# Equity Flashcards

Calculate the implied growth rate in residual income given the market price-to-book ratio and an estimate of the required return on equity.

Distinguish between required return and expected return.

Calculate and interpret the present value of growth opportunities (PVGO) and the component of the leading price-to-earnings ratio (P/E) related to PVGO.

Define invested capital.

Cash and cash equivalents plus net fixed assets plus operating assets less operating liabilities (i.e., working capital requirements). Operating assets reflect receivables, inventories, and prepaid expenses. Operating liabilities include payables and accrued expenses.

List the steps in the development of a sales-based pro forma company model.

Identify the two primary versions of the three-stage growth models.

Describe the two major sources of errors in the valuation exercise of a sensitivity analysis.

Describe the top-down approach to projecting future revenue.

Explain and calculate the weighted-average cost of capital (WACC) for a company.

Judge the competitive position of a company based on a Porter’s five forces analysis.

Determine the company’s position with regard to the threat of substitute products, rivalry among existing competitors, threat of new entrants, and the bargaining power of suppliers and customers.

Describe the adjustments to earnings and capital required for the EVA interpretation.

Explain the justified price multiple for a stock.

The justified price multiple uses fair or relative value. Based again on the market perspective, market price multiples less than justified multiples are undervalued and market multiples greater than justified multiples are overvalued.

Evaluate whether a stock is undervalued, fairly valued, or overvalued based on a free cash flow valuation model.

Evaluate the use of net income and EBITDA as proxies for cash flow in valuation.

Calculate the equity control premium adjustment for valuing a private company.

Evaluate whether a stock is overvalued, fairly valued, or undervalued by the market based on a DDM estimate of value.

Explain the appropriate adjustments to net income, EBIT, EBITDA, and cash flow from operations (CFO) to calculate FCFF.

FCFF = NI + NCC + Int(1−t) − FCI − WCI

=CFO + Int (1−t) − FCI

=EBIT (1−t) + Dep − FCI − WCI

=EBITDA (1−t) + Dep(t) − FCI − WCI

Evaluate the effects of technological developments on demand, selling prices, costs, and margins.

Describe how control premiums are determined.

Explain the use of sensitivity analysis in FCFF and FCFE valuations.

Calculate and interpret the implied growth rate of dividends using the Gordon growth model and current stock price.

Identify the reasons why earnings may need to be adjusted upward for profitable private companies.

Describe a hybrid approach.

Describe strengths and limitations of the Gordon growth model and justify its selection to value a company’s common shares.

Compare growth rates in the first stage for the two versions of the two-stage free cash flow model.

Estimate the required return on an equity investment iusing the capital asset pricing model.

Calculate the value of noncallable fixed-rate perpetual preferred stock.

Explain how dividends, share repurchases, share issues, and changes in leverage affect future FCFF and FCFE?

List the concerns analysts have when estimating the required return on equities in a global context.

Estimate the required return on an equity investment using the BIRR model.

Calculate residual income using the model for valuing small businesses in tax cases.

Calculate the value of a common stock using the Gordon growth model (GGM) and explain the model’s underlying assumptions.

List the advantages and drawbacks of dividend yield.

Dividend yield is a component of total return and is less risky than the capital gains component. The market may or may not price these two components of total return differently.

Higher dividend yield implies lower earnings growth.

Explain strengths and weaknesses of residual income models.

Explain how competitive factors affect prices and costs and describe the relationship between return on invested capital and competitive advantage.

Define sustainable growth rate (SGR).

Explain continuing residual income and justify an estimate of continuing residual income at the forecast horizon given company and industry prospects. Calculate and interpret the intrinsic value of a common stock using a multistage residual income model.

Describe the justified EV/EBITDA multiple based on fundamentals, all other things remaining the same.

Calculate and interpret the sustainable growth rate g of a company, and demonstrate the use of DuPont analysis to estimate a company’s sustainable growth rate.

Explain how to forecast industry sales and costs when they are subject to price inflation or deflation.

Forecast nonoperating costs (e.g., financing costs and income taxes).

Explain the use of spreadsheet modeling to forecast dividends and to value common shares.

Calculate the value of a company using the free cash flow, capitalized cash flow, and excess earnings methods.

Explain the income, market, and asset-based approaches to private company valuation.

Income – The value of an asset as the present value of its expected future cash flows.

Market – The value of an asset based on market price and enterprise value multiples from recently sold comparable assets.

Asset-based – The value of a business as the net value of its assets less liabilities.

Evaluate whether a stock is overvalued, fairly valued, or undervalued based on a residual income model.

Perspectives on valuation from the market price:

Undervalued: P < V

Fairly valued: P = V, +/−

Overvalued: P > V

Describe why the relation between r and g is critical.

Compare models used to estimate the required rate of return to private company equity

Calculate the value of a private company based on the prior transaction method (PTM).

Evaluate the effects on private company valuations of discounts and premiums based on control and marketability.

Where discounts for both control and marketability are appropriate, first reduce the marketable control position to noncontrolling and then the marketable minority position to nonmarketable:

VNMP = VMCP(1−DLOC) (1−DLOM)

Caution: Lack of control may be indicated by using nonnormalized earnings metrics.

Calculate the value of a private company using pricing multiples derived by any market approach method.

Explain why the rationale that companies with lower negative P/Es are preferred for companies with zero or negative earnings.

Calculate and interpret the justified P/S ratio for a stock based on forecasted fundamentals.

How are residual income, economic value added, and market value added used?

If a company is generating more (less) income than its cost of capital, it is generating positive (negative) residual income, and therefore creating (destroying) value. Alternatively stated, the firm creates value when its ROE exceeds it’s required return on equity.

This may be used for performance incentives.

Explain why revenue and expenses associated with nonoperating real estate are removed from the income statement during normalization.

Explain the effects on private company valuations of discounts and premiums based on control and marketability.

Describe rationales for and possible drawbacks to using alternative price multiples and dividend yield in valuation.

Explain the bottom-up approach to projecting future revenue.

Describe noncash charges (NCC).

Explain the two approaches to overcoming the weaknesses in required return estimation for developing countries.

Describe the disadvantages of price to cash flow.

Describe the Pastor-Stambaugh model (PSM).

Describe the advantages and disadvantages of the guideline public company method (GPCM).

Describe free cash flow if a company also has preferred stock in its capital structure.

Compare public and private company valuation.

Describe how working capital accounts are typically forecast using efficiency ratios.

Explain an analyst’s choices in developing projections beyond the short-term forecast horizon.