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FS analyysi > Firman v_aluaatio #2 > Flashcards

Firman v_aluaatio #2 Flashcards

1
Q

There are three steps involved in valuing a company:

A

There are three steps involved in valuing a company:

STEP 1: Forecast future amounts of the financial attribute that ultimately
determines how much a company is worth.

STEP 2: Determine the risk or uncertainty associated with the forecasted
future amounts.

STEP 3: Determine the discounted present value of the expected future
amounts using a discount rate that reflects the risk from Step 2

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2
Q

Name the Financial attribute that ultimately

determines how much a company is worth?

A
  • Dividends
  • Free cash flows
  • Accounting earnings
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3
Q

Explain Dividend discount model (DDM)?

A

Value of equity is simply the present value of future dividends discounted by the cost of equity.

Cost of equity capital is used as a discount rate.

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4
Q

Dividend discount model (DDM) and Gordon Growth Model?

A

Using the assumption that dividends will grow at a constant rate, the dividend discount model can be adapted to the so-called Gordon Growth Model.

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5
Q

Name the Gordon Growth Model’s three assumptions?

A

The Gordon Growth Model has three assumptions:

  1. Current dividends (DIV1)
  2. Cost of equity (re)
  3. Dividend growth rate (g)
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6
Q

How do we do Dividend discount model in practice?

A

In practice, we predict future dividend per share (DPS) for next 3-5 years, and use a growth rate (g) in dividends to forecast dividend for the period thereafter (terminal value).

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7
Q

Where to get the dividend forecasts?

A

Current dividends (DIV1) can be obtained from

  • Internet
  • Annual reports
  • Other public sources

Dividend growth rate (g) should be determined such that the analyst:

  • Shows how sensitive value is to this assumption
  • Introduces the concept of a just barely sustainable dividend growth rate
  • Shows this is the appropriate growth rate to be used in the model
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8
Q

Explain Discounted free cash flow (DCF) model?

A

Value of equity
= Present value of future free cash flows + Financial assets - Interest-bearing debt

  • Present value of future cash flows is the Enterprise Value (equity+debt), is the present value of the expected free cash flows discounted by WACC.
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9
Q

Good to know about Discounted free cash flow (DCF) model?

A

Expected free cash flows have to be positive some time over the life of the asset

Firms that generate cash flows early in their life will be worth more than firms that generate cash flows later
–> the latter may however have greater growth and higher cash flows to compensate

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10
Q

Mitä yhteistä on Value creation, cash flows and WACC?

A

A firm can be seen as a portfolio of projects
–> Some with positive Net Present Values (NPV) and some with negative NPVs

The value of the firm is the sum of the NPVs of its component projects

Greater future cash flows increase NPVs –> Increasing ROIC will increase firm value

Lower discount rates increase NPVs –> Decreasing WACC will increase firm value

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11
Q

More about Discounted free cash flow (DCF) model?

A

Forecasts and discounts the expected free cash flows the core operations will generate

Most widely used valuation model

First step in financial statement analysis is to develop historical free cash flow statements

These statements separate free cash flows from all other cash flows

Historical statements can be utilized in predicting future free cash flows

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12
Q

How do we get from Financial Statements to Financial Statements Analysis?

A

GAAP Financial Statements

  • > Historical free cash flow statements
  • > Historical ratios
  • > Financial statement analysis
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13
Q

How do we get from Forecast assumptions to Valuation?

A

Forecast ratios

  • > free cash flow forecast
  • > Valuation
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14
Q

Summary of DCF model?

A

DCF model is the most commonly used valuation model that has a clear logic:

  • Value of the firm is the sum of the NPVs of projects
  • The same model works for both project and firm valuation
  • There is a link between the DCF model and the current value creation of the firm
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15
Q

Problems with DFC model?

A

It relies heavily on the terminal value
-> Very sensitive to the estimated growth rate, WACC, and steady state conditions

It is subject to the timing of payment streams

  • > Estimating the period in which payments will occur is difficult
  • > Free Cash Flow streams are highly volatile over time.
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16
Q

Why DCF model is NOT a value creation concept?

A

Cash flow from operations (value added) is reduced by investments (which also add value)
-> Investments are treated as value losses

Value received is not matched against value surrendered to generate value

A firm reduces free cash flow by investing and increases free cash flow by reducing investments
Free cash flow is partially a liquidation concept

Also, analysts forecast earnings, not cash flows

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17
Q

Can EVA be used in a valuation model?

A

Earnings-based valuation models are based on the logic of EVA and residual income we have already learnt
-> Rely on future EVA or residual income (abnormal earnings) – not the current or past

Important characteristics

  • Much smaller terminal value -> less forecasting needed
  • Earnings are less volatile than cash flows -> more precise forecasting
  • Directly associated with the value creation of the firm
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18
Q

What is the formula for Abnormal earnings (AE) model?

A

Value of equity (V_0)

= Book value of equity (B_0) + Present value of future abnormal earnings PV(AE)

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19
Q

What are the implications of Abnormal earnings model?

A

What matters most to investors is:

  1. The amount of money they turn over to management
  2. The profit management is able to earn on that money
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20
Q

How do you calculate Abnormal earnings?

EI se malli siis!

A

Abnormal earnings = Earnings - expected return*Capital

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21
Q

What do the parts of Abnormal earnings formula mean?

A

Abnormal earnings = Earnings - expected return*Capital

  • Earnings = What management does with the money?
  • Capital = What shareholders entrust to management?
22
Q

What happens to abnormal earnings if the

a) Management does better than expected?
b) Management does worse than expected?

A

a) If management does better than expected = abnormal earnings is positive.
b) Management does worse than expected = abnormal earnings is negative.

23
Q

Abnormal earnings model: Premium and discount

A
  • Investors willingly pay a premium over BV for companies that earn positive AE
  • ROE exceeds the cost of equity
  • Firms that earn negative AE sell at discount to BV
  • ROE is less than the cost of equity
24
Q

Abnormal earnings model protects from paying too much for earnings growth

A

Suppose a firm increases earnings by a new investment

  • Abnormal earnings before the new investment: AE = 12 – (0.10 x 100) = 2
  • Abnormal earnings after the new investment of $20 million earning at 10%: AE = 14 – (0.10 x 120) = 2

No value added from the new investment

Creating earnings by accounting methods also increases residual earnings but reduces book value
-> The net effect of these action on the equity value is zero

25
Q

Beware of paying too much for growth!

A
  • Investment creates growth but does not necessarily add value
  • Earnings growth can be created by the accounting
  • Current stock price may reflect too high growth expectations!
26
Q

What did Benjamin Graham say about paying too much for growth?

A

“But the combination of precise formulas with highly imprecise assumptions can be used to establish, or rather justify, practically any value one wishes, however high, for a really outstanding issue.”

-Benjamin Graham

27
Q

Give an example of case when valuation is needed in preparing financial reports?

A

Impairment tests are example of cases when valuation is needed in preparing financial reports.

28
Q

What is Intrinsic value?

A

Intrinsic Value = PV(Future cash flows of a firm)

ELI = expected future payouts to shareholders. Share gives the right to have a share of the firms cash flow, ELI dividends!

29
Q

Remember!

A

Valuation is only an educated guess!

So, do not focus on getting the right outcome, but instead focus on doing the valuation right!

30
Q

Earnings are not the same as cash flows!

A

Earnings are not the same as cash flows!

Earnings are formed on accrual basis.

31
Q

TRUE OR FALSE?

Operating cash flows are the reason companies exist!

A

TRUE!

Operating cash flows are the reason companies exist!

32
Q

Mistä Assets koostuu ja miten Assets voidaan ilmaista toisella tavalla?

A

Assets = Liabilities + Equity

Assets can be divided into
->  
Cash + (Non-Cash Assets) 
->
Cash + (Non-Cash Assets) = Liabilities + Equity
33
Q

What is the Balance sheet Plug?

A

Balance sheet Plug = Unsupported adjustment to an accounting record or the general ledger done to balance the book.

A plug must be immaterial in order to be justified!!!

34
Q

Why would we use a plug?

A

If we have an error in accounting, we can use a plug, because it might not be cost effective to try to find the error.

In financial planning, plugging the balance sheet is necessary.

35
Q

As a result of plugging during forecasting exercises we end up with what?

A

As a result of forecasting exercises we are most likely faced with cash surplus OR cash deficit. Which results in imbalance in the balance sheet equation.

Usually balance sheet is plugged by moving the imbalance into a financial asset, liability or equity account.

36
Q

What are the 3 ways of dealing with cash deficit?

A

Cash deficit is harder and requires knowing the consequences of doing so. We can put the cash deficit into:

  1. Cash & Marketable Securities
  2. Debt
  3. Equity

But usually it is put to:
4. Revolver (revolving credit line)

Additional borrowings can be put to:
5. Long-term debt

37
Q

How do we usually deal with cash surplus?

A

Cash surplus is easily dealt with, by adding it to Cash account.

38
Q

Why is cash deficit usually put into a revolver?

A

Cash deficit is usually put into a revolver so that cash losses lead to additional borrowing, so that we don’t end up with negative cash!

Be aware! Revolver using is a sign that models need to be looked at again.

39
Q

Automation of a plug should not be done, why?

A

Without the human, we could have a situation where automation covers an error in the model without us knowing.

40
Q

What is Terminal value?

A

Terminal value is the value beyond the forecasted period when future cash flows can be estimated. Terminal value assumes a business will grow at a set growth rate forever after the forecast period. (which usually lasts 5 years) -> Going concern -ajattelu!

All present value models rely on forecasting and terminal value.

41
Q

Going concern

A

Going concern is a principle that expects the company to continue operating indefinitely.

ELI -> It would not be liquidated.

42
Q

Can you name the two common methods of determining Terminal value?

A
  1. Gordon Growth model (Perpetual growth)
  2. Exit multiples

These are two different ways of saying the same thing! Both lie on determining proper discount rates.

43
Q

What is the assumption of Gordon Growth model (Perpetual growth)?

A

Gordon Growth model (Perpetual growth) assumes that:

Business will continue to generate cashflow at constant rate forever.

44
Q

What is the assumption of Exit multiples?

A

Exit multiples assumes that:

Business will be sold for a multiple of some market metric.

45
Q

Which one do academics and investment professionals prefer, Exit multiples or Perpetual growth?

A

Academics prefer Perpetual growth.

Investment professionals prefer Exit multiples.

46
Q

Terminal value calculation estimates the value after what?

A

Terminal value calculation estimates the value after the forecast period.

47
Q

Terminal growth rate is usually in line with what?

A

Terminal growth rate is usually in line with long-term INFLATION RATE!

Mutta yleensä pienempi tai yhtä suuri, kuin GDP growth rate.

48
Q

What is one disadvantage in perpetual growth model?

A

Perpetual growth lacks market driven analytics employed in Exit multiples approach!

Such market driven analytics would result in a terminal value that is based on operating statistics present in a proven market. It would depict how the market would value the company.

49
Q

What kind of investors prefer Exit multiples?

What does this imply?

A

Investors who assumer infinite window of holding the investment, prefer Exit multiples over perpetual growth approach.

This would imply:

a) Terminal value = Net realisable value of a company’s assets.
b) Equity of the firm will be acquired by a larger firm.

50
Q

Exit multiples estimate a fair price by multiplying what?

A

Exit multiples estimate a fair price by multiplying financial statistics (esim. Sales, profits, EBITDA) by a factor that is common for similar firms that were recently acquired.

So we get a formula:

(yksinäistävaan) Sales/Profits/EBITDA/… * Exit multiple (e.g. average of recent exit multiples of other transactions)

51
Q

Why should exit multiples approach be used carefully?

A

Because multiples change over time!

So we should always calculate the implied terminal growth rate! Because a multiple that seems good at first might give an unrealistic growth rate!

52
Q

Terminal valuesta loppuyhteenveto!

A

Terminal value is easily established, but the devil sits in the details!

FS analyysi (14 decks)

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