Equity valuation fundamentals

Question 1

Gordon growth model for equity risk premium

Answer 1

(D1/P) + g - rfr_long-run

D1/P = 1-year forecasted dividend yield on market index

Question 2

Ibbotson-Chen (2003) model for equity risk premium

Answer 2

(1 + infl)(1 + Eg_EPS)(1 + Eg_P/E) - 1 + Y - rfr
Y - expected yield in market index
Eg_EPS ~ expected growth of the real GDP ~ labor productivity growth + labor supply growth

Question 3

What is Beta

Answer 3

Measure of systematic risks of an asset

Question 4

What are 3 forward-looking methods for estimation of equity risk premiums

Answer 4

1) Based on the Gordon growth model - developed countries where assumptions of stability work
2) Supply-side (macroeconomic) models - developed countries where capital market is big enough to have a strong link with macroeconomic variables
3) Survey estimates

Question 5

Fama-French (1993) model for costs of equity

Answer 5

Takes into account difference in returns between small- and big-cap companies as well as between high Book/Market portfolio and low ones
RF + B_mkt(R_mkt - Rfr) + Bsmb(R_small _ R_big) + B_bm*(R_high_B/M - R_low_B/M)

Question 6

Pastor-Stambaugh (2000) model for cost of equity

Answer 6

Adds liquidity risk premium to Fama-French model

Question 7

Burmeister-Roll-Ross (2003) model for cost of equity

Answer 7

Macroeconomic model taking into account 5 risks:

1) Confidence risk (diff between corp and gov bonds)
2) Time-horizon risk (diff between long-run and short-run bonds)
3) Inflation risk
4) Business cycle risk
5) Market timing risk (accounts for unexpected variance)

Question 8

Build-out methods for estimation of cost of equity

Answer 8

Applied when direct Beta estimation is not possible

1) Rfr + equity risk premium + size / specific premium
2) Bond-yield plus: YTM(firm’s long-run debt) + equity holding premium (usually 3-5%)

Question 9

Adjusted Beta

Answer 9

Beta has tendency to revert to 1.0, so adjusted Beta is calculated as 2/3*Beta + 1/3

Question 10

Unlevering of Beta

Answer 10

Process needed to isolate systematic risk
Beta_unlevered = Beta(1/(1 + Leverage)) = BetaEquity/Assets
Beta_levered-up = Beat_unlevered*(1 + Leverage)

Question 11

How to account for FX risks in international investments?

Answer 11

1) Country spread model - adjust premium by difference between bond yields on different markets
2) Country risk rating model - cross-country regressions of equity risk premiums on countries’ credit ratings

Question 12

WACC

Answer 12

D/AR_d(1 - tax) + E/A*R_e
Weights of D and E should be taken according to the target capital structure
Tax shield is applied only to an extent of tax-deductibility of interest payments

Question 13

How cost structure of firm´s operations relates to its´s buyers bargaining power?

Answer 13

The higher volume of fixed costs, the better bargaining position of buyers

Question 14

Is driving competitors out a good strategy?

Answer 14

No, it isn’t even on low-growing markets

It is costly and if industry is attractive new competitors will emerge

Question 15

Steps of building a sales-based pro forma forecast

Answer 15

1) PnL: Sales
2) PnL: COGS
3) PnL: SG&A
4) PnL: Financing costs
5) PnL: Taxes
6) Balance sheet
7) CAPEX - feedback to PnL
8) Cash flow statements