante) / Realized Alpha

A
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12
Q

Internal rate of return

A

The discount rate that equates the present value of the asset’s expected future cash flows to the asset’s price

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13
Q

The equity risk premium (ERP)

A

RM - Rf

The equity risk premium is the incremental return that investors require for holding equities rather than a risk-free asset

Two broad approaches:

  1. Historical estimates
  2. Forward looking estimates
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14
Q

ERP: Historical estimates

A

Historical average of difference between returns from a broad-based equity index and the risk-free (Government Bond) return. Two issues:

  • Arithmetic or Geometric mean:
    • Arithmetic mean for single period models e.g. CAPM
    • Geometric mean is preferred as typically looking at multi-period context
  • Risk-free rate: Long-term Government Bond yield preferred to short term T-Bill yield as looking at a multi-period context

Adjusted Historical estimate: Poorly performing companies tend to get removed from major indices, thus overestimating the equity premium

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15
Q

ERP: Forward looking estimates (ex-ante estimates)

A

Three common ways:

  1. Gordon Growth Model Equity Risk Premium
    = forecasted dividend yield
    + consensus long-term earnings growth rate
    – current long-term government bond yield

= > GG: [r = D1 / P0 + g] - current long-term government bond yield

  1. Macroeconomic models: Multiple regression approach, e.g. Ibbotson and Chen model uses 4 variables to develop the equity risk premium estimate:
    1. Expected inflation
    2. Expected growth rate in real earnings per share (GDP growth)
    3. Expected growth rate in the P/E ratio
    4. Expected income component​ (e.g. div yield of S&P500)

=> Compound 1,2,3 (x* x* x) and add 4. => RM - Rf = ERP

  1. Survey estimates
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16
Q

CAPM

A

Calculates required return for an investment

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17
Q

Estimating a Beta for a public company

A
  • Regression analysis is regressing stock return against the market
    • Issues to consider:
      • Choice of index
      • Length of data period and frequency of observations
      • Adjusting a historic (raw) Beta to make it forward looking
      • Commonly adjusted using the Blume method which is an autoregressive model = > Blume method assumes Betas mean revert to one
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18
Q

Adjusted Beta: Blume method

A

Adjusting a historic (raw) Beta to make it forward looking

Commonly adjusted using the Blume method which is an autoregressive model

Blume method assumes Betas mean revert to one (1* 1/3 = 1/3)

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19
Q

Estimating the Beta for non-public company or thinly traded company

A
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20
Q

Unlever Beta

A
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21
Q

Relever Beta

A

“with debt of 20% in the capital structure”
=> Debt: 20 ; Equity 80 ; Total 100 => D/E = 20/80 = 0.25

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22
Q

Fama-French: Multifactor models

A

Fundamental Multifactor: Calculating the required return on equity

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23
Q

Pastor-Stambaugh model

A

Extensions to Fama-French:

LIQ is the excess return from investing proceeds from shorting high liquidity stocks into a low liquidity stock portfolio, i.e. earning a liquidity premium

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24
Q

Macroeconomic / Statistical factor models

A

The required return on equity:

  1. Macroeconomic factor models
    • Factors are economic variables that affect the expected future cash flows and/or the discount rate e.g. five-factor BIRR Model uses the following factors:
      • Confidence risk
      • Time horizon risk
      • Inflation risk
      • Business cycle risk
      • Market timing risk
  2. Statistical factor models
    • Applied to historical returns to determine stock portfolios (acting as factors) that explain returns
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25
Q

Build-Up Method for required return on equity

A

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

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26
Q

Required return on equity: Bond Yield Plus Risk Premium (BYPRP) method

A

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
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27
Q

Weighted average cost of capital (WACC)

A
  • Assumes firm has established optimal (target) capital structure
  • Use market values, not book values (Equity & Debt)
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28
Q

Discount rate selection

A

Key is to be consistent:

  • Nominal cash flows need nominal discount rate
  • Real cash flows need real discount rate

REAL EXLUDES INFLATION

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29
Q

Industry and Company Analysis Approaches:

Top-down

Bottom-up

Hybrid

A
  • 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
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30
Q

Income statement (IS) modelling

A
  • 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
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31
Q

IS: Cost of goods sold (COGS)

A

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
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32
Q

IS: Selling, general and administrative expenses (SG&A)

A

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
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33
Q

IS: Finance Expenses

A
  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
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34
Q

IS: Corporate income tax

A
  • 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
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35
Q

Balance sheet modelling

A
  • 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.
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36
Q

Return on invested capital (ROIC)

A
  • 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.
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37
Q

Return on capital employed (ROCE)

A
  • 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.
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38
Q

Porter’s 5 Forces: Impact of competitive forces on prices and costs

A
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39
Q

Inflation and deflation

A
  • 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
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40
Q

Industry and Company Analysis: Technological developments

A
  • 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
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41
Q

Long-term forecasting

A
  • 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.
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42
Q

Valuation Models − Overview

Dividends
FCF
Residual Income

A
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43
Q

Multiple Holding Period (Ba II Plus CF function)

A

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

44
Q

Constant Growth Model

A

Assumptions:

  • Dividends grow at a constant rate forever
  • r > g
45
Q

Valuing Fixed-rate preferred stocks

A

Fixed-rate preferred stocks are valued as perpetuity

46
Q

Using GGM to determine the present value of growth opportunities (PVGO)

A

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]

47
Q

Justified P/E

A
48
Q

Strengths and Weaknesses of Dividend Valuation Models

A
  • 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
49
Q

DDM: Two Stage Model

A

High-growth followed by stable growth Example:

Compute each Dvidend + Terminal value and PV back

50
Q

Combining DDM with P/E for terminal value

A

Example

51
Q

H-model

Formula

A

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

52
Q

DDM: Three-stage Model

A
  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)
53
Q

DDM: Multistage Model Strengths and Weaknesses

A
  • 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
54
Q

Deriving Required Return

from DDM & H-Model

  • Po = Div1 / (r - g)
  • H = XXXX
A
55
Q

Sustainable growth rate (SGR)

Formula with ROE

A

g = RR + ROE

>> DuPont >>

g = PRAT

56
Q

DDM Summary

A
57
Q

DDM Summary 2

A
58
Q

Free Cash Flow to the Firm (FCFF)

A
  • Cash available to ALL investors (debt + equity > WACC)
  • Discounted using WACC
59
Q

Free Cash Flow to Equity (FCFE)

A
  1. Cash available to stock holders ( Just equity > discount using CE)
  2. Discounted using cost of equity
60
Q
A
61
Q

Two-Stage FCF Models​

A
62
Q

When to use free cash flow models

A

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

63
Q

Treatment of non-cash items

Substracted or Added back ?

A
64
Q

Calculating FCFF / FCFE from Net Income

A

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)

65
Q

Calculating FCFF / FCFE fro​m CFO

A

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.

66
Q

Calculating FCFE from FCFF

A

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

67
Q

Calculating FCFF from EBIT and EBITDA

A

FCFF = EBIT(1-t) + NCC - FC Inv – WC Inv

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

68
Q

FCFE using the target debt ratio (Debt/Total assets)

A

FCFE = Net Income - (1 - Debt Ratio)*(Capex - Depreciation + Working Capital)

DR = Debt / Total Assets

69
Q

Free Cash Flow Issues

A
  • 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
70
Q

FCF: Dealing with inflation

Not likely to be asked

A

For countries with volatile inflation levels FCF may be calculated on a real basis = discounted using a real discount rate

Real discount rate​:

Country return (real) x%
+/- Industry Adjustment x%
+/- Size Adjustment x%
+/- Leverage Adjustment x%
= Required rate (real) xx%

71
Q

FCF: ESG Considerations

A

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
72
Q

FCF Reading workshops in Fitch Videos (Two-stage etc)

A
73
Q
  1. PE: Inflation Adjustments
A

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)
74
Q

PE Advantages / Disadvantages

A

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

75
Q

Earnings Yield

A
  • 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
76
Q

Leading / Trailing PE

A
77
Q

PEG Ratio

A
78
Q

Terminal Value

A
79
Q

P/B Ratio

A/D and Formula

A

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
80
Q

P/S Ratio

A/D and Formula

A

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
81
Q

P/CF Ratio

A/D and Formula

A

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

82
Q

EV/EBITDA

A

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
83
Q

Dividend Yield

A

Advantages

  • Key part of total return
  • Not as risky as capital appreciation component

Disadvantages

  • Ignores capital appreciation
  • Dividends paid now displace future cash flow
84
Q

Other Considerations for Multiples

A

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
85
Q

Different types of average:

  • Arithmetic mean
  • Weighted mean
  • Harmonic mean
  • Weighted harmonic mean
A
86
Q

Residual Income

Formula with NI and NOPAT

A

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)

87
Q

Economic Value Added (EVA)

A

NOPAT = EBIT (1 - t) = NI+ Interest (1-t) = (S - COGS - SG&A - D)(1 - t)

RI = NOPAT - (WACC * Total Capital)

88
Q

Common adjustments when calculating EVA

A
  • 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
89
Q

If ROE > r then RI is

If ROE = r then RI is

A

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

90
Q

Single-stage residual income valuation (Constant growth model)

Formula

A
91
Q

EVA implications

A
  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
92
Q

Advantages and Disadvantages of Residual Income

A

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)
93
Q

When is residual income model appropriate?

A

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
94
Q

Multi-stage residual income model

A
95
Q

Multi-stage: Assume terminal year premium over book value

A

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

96
Q

Multi Stage: Assume continuing RI in perpetuity

A

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

97
Q

Multi Stage: Assume ROE reverts to required return over time

A

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

98
Q

Private vs. public: Similarities and contrasts - company specific

A
99
Q

Private vs. public: Similarities and contrasts – stock specific​

A
100
Q

Motivation for Valuation

Transactionbased valuations

Compliancebased valuations

Litigation-based valuations

A
101
Q

Definitions of Value

A

Investment Value: What it is worth to an individual investor

102
Q

Value of Business: Excess Earnings

A
103
Q

Valuation Discounts and Premiums

A
104
Q

Value of Business: Asset-based approach

A

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
105
Q

Value of business: Market approach

A

Multiples based approach

CFA Level 2 (10 decks)

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