Study Session 12 - Equity Valuation Flashcards
Which cash flow and rate used for firm valuation
FCFE @ required return on equity
Equity value= Firm value - market value of debt
General FCFF calculation
NI + Noncash charges + Interest * (1-tax rate) - Fixed Capital investment (capex) - Working Capital investment
1) General Fixed Capital Investment calculation
2) If no long-term assets were sold during the year
3) If long-term assets were sold during the year
1) capex - proceed from sales of long-term assets
2) capex = ending gross PP&E - beginning gross PP&E
3) capex - proceeds from sale of long-term assets OR ending net PP&E - beginning net PP&E + depreciation - gain on sale + loss on sale
FCFF calculation starting with CFO
CFO + interes*t(1-tax rate) FCInv
FCFE calculation starting with FCFF
FCFF - interest*(1-tax rate) + net borrowing
Calculating FCFF from EBIT
EBIT*(1-tax rate) + dep - FCInv - WCInc
Calculating FCFF from EBITDA
EBITDA(1-tax rate) + dep tax rate - FCInv - WCInv
Calculating FCFE from CFO
CFO - FCInv + net borrowing
What to do if the stock has preferred shares…
treat them just like debt, except preferred dividend are not tax deductible
Which cash flow and rate used for firm valuation
FCFF @ WACC
FCFE vs Dividend discount model
FCFE takes a control perspective that assumes that recognition of value should be immediate
DDM take a minority perspective, under which value may not be realized until the dividend policy accurately reflects the firm’s long-run profitability
2 methods of forcasting FCFE
1- apply a growth rate
2- using a target debt-to-assets ratio (DR)
FCFE= NI-(1-DR)(FCInv-Dep) - (1-DR)WCInv
Effect of dividend, share repurchases, share issues, and changes in leverage on the future FCFE and FCFF
dividends, share repurchases and issues have no effect on FCFF and FCFE. Changes in leverage have only a minir effect on FCFE and no effect on FCFF
FCFF and FCFE represent cash flow available to investors and shareholders, respectively, before any financing decision
2 method for focasting the terminal value in a multistage valuation model
1) apply a stable growth rate FCF/(r-g)
2) use a valuation multiple like P/E
terminal value= trailing P/E* earning in year n
“””” = leading P/E * forecasted earnings in year n+1
Rationale for using P/E
- earnings power
- popular in the investment community
- empirical research shiws that its differences are significantly related to long-run average stock returns
Shortcomings of P/E ratio
- earnings can be negative
- the volatile, transitory portion
- management discretion within allowed accounting practices
Trailing and leading P/E
Trailing: Market price per shre/EPS past 12 mo
Leading: Market price per share/forecasted EPS over next 12 months
advantages of P/B
- Book value is a cumulative amount that is usually positive, even when loss occur and negative EPS
- more stable than EPS
- approriate value of NAV fir firms that primarily hold liquid assets
- approriate ratio for expected out of business firms
disadvantage of P/B
- do not reflect the value of intangible economic assets
- different accounting convention
- inflation and technological change
P/B ratio
market value of equity/Book value of equity
book value of equity=
common shareholder’s
= total assets - total liabilities - pref. stock
advantage of P/S
- meaningful even for distressed firms. always positive
- not easy to manipulate sales
- not as volatile as P/E
- approriate for stocks in matire or cyclical industries and star-up with no records of earnings
disadvantage of P/S
- high growth in sales does not necessaraily inducate high operating profit
- dies nor capture differences in cost structure
advantage of P/CF
- CF harder to manipulate than earnings
- more stable than P/
- handkes tge provlem of differences ibthe quality of reported earnings, which is a probkem for P/E
Advantage of dividend yield D/P
- commonly used for valuing indexes
- contributes to total investment return
trailing D/P
leading D/P
trailing: 4*most recent quarterlu div/market price per share
leading: forecasted dividends over next four quarters/market price per share
two method to normalize earnings
1- historical average EPS
2- average return on equity: Normalized EPS is eastimated as average ROE*BVPS. prefered because account for size effects
justified trailing P/E calculation
P_0/E_0 = D_0*((1+g)/E_0)/(r-g)
= (1-b)*(1+g)/(r-g)
justified leading P/E calculation
P_0/E_1= D_1/E_1/(r-g)
= (1-b)/(r-g)
or
Trailing P/E / (1+g)
justified P/B calculation
(ROE-g)/(r-g)
sustainable growth calculation
ROE*retention ratio
NI/SalesSales/assetsassets/equity*ret. ratio
justified P/S calculation
(E_0/S_0)(1-b)(1+b)/(r-g)
justified P/CF calculation
FCFF_0*(1+g)/(r-g)
justified yield calculation
(r-g)/(1+g)
three main limitation of a predicted P/E estimated from linear regression
- The predictive power of the estimated P/E regression for a different time period and/or sample of stocks is uncertain
- The relationship between P/E and fundame tal variables examines may change over time
- multicollinearity is often a problem, difficult to interpret
PEG ratio calculation
P/E ratio / g
drawback of PEG
relationship between P/E and g is not linear, which makes comparisons difficult
doest not account for risk
terminal calue in year n based on:
leading P/E
trailing P/E
justified leading P/E * forecasted earnings in year n+1
justified trailing P/E * forecasted earnings in year n
adjusted CFO calculation
CFO+ bet cash interest outflow*(1-tax rate)
entreprise value calculation
EV= market value of common stock + market value of preferred equity + market value of debt + minority interest - cash and investments
EV/EBITDA is useful for:
may be more useful than P/E when comparing firms with different degrees of financial levrage
useful for valuing capital-intensive businesses with high levels of depreciatio/ amortization
usually positive even when EPS is not
drawback of EV/EBITDA
if working capital is growing, it will overstate CFO
earning surprise calculation
reported EPS - expected EPS
standardized unexpected earnings (SUE) calculation
earnings surprise/standard deviation of earnings surprise
the portfolio or index P/E is best calculated as….. weighted harmonic, mean, arithmetic, harmonic mean???
weighted harmonic mean P/E.
1/sommation(weight/(P/E))
page 213 volume 3
economic value added (EVA) calculation
NOPAT-(WACC*total capital)
=
EBIT*(1-t)-$$WACC
market value added (MVA) calculation
market value - total capital
Residual income per share in year t calculation
E_t-(rB_t-1) = (ROE-r)B_t-1
Intrinsic value of stock at time 0 using residual income
V_0= Book value_0 + RI1/(1+r)^1 + RI2/(1+r)^2 + RI3/(1+r)^3+….+RIn/(1+r)^n
Value tends to be recognized earlier in the RI approach than in other present value-based approach. why?
because, for the other approach like DDM, a large portion of the estimated intrinsic value comes from the present value of the expected terminal value
general formula for valuation with residual incone approach
V_0= Book value_0 + [(ROE-r)*B_0/(r-g)]
Continuing residual income concept and calculation
it is the residuak income that is expected over the lobg term (kind of terminal value)
PV of continuing residual income in year t-1=
RI_t/(1+r-w)
where w= persistence factor (between 0, high persistence, and 1, no persistence)
higher and lower persistence factor in the continuing residual income
higher: low dividend, historically high persistence in the industry
lower: high ROE, high accounting accruals, significant levels of nonrecurring items
strenghts of residual income models
- terminal value does not dominate the intrinsic value estimate
- use easy-to-find accounting data
- does not need dividend or positive and stable FCF in tge short run
- focus on exonomic profitability
weakness of residual income models
- accounting data can be manipulated by management
- numerous nd significant adjustment on accounting data
- the model assume that the clean surplus hold
Residual income models are not appropriate when:
clean surplus accounting relation is violated significantly
uncertainty concerning the estimates of book value abd return on equity
accounting issues in applying residual income models
clean surplus violations variations from fair value intangible asset effects on book value nonrecurring items and other aggressive accounting practices international accounting differences
Discount for lack of control (DLOC) calculation
1-(1/(1+control premium))
when we apply discount for lack of marketability (DLOM)?
when a interest in a firm cannot be easily sold
total discount with DLOC and DLOM
total discount = 1-[(1-DLOC)(1-DLOM)]
