Week 4 - Equity Valuation and Portfolio Management

Question 1

What is the most important information in performing valuation work?

Answer 1

Forecasting cashflows is the most important part, and requires a sound understanding of the company being valued. Mathematical models are important but of secondary concern

Question 2

Define EBITDA, EBIT, EBT and NPAT

Answer 2

EBITDA - Earnings before interest, tax, depreciation and amortisation
EBIT - Earnings before interest and tax (operating profit)
EBT - Pre-tax profit
NPAT - Net profit after tax

Question 3

What are the three categories of cash flows?

Answer 3

1) Operating (relating to net income)
2) Financing (relating to non-current liabilities, e.g. borring, repayments, capital raising etc.)
3) Investing (capital expenditure - either maintenance or expansion)

Question 4

How are interest and dividends treated under IFRS and GAAP? What are the implications of this difference?

Answer 4

Under GAAP, interest received and paid and dividends received are under operating cash flows, while dividends paid are considered financing cash flows. Under IFRS/AASB the firm has the right to choose which they please. Companies are then able to manipulate their cash flow statement - e.g. Telstra put interest paid against financing, which boosted operating cash flows to make them appear better

Question 5

Define working capital and gross profit.

Answer 5

Working capital = Receivables + Inventories - Payables

Gross profit = Cash from sales - cash payments + change in Working capital

Question 6

What is the Free Cash Flow to Equity (FCFE)? How does this relate to dividend coverage?

Answer 6

FCFE = NPAT + Depreciation - Capex - change in Working capital

We do this because depreciation is a cash flow that has not really occurred but has been deducted to reach NPAT, so we add it back to recoup this difference and subtract actual capital expenditure.
Dividend coverage should also be assessed relative to FCFE and not just NPAT as FCFE gives a better estimate of how money has actually moved.

Question 7

Why might managers to be motivated for ‘earnings management’?

Answer 7

1) Earnings might otherwise fall short of market consensus and cause a share price drop
2) May be able to offset disturbances in earnings trends that have occurred due to non-recurring events
3) Managers can set the base low for future growth when appointed as a new manager (taking out the garbage)
4) Pending IPO requires positive earnings growth
5) Earnings risk breaching a debt covenant - EBIT/Interest > 3 (need to maintain earnings)
6) Managers’ compensation is linked to earnings growth hurdles

Question 8

What tricks can be used to manage earnings?

Answer 8

1) Change depreciation method (straight line to accelerated)
2) Capitalisation of costs so that only depreciation hits P&L
3) Estimate asset write-downs
4) Allow for noncollectable accounts/false sales
5) Exaggeration of restructuring provisions which can be toned back later to increase earnings

Question 9

What are some signs companies may be in trouble?

Answer 9

1) Accounts receivable increase relative to sales - poor management/false sales (longer they are unpaid, the less likely to be paid)
2) Inventories increase relative to sales - poor stock control, deterioration of assets, reduction in demand
3) Accounts payable increase relative to expenses - difficulty in paying expenses/collecting receivables
4) Low capex relative to depreciation - asset base is not replenished

Question 10

What are some key considerations when comparing a company to itself/competitors?

Answer 10

1) When comparing, use mid-cycle earnings as the baseline, otherwise the numbers will be too volatile (as a point in time can change drastically)
2) There is a strong country effect present, be hesitant when comparing across countries as national markets appear cheap/expensive when compared to other nations
3) Calculate ratios for a company across time, and compare to itself prior
4) Compare to companies within the same industry and with a similar vertical structure (i.e. have they acquired similar operations in the supply chain?)

Question 11

What is the intuition behind the DDM model? What is the key formula?

Answer 11

The intuition behind the DDM model, is that companies experience a certain return on equity, which is retained (retention rate of b) or paid out in dividends (a total amount of E(1-b) is paid out in dividends). The stock experiences earnings growth of (1+bROE) as whatever return was not paid out remains invested at a similar rate of return. This continues exponentially and arrives at the formula:

P = (1-b)E/(k-bROE)

k is the discounted rate of return, based on the CAPM model - i.e. k = r(f) + beta* [r(m)-r(f)]

Question 12

How should equity markets perform in an environment of stagflation?

Answer 12

In a weak economy, we expect E and ROE to decrease. Further, volatility increases and thus we expect to see an increased risk margin and decrease in the risk free rate. On balance it is likely that the P/E ratio decreases.

It is important to address questions like this by looking at all the different parts of the DDM - E, k (volatility of risk and risk-free rate), ROE

Question 13

What is the PEG? Is it useful?

Answer 13

PEG is the PE to Growth ratio and is an unreliable rule of thumb. It is difficult mathematically, but is maximised at moderate growth rates.

PEG = (1-b)/[(k-g)*g]

Question 14

What is the P/B ratio? Outline key formulas and explain the relationship between ROE and k and its impact on valuation premium.

Answer 14

We define ROE to be E/B (earnings/book value - a simplifying assumption that does not always hold). Thus we have that P=(1-b)E/[k-bE/B] and finally

P/B = 1 + (ROE - k)/[k - b*ROE]

This shows us that a P/B ratio is high when ROE > k (equity discount rate), and that in this scenario a higher retention rate is likely to increase this ratio further (increase in valuation premium). On the contrary, when ROE < k then a higher retention rate improves valuation premium.

Question 15

Define some of the key assumptions surrounding the DDM model. Is it useful?

Answer 15

The DDM model assumes the return on an existing asset base is constant and earnings are asset driven. Without any new capital, earnings would be the same as the previous year. In reality, ROE may vary due to changes in technology/competitive environment.

As a whole, the single phase model is highly sensitive to current assumptions and is not good on a company level, particularly when dividend payout is very low or high. It is useful in understanding relativity of P/E due to differences in risk (k) and growth (ROE). Far better at a market aggregate level. A three-phase model fixes some issues but remains sensitive to phase 3 assumptions.

Question 16

What is the Free Cash Flow to Firm (FCFF) valuation model? What assumptions does it make?

Answer 16

Value of firm is sum of all future FCFF subject to a discount rate of the WACC (weighted average cost of capital). To find this, assumptions need to be made surrounding the optimal capital structure.
A more accurate model explicitly values the next five years of cash flows before making an assumption about final growth - usually around inflation of 2%-2.5%.

Question 17

How do you find the Value of Equity under the FCFF model?

Answer 17

Value of equity is Value of firm - Value of debt. Always remember this fact.
Calculate value of firm using the typical FCFF model. Please note also that the actual debt mentioned here will be different from the optimal capital structure assumed in the WACC calculation.

Question 18

Define the FCFF and FCFE.

Answer 18

FCFF = EBIT(1-t) + Depreciation - capex - change in WC
FCFE = FCFF - Interest(1-t)
= NPAT + Depreciation - Capex - change in Working capital

Question 19

Typically, where do imputation credits fit into the FCFF and FCFE models?

Answer 19

In larger companies of Australia, franking credits are not present in their valuation as these companies often have foreign holdings, for which franking credits are not relevant. For smaller domestically held firms, franking credits are sometimes accounted for in valuation work. It is important to always ask the question (mention during exam) - where are franking credits in this model? Have they been accounted for explicitly by adjusted WACC, or implicitly by ignoring them and using lower WACC.

Question 20

What is the cost of equity adjustment?

Answer 20

Adjustment = Dividend Yield * Franking (%) * T(c)/[1-T(c)] * UtilRate

where T(c) is the company tax rate

Question 21

What is the formula to derive the WACC?

Answer 21

WACC = k * E/[E+D] + (1-t)iD/[E+D]

Where k is the cost of equity, i is the cost of debt dependent on corporate rating (do NOT forget that i considers corporate credit rating) and t is corporate tax, E,D reflect optimal structure.

In practice, bond yield is taken as a recent average or estimate of ‘fair’ yield over a spot check. k > i, therefore as proportion of debt increases, WACC also decreases, however k, i both increase with leverage (higher debt proportion), thus decreasing to a point with increased debt - the optimal capital structure.

Question 22

What adjustment must sometimes be made to the cost of equity?

Answer 22

Sometimes a risk premium of 3%-5% is added to small stocks (e.g. equity below $100m) to reflect additional factor risk

Question 23

What are the three phases of cash flow models?

Answer 23

1) Growth - capex > depreciation, low dividend payout
2) Transition, capex approaches depreciation, increased dividend payout and slowing growth
3) Maturity - capex = depreciation, payout and growth remain stead

Question 24

In what scenario is the FCFF model preferred to the DDM model? Why?

Answer 24

When capital structure is changing, trajectory of dividends can be distorted - FCFF is independent of capital structure. When dividends are volatile (or at very high/low ratios) then FCFF reflects firm profitability and is easier to forecast. It is still critically sensitive to terminal value assumptions.

Question 25

How should the relationship between sales and the balance sheet be accounted for in forecasting equity cash flows?

Answer 25

After considering sales projections, consider the balance sheet and expected profit margin. Is new capital raising needed - depends on whether firm is capital intensive or not. B/S determines interest, depreciation, tax, expenses - factors that all must be considered in cash flow calculation.

Question 26

What are realistic growth assumptions?

Answer 26

Growth = retention * return on retention

This defines internally sustainable growth (no need for new capital raising). But also assumes that growth can only occur by expanding asset base - note that return on retention should relate to new investment not prior investment. At least in the short term, return dynamics are not stable and so profitability varies greatly

Question 27

What are Porters 5 determinants of competition (drivers of ROE)?

Answer 27

1) Barriers to entry (e.g. low vs high tech)
2) Rivalry between competitors (e.g. oligopolies vs perfect competition)
3) Pressure from substitute products (e.g. digital vs CD)
4) Bargaining power of buyers (e.g. Woolworths milk)
5) Bargaining power of sellers (e.g. iron ore)

Question 28

What factors should be considered when choosing comparable companies for a valuation based on simple multiples?

Answer 28

Note that this approach uses the FCFF approach and applies a multiple based on observations of a similar firm.

1) Which publicly trading companies are most similar - typically same industry
2) Use Porter’s analysis
3) Are earnings distorted by cyclical/transient factors?
4) Consider that companies with multiple divisions can be tricky to forecast for

Question 29

What additional factors should be considered in valuations?

Answer 29

1) Non-operational assets should be valued separately
2) Need to be careful about including a loss making division in earnings based comparable valuation (as growth will not be projected to be negative otherwise the division would be shut down)
3) Stakes in private companies are at a discount to public ones because of lack of marketability

Question 30

What are three different definitions for value investing?

Answer 30

1) Low P/E investing - investing in stocks with low P/E ratios
2) Contrarian investing - investing in stocks perceived by the market as having problems
3) High yield - selecting stocks with high dividend yield

Question 31

What goes wrong with value investing?

Answer 31

Cheap valuation is misinterpreted, sometimes using a poor valuation method. Alternatively, the cheap valuation could be indicative of something genuine impairing growth prospects, e.g. profitability on new investment is structurally low (due to competition). There is nothing a good quality manager can do about a bad company

Question 32

What goes wrong with growth investing?

Answer 32

The risk for growth investors is that their view does not materialise, growth disappoints and valuations get re-rated downwards.

Question 33

What is the preferred environment for value and/or growth?

Answer 33

In strong growth or peak, choose value investment - fewer problems when environment is positive (picking the cheapest of healthy situations while growth stocks are at risk of paying too much).
In downturn or recession choose growth investments (picking the most economically robust of a conservatively priced market as value stocks will plummet)

Question 34

What is the now discredited Fed model? What is a better method to value the market?

Answer 34

EY/B = (E/P)/y = (y+ERP-bROE)/[(1-b)y]
= 1 + [ERP-b(ROE-y)]/[(1-b)y]

Suggests that earnings yield and bond yields moved closely together. Held during 1980s and 1990s but far less robust in the 2000s. In theory the ratio will vary over time depending on the changing ERP and ROE. These are variations and not mispricing.
A better method is to use the CAPE - cyclically adjusted P/E ratio which takes an average of the past 10 years of data.

Question 35

What are the two indices commonly used to calculate market returns?

Answer 35

1) Price indices - exclude dividend income
2) Accumulation indices (Total Return) - includes reinvested dividends

Total return = capital appreciation component (price index) + reinvested dividends

Question 36

How is Australia different pre-1991 and post-1991?

Answer 36

1) Floating of AUD - allows for less disruption during commodity booms
2) Introduction of franking credits - boosts the demand for dividend yield above capital appreciation, also reduces growth as more is paid out instead of reinvested
3) Shift in market sectors, decrease in resources and manufacturing, increase in financials (and decrease in volatility)
4) Reduction in protection, led to more interaction with the global economy
5) As a result, volatility has systematically diminished. Lower risk premiums have been demanded, and the annual return frequency is far more moderated than when compared to the previous 25 years.

Question 37

How has the floating exchange rate helped the economy in commodity booms?

Answer 37

During the commodity booms, the floating exchange rate has allowed for immediate adjustments in the exchange rates (an appreciation) which diminishes benefits for mining companies. This has led to fewer structural shifts during these periods and far less disruption to the economy.

Question 38

How has the economy shifted structurally? How has this impacted the market?

Answer 38

There has been a systematic decrease in the resource and manufacturing sector and an increase in the financial sector. The resource sector is typically more volatile, which has caused a reduction in overall volatility.

Question 39

How does equity performance respond to:

1) Low-moderate inflation
2) High cost-push inflation
3) High demand-pull inflation
4) Deflation

Answer 39

1) Low-moderate inflation is good (as it is sustainable and confidence is up)
2) High cost-push inflation is bad (as firms have no control and profitability diminishes)
3) High demand-pull inflation is ok (profit margins increase and it is easier to expand, though there is feedback into wage prices etc.)
4) Deflation is bad, compared to bonds (confidence in market is down and decreased demand as fewer consumers are spending)

Question 40

How does equity performance respond to:

1) Tightening MP
2) Expansionary MP

Answer 40

1) Tightening MP leads to a drop in equity performance
2) Loosening MP leads to an improvement in equity performance

These movements are tied down to business borrowing/investment rates. If cash rate increases, cost of debt and borrowing increases, reducing profitability, whereas a cash rate decrease improves ability to pay off debts, leaving money to be spent elsewhere, improving future prospects and profitability.