Section II.B. Equity

Question 1

How do you determine Size (capitalization)?

Answer 1

• Value of a company
• Multiply the share price times the number of common shares outstanding
• Example:
– ABC Co. share price = $40
– # of shares outstanding = 2 million
– Market cap = $80 million (40 x 2,000,000)

Question 2

What is Style (growth or value) equities?

Answer 2

Growth:
• High growth expectations
• High earnings expectations
• Market price higher than fundamental valuation (due to expectations)

Value:
• Identify undervalued or out-of-favor stocks or assets
• Invest in stocks that trade below intrinsic value
• Market price is lower than fundamental valuation

A high-book-to-market stock is typically considered a value stock while a low-book-to-market stock is typically considered a growth stock.

Question 3

What are Volatility (defensive vs. dynamic) stocks?

Answer 3

• Defensive stocks are less susceptible to
economic conditions and cycles (e.g., food,
power, water, gas).
• Dynamic stocks offer greater growth
opportunities albeit with greater risk.
• Defensive and Dynamic Index measures total company risk as a combination of earnings variability, return on assets, leverage and volatility (Russell Investments).

Question 4

What are Developed Markets?

Answer 4

Markets that include stable political
environment, a stable currency, financial
and accounting regulations, liquidity, and
established financial markets with a long
history.

Examples
United States, Japan, Germany, U.K.

Question 5

What are Emerging Markets?

Answer 5

Markets that exhibit the following:
some financial and accounting standards, financial market regulation, increasing
liquidity in stock and bond markets, growing economies.

Not known for market efficiency.

Examples
China, Russia, Brazil, India

Question 6

What are Frontier Markets?

Answer 6

Markets that include less advanced economies and financial exchanges. Also known as “pre-emerging markets”.

Risks
Currency, political instability, illiquidity, lack of regulation, lack of financial and accounting standards

Examples
African nations, certain southeast Asian nations, much of Central and South America, Eastern Europe

Question 7

ADRs vs. Ordinary Shares

Answer 7

American Depository Receipts (ADRs)
a negotiable certificate (or note) issued by a U.S. bank representing ownership of shares in a foreign stock that is traded on a U.S. exchange; ADRs are denominated in U.S. dollars

Ordinary shares
Shares held in local currency

• a.k.a. “common shares”
• Not preferred shares
• Voting rights
• Equity ownership in company
• Secondary rights to dividends
• Last in liquidation

Question 8

What is the Dividend Discount Model
(Gordon Growth Model)?

Answer 8

Method for determining the value of a stock by discounting future cash flows (dividends) back to present value

Formula on CIMA Formula Sheet
P0 = D1 / (r-g)

-or-

Value or price = dividend per share / (discount rate – growth rate)

The dividend discount model is expressed as: value of a stock = cash flow per share divided by the discount rate minus the growth rate.

Simplified example: Boola Boola stock has a dividend per share of $1.50. The expected growth rate is 4.5% and the stated discount rate is 7.25%. Using the dividend discount model, the stock is worth $54.55 per share.

Value = $1.50 / (.0725 - .0450) = $54.55

Question 9

What is the Free Cash Flow?

Answer 9

Financial measurement of a company’s ability to enhance shareholder value, grow or expand

Operating cash minus capital expenditures

Formula

FCF = EBIT (1-tax rate) + Depreciation and
Amortization – Change in Working Capital –Capital Expenditure

Note: this formula is not on the CIMA Formula Sheet

Question 10

What is Weighted Average Cost of Capital?

Answer 10

Defined: calculation to determine the total cost of all forms of capital, equity, debt, preferred, etc.; each category is weighted proportionately to determine overall cost of funds

Formula:

WACC = (E / (D+E)) (Re) + (D/(D+E))(Rd)(1-t)

E=market value of equity
D=market value of debt
Re=cost of equity
Rd=cost of debt
t=corporate tax rate

Note: this formula is not on the CIMA Formula Sheet

The most appropriate discount rate to use when applying a FCF (free cash flow) valuation model is the WACC.

Question 11

What is Book Value?

Answer 11

• Book values are based on historical cost, not actual market values.
• It is possible, but uncommon, for market value to be less than book value.
• “Floor” or minimum value is the liquidation value per share.
• Tobin’s q is the ratio of market price to replacement cost.
• High book value (high BtoM) indicates a stock may be undervalued
• Low book value (low BtoM) indicates a stock may be overvalued

Question 12

Intrinsic Value vs. Market Price

Answer 12

• The intrinsic value (IV) is the “true” value,
according to a model.
• The market value (MV) is the consensus value of all market participants.

• The return on a stock is composed of dividends and capital gains or losses.

Expected HPR= E(r)=
(E(D1)+[E(P1)-(P0)])/ P0

• The expected HPR may be more or less than the required rate of return, based on the stock’s risk.

Question 13

Required Return:

Answer 13

• CAPM gives the required return, k:

k = Rf+β[E(Rm)-Rf]

• If the stock is priced correctly, k should
equal expected return.
• k is the market capitalization rate.

Question 14

P/E and Growth Rate

Answer 14

Wall Street rule of thumb:

The growth rate is roughly equal to the P/E ratio.

“If the P/E ratio of Coca Cola is 15, you’d expect the company to be growing at about 15% per year, etc. But if the P/E ratio is less than the growth rate, you may have found yourself a bargain.”

Quote from Peter Lynch in One Up on Wall Street.

Question 15

Liquidity Ratios

Answer 15

In general – ratios meant to show the strength of a company in its capacity to pay off short-term debt with cash and short-term assets

Quick Ratio:
= (cash + cash equiv. + short-term investments + receivables) /current liabilities

Current Ratio:
= current assets/current liabilities

Question 16

Price-Weighted Average

Answer 16

Portfolio: Initial value $25 + $100 = $125
Final value $30 + $ 90 = $120
Percentage change in portfolio value
= -5/125 = -.04 = -4%

Index: Initial index value (25+100)/2 = 62.5
Final index value (30 + 90)/2 = 60
Percentage change in index
= -2.5/62.5 = -.04 = -4%

Question 17

Cap-Weighted Index

Answer 17

also known as a “market-value weighted
index” this index weights individual
companies or stocks based on their market capitalization thus larger stocks receive more proportional representation in the index; the value of a cap-weighted index may be computed by summing the value of all market capitalizations and dividing by the number of stocks in the index

Advantages
• The total return of the index roughly mirrors the change in the total market value of all stocks.
• Rebalancing this type of index is simple.
• Since the index automatically adjusts to changes in stock prices, it is easy to create a tax efficient mutual fund or ETF to track this type of index.

Disadvantages
• If stock prices reflect emotions over the short term, then the index will systematically own too much of overpriced stocks and too little of bargain priced stocks.
• The index is heavily influenced by the few companies with the largest market capitalizations. For instance, the top 20 stocks in the S&P 500 index can account for one-third of the total index.

Examples:

NYSE Composite
S&P 500
NASDAQ Composite
Hang Seng (Hong Kong)
Russell 2000
Wilshire 5000
MSCI EAFE

For cap-weighted indexes, stock splits and stock dividends are accounted for and do not necessitate rebalancing. Cash dividends do not impact the index. New stock issued and outstanding would however require an adjustment or rebalancing activity.

Question 18

Fundamentally Weighted Index

Answer 18

a type of equity market index where selection and weighting criteria are based on factors such as revenue, dividends, or book value (i.e., measurements of fundamental analysis)

Advantages
• Since the index is not influenced by price, it is not influenced by short term emotions. Unlike market cap weighted indexes, pricing errors are random.
• Since fundamental rankings between companies are based upon sales, book value and other measures of economic size that change relatively slowly, the index can be managed through ETFs or mutual funds on a relatively tax efficient basis.

Disadvantages
The index does not use relative or absolute value to determine company weights in the index

Question 19

Equal Weighted Index

Answer 19

Defined
an index in which all securities or components are given equal (the same) weighting

Advantages
• The index is highly diversified with all stocks in the universe equally weighted.
• As opposed to market cap weighting, the index does not overweight overpriced stocks and underweight underpriced stocks. Pricing errors are random.
• Easy to construct relatively tax efficient ETFs and mutual funds.
• Usually adds 1 – 2 percent in annual return over long periods after expenses vs. market cap weighted indexes.

Disadvantages
• No distinction is made between the relative or absolute valuation of stocks
within the universe.
• Difficult to keep the stocks in the index equally weighted due to constant price fluctuations.
• Difficult for this type of index to manage substantial amounts of money due to the need to invest equal amounts in both the largest and smallest stocks.

Question 20

Potential benefits and risks of
international diversification in a portfolio

Answer 20

Benefits
Less risky portfolio (smoother returns-experience if well diversified)
Opportunity for higher returns
Can diversify political, economic and currency risk

Risks
Can increase exposure to political, economic and currency risk
Higher fees and costs
Less transparency in some cases
May increase volatility (if not properly diversified)

Question 21

Changes in correlations over time
across…

Answer 21

• sectors
• countries
• regions

• Since the 1990’s there has been an increase in correlation in equity prices of many international developed markets.
• There is a fair amount of speculation as to why this has occurred and if correlations will remain at this level or possibly move even higher.
• Possible reasons for increased correlations:
– Globalization (advances in technology, communication, etc.)
– Increased volatility and crises lead to higher correlations
– Increase in emerging market capitalization

Question 22

Price to Earnings (PE or P/E) Ratios

Answer 22

Defined
The price-to-earnings ratio is a common valuation measurement calculated by dividing the share price of a security by its current or future earnings per share. It can also be calculated by dividing the market capitalization by the total earnings.

Example
Current PE ratio = share price/current earnings per share

Forward PE ratio = share price/expected earnings per share

Question 23

Shiller PE Ratio

Answer 23

• also known as the “cyclically adjusted (CAPE) PE”
• smoothes out fluctuations in earnings due to the business cycle
• uses earnings per share figures adjusted for inflation and averaged over 10 years as the denominator

CAPE Ratio formula:

Share price / 10-year earnings average adjusted for inflation

Question 24

Calculate the CAPE

Q: Bulldog Inc. has a price per share of $112 and has earnings per share of $5.12. Over the last 10 years it has had an average earnings per share of $3.89 per
share, with and EPS adjusted for inflation of $3.40 over the same period. Calculate the Shiller CAPE ratio.

Answer 24

A: $112 / $3.40 = 33

Note: Current PE is 22 (= $112 / $5.12)

Question 25

Price-Earnings-Growth Rate (PEG Ratio)

Answer 25

This ratio employs the P/E ratio and relates it to a firm’s expected growth rate per year (EGR). It reflects the firm’s potential value of a share of stock.

PEGR = (P/E) / EGR

Suppose that a firm with a P/E of 8.72 expects an annual growth rate of 8%. Its PEGR would be

8.72/8 = 1.09

It is theorized that PEGRs represent the following:

If PEGR = 1 to 2: The firm’s stock is in the normal range of value.

If PEGR < 1: The firm’s stock is undervalued.
If PEGR > 2: The firm’s stock is overvalued.

Question 26

Book-to-Market

Answer 26

• a measure of an asset’s value calculated by dividing the asset’s book (accounting) value by its market value
• a positive ratio indicates that the market is discounting the asset

Question 27

Book Value

Answer 27

Defined
A valuation based on a company’s assets minus its liabilities.

Formula:
Book Value = assets minus liabilities

Book Value Per Share
= (assets-liabilities) / shares outstanding
= shareholder equity / shares outstanding

Question 28

Price to Book Ratio

Answer 28

Defined
Calculated by dividing the share price by book value per share. It can also be calculated by dividing the market capitalization by the book value (assets – liabilities). This metric compares a stock’s price to its accounting or book value.

Examples
P/B ratio = share price/[(assets-liabilities)/shares outstanding]

Question 29

Q Ratio

Answer 29

• developed by James Tobin (Yale)
• a valuation model that says the actual value of all companies should be equal to the replacement cost of their assets
• a value under 1 indicates an undervalued equity while a ratio of greater than 1 implies the stock is overvalued
• formula = total market value of firm divided by replacement cost (of assets – liabilities)

Book value per share is assets minus liabilities divided by number of shares. Liquidation value per share is the amount a shareholder would receive in the event of bankruptcy. Market value per share is the market price of the stock.

Companies with assets that are hard to value and/or replace, such as personnel, goodwill, and intellectual property, are not optimal for measurement by Tobin’s Q.

According to Tobin, in the long run, the ratio of market price to replacement cost should tend toward 1.

Question 30

Return on Equity (ROE)

Answer 30

Defined
ROE is a ratio that measures how well company management is performing for shareholders (i.e., profitability). It is calculated by dividing after-tax earnings by shareholder’s equity (i.e., book value). It can also be calculated by dividing earnings per share by book value per share.

Example
ROE = net earnings/shareholder’s equity
= net earnings/book value
= earnings per share (aka EPS)/(book value per share)

Formula for P/B, P/E and ROE:
P/B = P/E * ROE

ROE formula when adding the impact of taxation and debt….

ROE = (Net Profit/Equity) = (1-Tax Rate)*[ROA + (ROA - i) * (D/E)]

Where:
• Net Profit = Earn After Taxes & Interest
• i = Interest Paid
• ROA = EBIT / Assets
• D/E = Debt as % Equity or the Debt-Equity Ratio

Question 31

Using Retention Ratio to solve for a company’s growth rate

Answer 31

One method for calculating a company’s growth rate is to use something called a
retention rate (or ratio). You multiply the ROE x the retention rate. Retention rate is
basically 1 minus the dividend rate paid out.

Example: Company has return on equity of 17%, earnings of $1.75 per share, and
pays a dividend of $0.25 per share. The retention rate (i.e., amount used to keep
growing the company – and is not paid out to shareholders) is calculated as follows:

1 – (dividend/earnings)
1 – (0.25/1.75)
1 – .1429
Retention Rate = 85.71%

Growth = ROE x retention rate
= 17% x 85.71%
=14.57% (answer)

Question 32

Best Valuation Metric for Start-ups

Answer 32

What is the best valuation metric for small companies including start-ups with no
earnings? Answer: it depends (of course).

So, you’ll want to dissect the
information given about the company in question very carefully.

Price to Earnings – no, if the company does not have earnings

Price to Discounted Cash Flow – this metric is used in practice but depends
greatly on the skill of the analyst to predict future cash flows

Price to Book – this could be used, but in some cases will not be very helpful
(e.g., a company in which assets like intellectual property are hard to value)

Price to Sales – this is often one of the better metrics for a start-up, assuming
the company has sales already

ROE and ROA – these metrics will not prove helpful until the company has
income (earnings)

Question 33

Using traditional methods of evaluation, which one of these stocks would be considered a value stock relative to the other?

                 ABC Co.	XYZ Corp. Revenue	$62.8b	$841m Earnings	$9.6b	$164m Book Value	$66.2b	$900m Market Capitalization	$230b	$9.4b Shares Outstanding	4.6b	39m Share price	$50	$241

Answer 33

ABC because it has a lower P/E ratio and a lower Price to Book ratio.

ABC P/B = 230b / 66.2b = 3.47 versus
XYZ P/B = 9.4b / 0.9b = 10.44

ABC P/E = 50 / (9.6 / 4.6) = 23.96 versus
XYZ P/E = 241 / (164m / 39m) = 57.31

Question 34

market capitalization rate

Answer 34

The market capitalization rate, which consists of the risk-free rate, the systematic risk of the stock and the market risk premium, is the rate at which a stock’s cash flows are discounted in order to determine intrinsic value.

is a common term for the market consensus value of the required return on a stock.

Question 35

Rocky Mountain Brewery Corp. is expected to pay a dividend of $2 in the upcoming year. The risk-free rate of return is 4% and the expected return on the market portfolio is 14%. Analysts expect the price of Rocky Mountain Brewery Corp. shares to be $22 a year from now. The beta of Rocky Mountain Brewery Corp.’s stock is 1.25.

The market’s required rate of return on Rocky Mountain Brewery Corp.’s stock is __________.

Answer 35

We can use the CAPM formula to solve for required rate of return:

4% + 1.25(14% - 4%) = 16.5%

Question 36

You wish to earn a return of 11% on each of two stocks, C and D. Stock C is expected to pay a dividend of $3 in the upcoming year while Stock D is expected to pay a dividend of $4 in the upcoming year. The expected growth rate of dividends for both stocks is 7%. The intrinsic value of stock C

Answer 36

will be less than the intrinsic value of stock D

PV0 = D1/(k-g); given k and g are equal, the stock with the larger dividend will have the higher value.

Question 37

A firm’s earnings per share increased from $10 to $12, dividends increased from $4.00 to $4.80, and the share price increased from $80 to $90. Given this information, it follows that

Answer 37

the stock experienced a drop in the P/E ratio

$80/$10 = 8; $90/$12 = 7.5

Question 38

A company whose stock is selling at a P/E ratio greater than the P/E ratio of a market index most likely has

Answer 38

a dividend yield which is less than that of the average firm

Firms with lower than average dividend yields are usually growth firms and have a higher P/E ratio than average.

Question 39

If a firm has a positive tax rate, a positive ROA, and the interest rate on debt is the same as ROA, then ROA will be

Answer 39

greater than the ROE

If interest rate = ROA; ROE = (1 - tax rate) ROA; ROA > ROE.

Question 40

A firm has a P/E ratio of 12 and a ROE of 13%. What is the price-to-book value?

Answer 40

P/B = P/E * ROE

    = 12 * 0.13

    = 1.56

Note that the above formula is derived from the definitional formulas for the ratios: P/B (Price to Book), P/E (Price to Earnings) and ROE (Return on Equity).

Recall, the denominator in ROE is Equity, which is based on book value and NOT a stock’s market price. See CIMA textbook pages 426-433 for more detail about these ratios.

For the specific derivation of the formula:

  P/E * ROE = [(Price/share) / (Earnings/share)] * [(Earnings/share) / (Book Value/share)]

      = [(Price/share) / (Earnings/share)] * [(Earnings/share) / (Book Value/share)]

      = [(Price/share)] * [ 1 / (Book Value/share)]

      = (Price/share) / (Book Value/share)

      = P/B

Reminder: the denominator of Equity in ROE is

= [(Price/share) / (Earnings/share)] * [(Earnings/share) / (Equity/share)]

= [(Price/share) / 1 ] * [ 1 / (Equity/share)]

= [(Price/share) / (Equity/share)]

= P/Eq

= P/B

Question 41

A firm has an ROA of 14%, a debt/equity ratio of 0.8, a tax rate of 35%, and the interest rate on the debt is 10%. The firm’s ROE is ______________.

Answer 41

ROE = (1 - 0.35)[14% + (14% - 10%)0.8] = 11.18%.

Question 42

Bulldog Stock enjoyed earnings last year of $21,000,000 while holding $100,000,000 in assets and $10,000,000 in liabilities. Bulldog’s book value and return on equity last year were

Answer 42

Book Value = assets minus liabilities = $100m - $10m = $90m

ROE = earnings / shareholder equity = $21m / $90m = 23.3%

Question 43

Market capitalization can be calculated by…

Answer 43

Market capitalization can be calculated by multiplying the share price by the number of shares outstanding.

Question 44

respectively, for IVY League stock.

Cash $10,000,000

Receivables $42,000,000

Inventories $35,000,000

Capital long-term investments $75,000,000

Property and equipment $225,000,000

Short-term accounts payable $27,000,000

Long-term debt $150,000,000

Answer 44

Current Ratio = current assets divided by current liabilities.

Current Assets for this company = cash, receivables, inventories = $87m

Current Liabilities = short-term accounts payable = $27m

$87m / $27m = 3.22

Quick Ratio = (cash and equivalents + ST investments + receivables) / current liabilities

Quick Ratio assets for this company = cash, receivables = $52m

Current Liabilities = short-term accounts payable = $27m

$52m / $27m = 1.93

Question 45

Correlations between stock markets of many different countries have risen over the last 25 years. Which if the following possible rationale/conclusions is a more common explanation of this change?

Answer 45

globalization and advancements in technology and communication

Recent Increase in Stock Market Correlations

Since the 1990’s there has been an increase in correlation in equity prices of many international developed markets.
There is a fair amount of speculation as to why this has occurred and if correlations will remain at this level or possibly move even higher.
Possible reasons for increased correlations:
Globalization (advances in technology, communication, etc.)
Increased volatility and crises lead to higher correlations
Increase in emerging market capitalization

Question 46

What is the CAPE ratio of the following stock?

Stock price $45.10/share

Forward looking PE ratio = 22.2

Current PE ratio = 31.6

Current earnings per share = $2.08

Inflation adjusted 10-year historical earnings per share = $1.12

Answer 46

Shiller PE Ratio

also known as the “cyclically adjusted (CAPE) PE”
smoothes out fluctuations in earnings due to the business cycle
uses earnings per share figures adjusted for inflation and averaged over 10 years as the denominator
CAPE Ratio formula:

share price / 10-year earnings average adjusted for inflation

$45.10 / $1.12 = 40.27

Question 47

What is the PEG ratio of the following stock and determine whether it is over or undervalued?

Stock price = $60.00/share

Current PE ratio = 32

Current earnings per share: $1.87

Projected earnings per share: $1.96

Answer 47

PEGR = P/E divided by expected growth rate

Solve for growth rate: ($1.96 - $1.87) / $1.87 = 4.81%

32 / 4.81 = 6.65

This ratio employs the P/E ratio and relates it to a firm’s expected growth rate per year (EGR). It reflects the firm’s potential value of a share of stock.

It is theorized that PEGRs represent the following:

If PEGR = 1 to 2: The firm’s stock is in the normal range of value.

If PEGR < 1: The firm’s stock is undervalued.

If PEGR > 2: The firm’s stock is overvalued.

Question 48

Use the retention rate to determine growth rate for the following company.

ROA = 2.12

ROE = 3.57

EPS = $0.87

PE Ratio = 17.25

Dividends = $0.12

Answer 48

Solve for retention rate: 1 – (dividend/earnings)

1 – (0.12 / 0.87) = 86.21%

Growth = ROE x retention rate

= 3.57 x 86.21% = 3.08%

Using Retention Ratio to solve for growth rate

One method for calculating a company’s growth rate is to use something called a retention rate (or ratio). You multiply the ROE x the retention rate. Retention rate is basically 1 minus the dividend rate paid out.

Another example: Company has return on equity of 17%, earnings of $1.75 per share, and pays a dividend of $0.25 per share. The retention rate (i.e., amount used to keep growing the company – and is not paid out to shareholders) is calculated as follows:

1 – (dividend/earnings)

1 – (0.25/1.75)

1 – .1429

Retention Rate = 85.71%

Growth = ROE x retention rate

= 17% x 85.71%

=14.57% (answer)

Question 49

What is the best metric for valuing a start-up company with no earnings, negligible and unstable cash flow, a high reliance on intellectual property for success, and lower than expected sales over its first three years of existence?

Answer 49

Best valuation metric for start-ups

What is the best valuation metric for small companies including start-ups with no earnings?

Answer: it depends (of course). So, you’ll want to dissect the information given about the company in question very carefully.

Price to Earnings – no, if the company does not have earnings

Price to Discounted Cash Flow – this metric is used in practice but depends greatly on the skill of the analyst to predict future cash flows

Price to Book – this could be used, but in some cases will not be very helpful (e.g., a company in which assets like intellectual property are hard to value)

Price to Sales – this is often one of the better metrics for a start-up, assuming the company has sales already

ROE and ROA – these metrics will not prove helpful until the company has income (earnings)