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Series 86 > Chapter 4 > Flashcards

Chapter 4 Flashcards

1
Q

Two primary forms of valuation:

A
  1. Relative valuation
  2. Discounted CF Analysis
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2
Q

Price-to-earnings (P/E) ratio

A

One of the most common ratios used in relative valuation. Typically, the diluted EPS is used in the denominator. The price/earnings ratio of a corporation is a comparison of its current price in the market relative to its earnings per share. It’s an indication of how the market capitalizes a company’s earnings, or what the market is willing to pay for each dollar of earnings. If the market value of the stock is trading at five times its earnings and the corporation’s EPS is $3.20, it’s expected that the price per share will be $16.00. An increase of one dollar in earnings would, in turn, project an increase in the share price by $5.00.

  • For companies that are particularly sensitive to cyclicality, the P/E ratio may not provide an adequate reflection of the company. If the trailing P/E is used, it may be especially high at the bottom of a cycle and excessively low at the top of a cycle. This is known as the Molodovsky Effect.
  • In order to counter the Molodovsky effect, analysts often use normalized EPS. Often this just simply entails taking the average EPS over a certain period of years.
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3
Q

Trailing EPS vs Leading EPS

A

Trailing EPS: Price ÷ trailing 12 months’ EPS

Leading EPS: Price ÷ projected EPS

  • When comparing two companies, EPS MUST use the same time frame.
  • Analysts MUST take into account nonrecurring items. Due to the effects of non-recurring items, the trailing P/E may not always be appropriate for the projection of future earnings. In such cases, it may be more pertinent to use the second method of calculating EPS called leading (forward) P/E.
  • One of the drawbacks of using leading EPS is that the projections may not be accurate.
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4
Q

Relative P/E

A

Investors use P/E as a proxy for earnings growth. If the perceived growth is less than the growth of a benchmark index, it will be reflected in the P/E. This is true for both a trailing P/E and forward-looking P/E. If the market multiple is 15, a company with an identical P/E is considered to have a relative P/E of 1.0.

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5
Q

Trailing P/E example:
A RA is evaluating Firm A’s trailing P/E ratio. Earnings for the first 3 quarters were $0.19, $0.21, and $0.18, respectively. The earnings for the fourth quarter of the prior year were $0.16, however there was an acquisition expense of $0.08. The current price of the stock is $16.40. What is the trailing P/E ratio

A

Adjusted earnings in Q4 of prior year = $0.16 + $0.08 = $0.24
Sum of earnings = ($0.24 + $0.19 + $0.21 + $0.18) = $0.82
$16.40 ÷ $0.82 = $20

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6
Q

P/E ratio example 2:
Given:
Annual dividend = $1.50
Dividend payout ratio = 40%
Dividend yield = 2%
What is the P/E ratio?

A

EPS = annual dividend ÷ payout ratio = $1.50 ÷ 0.40 = $3.75
Price = annual dividend ÷ dividend yield = $1.50 ÷ .02 = $75
$75 ÷ $3.75 = 20

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7
Q

True or false: P/E is a good tool when earnings are negative?

A

False, earnings yield is a better option

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8
Q

Earnings yield

A

The reciprocal of P/E. Earnings yield is good for ranking companies from least expensive to most expensive in terms of the earnings that one dollar of investment will purchase.

  • A lower earnings yield (more negative) indicates which company is more overvalued.
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9
Q

The Fed Stock Valuation Model (FSVM)

A

A method of valuing the overall stock market by comparing the forward earnings yield of a broad stock market index against the yield on 10-year Treasuries.

  • When the 10-year yield is larger than the stock market’s forward earnings yield, the market is overvalued and if vice versa it’s undervalued.
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10
Q

P/E-to-Growth (PEG) Ratio

A

A ratio that goes a step further than the P/E by addressing expectations for continued operations of the company. When using the PEG, investors will normally look for a ratio of 1.0 or less. A ratio > 1 indicates it’s overvalued, whereas a ratio < 1 indicates it’s undervalued.

Formula: P/E ratio ÷ annual growth rate of the company (in %- DO NOT convert to decimal)

  • The forward growth rate can be a projection or use historical data.
  • There are weaknesses of the PEG ratio. Mainly, there is an assumption that the growth rate forecast will be accurate or that the historical trend will continue. Also, if the PEG ratio is used to compare firms accross different industries, there might be other factors to consider that would justify a higher PEG ratio (ex: Aggressive investor interest in tech).
  • Similar to the P/E ratio, it’s pointless if there are negative earnings.
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11
Q

True or false: If a company has historically traded at 15 times earnings, and is currently trading at 12 times earnings, it might signal a buying opportunity?

A

True. This is an example of an undervalued stock.

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12
Q

PEG ratio example:
Given:
Market cap = $440mm
NI = $40mm
TA = $400mm
TL = $150mm
Dividend payout ratio = 50%
What is the PEG ratio?

A

P/E ratio = Market cap ÷ NI = 440 ÷ 40 = 11
ROE = 40mm ÷ (400mm - 150mm = 250mm) = 16%
Growth rate = [ (1 - dividend payout ratio) * ROE ] = [ (1 - 0.50) * 0.16 ] = 8%
PEG ratio = 11 ÷ 8 = 1.375

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13
Q

How to calculate the price target from the PEG ratio

A

PEG ratio * growth rate = P/E ratio
P/E * next year’s EPS = price target

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14
Q

Rule of 72

A

To find the growth rate, take 72 ÷ # of years it will take earnings to double

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15
Q

Compound annual growth rate

A

Formula: ((ending value ÷ beginning value)^(1 ÷ # of years)) - 1

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16
Q

Avg. Annual growth rate

A

The average growth rate for a period of time

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17
Q

Annual growth rate calculation

A

((ending value ÷ beginning value) - 1) * 100

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18
Q

Price-to-Cash flow (P/CF)

A

Measures the price per unit of CF. CF in this context means FCF: CFO - CAPEX.

The free CF yield is equal to the recipracol of the P/CF.

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19
Q

Price-to-sales

A

Useful for evaluating firms w/ negative earnings, having low margins, or are start-ups. This ratio can be used to mitigate differences in a firm’s capital structure and leverage. Also, this ratio IS NOT influenced by a firm’s accounting decisions.

Formula: Market cap ÷ Sales/revenue

  • This ratio can vary substantially by industry.
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20
Q

Price-to-book (P/B)

A

This is a less volatile # that P/E. P/B is a common metric for financial sector stocks since they hold large amts of liquid assets.

Formula: Price ÷ BVPS

  • If P/B is < 1 it means that the firm is selling below its BV and theoretically below its liquidation value.
  • Some investors will avoid any companies that trade above 2X BV.
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21
Q

How to calculate BV

A

Shareholders’ equity ÷ # of shares of stock outstanding

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22
Q

Enterprise value (EV)

A

The EV is the real tangible price that a company can be purchased. However, EV IS NOT necessarily the price a buyer is willing to pay or a buyer is willing to accept.

Formula: Market cap of CS and PS + debt + capital leases + minority interet - cash & cash equivalents
OR
equity value + net debt

  • Cash & cash equivalents are added back since the purchaser will acquire these and thus considered a reduction to the acquisition cost.
  • If a firm has cash and no debt OR cash > debt, the EV < market cap.
  • If a firm has no cash, the EV is the MV of the stock + MV of debt.
  • If a firm has cash < debt, the EV > market cap
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23
Q

Equity value calculation

A

(EV + cash) - (long-term debt + short-term debt)

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24
Q

EBITDA

A

EBITDA allows for firms w/ different amts of interest, taxes, and D&A to be compared.

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25
Q

EV-to-EBITDA

A

When comparing this ratio between two companies, a lower ratio could signal an undervalued firm and if vice versa it could be overvalued.

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26
Q

How to calculate the EV of a company after an acquisition

A
  1. To calculate the new market cap: take (the $ amt of the acquisition funded by equity ÷ purchaser’s stock price). This value is the new amount of shares added to the shares outstanding.
  2. Multiply #1 * market price per share to get the market cap
  3. # 2 + net debt (debt - cash) of both companies
  4. # 3 + the $ amt of debt that was used to fund the acquisition.
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27
Q

EV-to-net sales

A

This ratio measure the economic value of a firm and its use to generate sales. By using this ratio, the RA eliminates the effects of different methods of calculating operating expenses (ex: lease accounting, capitalizing expenses, etc.)

Net sales = revenue - trade discounts - returns & allowances - excise taxes

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28
Q

Value of the firm calculation

A

CF to the firm ÷ (1 + WACC)

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29
Q

Value of the equity calculation

A

CF to equity ÷ (1 + COE)

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30
Q

Cost of capital

A

The required rate of return necessary to enter into and finance corporate projects. It’s the opportunity cost of entering into business decisions.

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31
Q

How to calculate cost of debt

A

Interest ÷ Principal

  • Add IB fees, legal fees, accounting fees, and/or printing costs to the denominator.
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32
Q

How to calculate cost of PS

A

Preferred dividend ÷ price of PS

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33
Q

True or false: Interest and dividends are after-tax entries?

A

False, interest expense is a pre-tax entry, whereas dividends are after-tax entries.

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34
Q

How to determine how much to increase EBIT when dealing w/ PS

A
  1. Preferred dividend ÷ (1 - tax rate %)
  2. # 1 * amt of PS issued
  3. Increase EBIT by #2 to cover the cost of the preferred dividend
    OR
    (Proceeds * after-tax cost of debt) ÷ (1 - tax bracket %)

Proceeds = Amt of PS issued * after-tax cost of PS/debt

This is a PS adjustment when calculating earnings available to common

  • If we don’t do this, earnings available to common shareholders will be higher for debt than PS.
35
Q

After-tax cost of debt

A

Pre-tax cost of debt * (1 - tax rate %)

36
Q

Two primary methods of calculating COE:

A
  1. CAPM
  2. DGM
37
Q

CAPM

A

Formula: k = Rf + (β * market risk premium)

38
Q

DGM

A

k = (D1 ÷ P0) + g

  • If the company invests the amount that it didn’t pay in dividends, and doesn’t earn the required rate of return (7.0%), the value of the stock should decrease
39
Q

True or false: If a company is going to create equity through a new issue of common stock, the cost of capital will be higher than through RE?

A

True, since there are underwriting fees associated w/ the distribution of the new issue, COE goes up.

40
Q

How to calculate cost of capital for a new issue?

A

[ D1 ÷ (P0 * (1 - F)) ] + g
- F = underwriting fee

41
Q

WACC formula

A

WACC = wd * rd * (1-T) + we * re + wps * rps

* Be careful if the exam gives pre-tax cost of debt!!!!

42
Q

How to calculate debt and equity weights given a D/E ratio? Ex: 40% D/E with $40MM in debt and $100MM in equity.

A

Total capital = $100MM + $40MM = $140MM
Debt % of Capital = $40MM ÷ $140MM = 28.57%
Equity % of Capital = $100MM ÷ $140MM = 71.43%

43
Q

True or false: If a company issued additional debt, the WACC would decline since the cost of debt is generally cheaper than the cost of equity. In addition, if a company replaced debt with preferred stock, the WACC would increase since there’s a tax shield (tax advantage) associated with debt?

A

True

44
Q

Free CF

A

CFs that are not required to be reinvested into operating activities in order to purchase new equipment or maintain present production capacity.

45
Q

FCFF

A

The CFO available to providers of capital (bondholders and stockholders) after operating expenses have been covered. Operating expenses include working capital (investments in inventory), fixed capital (investment in new or maintenance costs on existing equipment), and the payment of taxes.

Formula: (EBIT * (1 - T)) + D&A - CAPEX - increases in WC

46
Q

FCFE

A

The cash available to stockholders after funding capital requirements and expenses associated with debt financing.

Formula: NI + D&A - CAPEX - increases in WC

47
Q

PV of FCFF

A

FCFF ÷ (1 + WACC)^t

  • By using free cash flow to the firm and the weighted average cost of capital, we derive a value for both the debt and equity holders of the company
48
Q

PV of FCFE

A

FCFE ÷ (1 + COE)
OR
FCFF - MV of debt

To get equity value per share, divide by shares outstanding

49
Q

Terminal value

A

The projected CFs for the indefinite future. For relative valuation, just multiply EV/EBITDA by the last projected CF

Formula in DCF analysis: Expected CF ÷ (discount rate - terminal growth rate)

50
Q

Enterprise value

A

(CF1 ÷ (1 + WACC)^1) + (CF2 ÷ (1 + WACC)^2) … (CFn ÷ (1 + WACC)^n)
OR
[ CF * (1 + g) ] ÷ (discount rate - growth rate)
OR
Net present value = Annual CF in perpetuity ÷ WACC

51
Q

Valuation using DDM

A

P0 = (D1 ÷ (1 + k)) + (D2 ÷ (1+k)^2) … + (dn ÷ (1 + k)^n)
- k = the discount rate consistent with the uncertainty of the dividend estimates.

  • DDMs are less sensitive to short-term fluctuations of value than other DCFs
52
Q

Valuation using DDM if no expected growth

A

P0 = D1 ÷ k

In the constant growth case, k = (d1 + g) ÷ P0

In the constant growth case, P0 = d1 ÷ (k - g)

g = b * roe
b - retention rate = (1 - payout ratio)

53
Q

Main challenges presented with DDMs

A
  1. What DDM should be used for a given company
  2. What method will be used to forecast dividends
  3. What discount rate should be used to discount CFs to PV
54
Q

True or false: FCF analysis may also be used to calculate the amount of additional leverage or borrowing a company can incur?

A

True

55
Q

Economic profit

A

Different than accounting profit because it takes into account cost of capital- not only profit from operations but also profit above the expected returns on CAPEX. Economic profit also incorporates market expectation and opportunity cost.

  • IF economic profit is > the cost of capital, value is created and if vice versa, value is destroyed.
56
Q

Marginal revenue formula

A

△TR ÷ △Q

57
Q

Marginal cost formula

A

△TC ÷ △Q

  • If MR > MC, economic value is created
  • If MR < MC, economic value is destroyed
58
Q

Sum-of-the-parts analysis

A

A process of valuing a company by determining what its aggregate divisions would be worth if they were spun off or acquired by another company.

Valuation is typically done by taking the current income of each segment and multiplying each respective income by the projected growth rate for the segment to the power of whatever time period. Then, sum the projected income of each segment together. Multiply this number by what similar companies sell in comparison to the NI (ex: 15X NI). Then, discount that number into present terms using ROE as the discount rate.

  • When using a sum-of-the-parts analysis it may be necessary to use different valuation metrics for each business unit. For example, you might use 6.0 times EBITDA for one unit, 1.5 times revenue for another unit, and 13.0 times earnings for a third unit. By adding the value of all three units, subtracting the net debt, and allowing for any non-operating adjustments, the research analyst could calculate the equity value of the firm. In some instances, you would use a DCF analysis with some businesses and a relative valuation with others
59
Q

What to look for when determining what ratios to use in relative valuation:

A
  1. P/E: Growth, payout, risk
  2. P/B: Growth, payout, risk, ROE
  3. P/S: Growth, payout, risk, net margin
  4. EV/EBIT: Growth, some reinvestment needs, leverage, risk
  5. EV/EBITDA: Growth, greater reinvestment needs, leverage, risk
  6. EV/S: Growth, net CAPEX needs, leverage, risk, operating margin
  7. EV/B: Growth, leverage, risk, and return on capital
  8. EV/EBITDAR: Companies that depend on leases (ex: restaurants and retail)

R in EBITDAR stands for restructuring

60
Q

Typical multiples used for certain sectors

A
  1. Cyclical industries → Relative P/E (w/ normalized earnings)
  2. High tech, High growth → PEG
  3. High tech, no earnings → P/S or EV/S
  4. Heavy infrastructure → EV/EBITDA
  5. REIT → P/CF or FFO
  6. Financials → P/BV, EV/B OR P/Net TBV
  7. Retail → P/S or EV/Sales
61
Q

When is it appropriate to use DCFs?

A
  1. When CFs are positive
  2. When CFs can be estimated reliably in future periods
  3. When the benchmark for risk (Treasuries) have a positive correlation to the stock price
62
Q

When is it appropriate to use DDMs

A

When all of #61 applies, and the dividends considered CFs are positive and can be accurately forecasted.

63
Q

M&A valuation

A

When one company agrees to purchase another, the acquiring company may use cash, its common stock, or a combination of the two. If the acquisition is made in stock, a research analyst would need to understand the concept of the exchange ratio.

Ex: Firm A agrees to acquire Firm B for a 20% premium using common stock. Firm A’s EPS is $3 and its P/E ratio is 16X. Firm B’s EPS is $1.25 and its P/E ratio is 20X. From these, we know that firm A trades at $48 and Firm B trades at $25.

64
Q

Exchange ratio formula

A

[ (EPS of acquiree * P/E ratio of acquiree) * any premium/discount ] ÷ (EPS of acquirer * P/E of acquirer)

65
Q

How to determine whether an acquistion is accretive or dilutive?

A

Sum of the net incomes of the two companies ÷ total number of shares of the acquirer, including the additional shares issued to fund the transaction.

Ex: Firm A agrees to acquire Firm B for a 20% premium using common stock. Firm A’s EPS is $3 and its P/E ratio is 16X. Firm B’s EPS is $1.25 and its P/E ratio is 20X. From these, we know that firm A trades at $48 and Firm B trades at $25. Firm B has $2mm shares outstanding and Firm B has $900m shares outstanding. Firm A’s NI is $6mm while Firm B’s NI is $1.125MM.

The total acquistion cost is $30 * 900,000 shares outstanding = $27MM. This will require $27MM ÷ 48 = 562,500 shares to be issued by Firm A to pay for the transaction. This will bring the total shares outstanding to (2MM + 562,500) = 2.5625MM. The new EPS for the firm is ($6MM + $1.125MM) = $7.125MM ÷ 2.5625MM = $2.78. Since the original EPS was $3.00, and now it’s $2.78, the transaction is immediately dilutive.

66
Q

How to determine the # of shares that the smaller firm in a merger will own?

A

Number of shares created ÷ Total number of shares after the merger

If a transaction is a combo of cash and stock, in order to find the % of ownership multiply the exchange ratio by the % of the offer in the stock.

If only cash is used: The additional interest expense needs to be deducted from EBIT in order to calculate the revised NI.

67
Q

Stock transaction vs cash transaction example:
Firm A
Revenue - $1,000
Operating income $98
Interest expense - $10
Taxes - $34
NI = $54
Shares outstanding - 60

Firm B
Revenue - $900
Operating income $92
Interest expense - $7
Taxes - $32
NI = $53
Shares outstanding - 30

(i) Firm B has agreed to be acquired by Firm A. The terms of the acquisition
require the issuance of 1.5 shares of Company A common stock for each share of Company B. What’s the effect on the EPS of Firm A following the acquisition?
(ii). If Firm A agrees to acquire Firm B for $250MM cash, raised by issuing 7% debentures, what’s the accretive effect on Firm B’s EPS, assuming no change in the tax rate for the company? Assume a 38.6% tax rate.

A

(i). EPS before transaction: $54 ÷ 60 = $0.9
EPS after transaction: 1.5 * 30 = 45 new shares that must be issued. 45 + 60 = 105. ($54 + $53) ÷ 105 = $1.02. It’s immediately accretive

(ii). Interest expense for debt raised = $250mm * 0.07 = $17.5mm
Combined revenue = $1,000 + $900 = $1,900
Combined operating income = $98 + $92 = $190
Combined interest expense = $10 + $7 + $17.5 = $34.5
Combined taxes = ($190 - $34.5) * (1 - .386) = $59.83
NI = ($190 - $34.5) - $59.83 ~ $95.5
EPS: $95.5 ÷ 60 = $1.59. It’s immediately accretive.

68
Q

True or false: An acquisition is considered accretive to shareholder value if the return on invested capital (ROIC) > the weighted average cost of capital (WACC)?

A

True

69
Q

Example: How enterprise value is affected by M&A
Prior to transaction:
Firm A:
CS outstanding = 2.4MM
Market value = $20.00
Debt outstanding = $52MM
Cash & Cash equivalents= $16.5MM
Firm B:
CS outstanding= 2MM
Market value = $11.00
Debt outstanding = $10MM
Cash & cash equivalents = $5MM

Firm A agrees to purchase Firm B for $20MM. The terms of the acquisition are: $6MM of Firm A’s CS (based on the MV of $20 per share); $4MM of newly issued Firm A 6.0% debentures; $10MM cash to Firm B shareholders, obtained from Firm A’s revolving credit line; and $10MM in assumed debt of Firm B. What is the new enterprise value if Firm A stock is trading at
$23.00 after the acquisition is complete?

A
  1. Combined CS: 2.4MM + ($6MM ÷ $20) = 2.7MM
  2. Combined debt outstanding: $52MM + $10MM + $4MM + $10MM = $76MM
  3. Combined cash & cash equivalents: $16.5MM + $5.5MM = $21.5MM
  4. Market cap = $2.7MM * 23 = $62.1MM
  5. # 4 + net debt (#2 - #3) = $116.6MM
70
Q

How do employee stock options affect M&A transactions?

A

Most companies will use the proceeds from the exercised options to repurchase shares in the opern market at the current market price. Any differential in the # of shares will be made up through treasury stock.

71
Q

Employee stock options’ affect on M&A transactions example:
Current shares outstanding = $6mm
Number of options: 300m at a strike price of $25 AND 200m at a strike price of $50
Current stock price = $30 per share

A

(300m * $25) = $7.5mm
$7.5MM ÷ $30 = 250m shares bought back
The difference between the # of shares repurchased and the # of shares granted through the exercise of options equals (300m - 250m) = 50m. This difference is issued from the firm’s treasury stock account, which will bring the # of shares outstanding to $6,050M

* the 200m options won’t be exercised since they’re out-the-money

72
Q

True or false: Transaction value = enterprise value?

A

True

73
Q

How to calculate goodwill after the transaction is complete?

A

Offer value - net tangible assets → This amount will be added to the acquirer’s existing goodwill to calculate the new total goodwill

Net tangible assets = Total assets - liabilities - existing goodwill - intangibles

74
Q

True or false: In a strong-dollar environment, U.S. companies will be more attractive takeover candidates by foreign acquirers?

A

False, they will be less attractive since foreign buyers will have less buying power.

75
Q

Common stockholders’ equity formula

A

Net worth - preferred stockholders’ equity

76
Q

True or false: Effecting a stock buyback will decrease ROE?

A

False, it’ll increase ROE

77
Q

True or false: If a company effects a stock buyback, it’ll decrease the firm’s outlook for internal growth?

A

False, effecting a buyback will cause income to be spread over fewer shares which will increase the firm’s outlook for internal growth.

78
Q

Events that will affect the P/E ratio

A
  • Projected growth rate of a company/industry: If a firm is expected to grow rapidly, it justifies a higher P/E ratio.
  • Litigation
  • Capital structure change by a company
  • Cost of capital: a relatively small difference in beta will cause a pronounced difference in the cost of capital.
79
Q

Example:
Firm A has a P/E ratio of 34 and normally trades at a premium of 150% to the S&P 500 Index. The historic range of the firm’s P/E is 20-35. If the S&P 500 Index has an average P/E of 18, which of the following descriptions best characterizes the company?
A. It appears to be underpriced
B. It’s a growth company w/ accelerated earnings
C. It’s in a mature, cyclical industry
D. It’s expected that the earnings of the company are decelerating

A

B. The high P/E ratio shows that the company is growing rapidly. Firms in mature industry typically show little growth.

80
Q

P/E ratio formula 2

A

Dividend payout ratio ÷ dividend yield

EPS = annual dividend ÷ payout ratio
Price = annual dividend ÷ dividend yield

81
Q

Dividend yield formula

A

Dividend payout ratio * earnings yield

82
Q

Sustainable growth rate formula

A

(1 - dividend payout ratio) * ROE

83
Q

Example:
Enterprise value = $1.2B
Stock price = $40
Shares outstanding = 19MM
Employee stock options ($25 stock price) = 6MM
Debt = $250MM
How to compute the equity value per share

A
  1. Use the treasury stock method to determine the new # of outstanding shares: (6MM * $25) = 150MM
  2. # 1 ÷ $40 = 3.75MM
  3. The difference between (6MM - #2 = 2.25MM shares) will be issued.
  4. Equity value = $1.2B - $250MM = $950MM
  5. $950MM ÷ (19MM + 2.25MM) 21.25MM = $45

Series 86 (7 decks)

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