CFA L2 Equity Valuation (Part 1) Flashcards
(115 cards)
1
Q
What is the purpose of valuation?
A
Determining the value of an asset.
2
Q
Intrinsic value (IV) of an asset
A
The valuation of an asset or security by someone who has complete understanding of the characteristics of the asset or issuing firm. It’s the PV of future CFs (CFs can be either dividends, free CFs, or RI).
- Not necessarily a perfect valuation.
- Most relevant metric for public equities
3
Q
Estimated Value (VE)
A
Investors’ estimates of intrinsic value
4
Q
True or false: Analysts seeking to produce positive risk-adjusted returns do so by trying to identify securities for which their estimate of intrinsic value are the same as the current market price?
A
False, analysts seeking to produce positive risk-adjusted returns do so by trying to identify securities for which their estimate of intrinsic value differs from current market price.
Relationship: IV of analyst - price = (actual IV - price) + (IV of analyst - actual IV)
5
Q
True or false: All models studied in CFA level 2 are based on the going concern assumption?
A
True
6
Q
Liquidation value
A
When a firm is no longer a going concern, this is the estimate of what the assets of the firm would bring if sold separately, net of the company’s liabilities
7
Q
Orderly liquidation value
A
Same as liquidation value but assumes an adequate amount of time to realize liquidation value.
8
Q
Fair Market Value
A
The price at which a hypothetical willing, informed, and able seller would trade an asset to a willing, informed, and able buyer.
Similar to fair value used in financial reporting.
- Over time, the fair market value of a firm should match its market price.
9
Q
Investment value
A
The value of a stock to a particular buyer.
- May depend on the buyer’s specific needs and expectations, as well as perceived synergies with existing buyer assets.
- With acquisitions, valuing a firm’s investment value will be more relevant than intrinsic value.
10
Q
General steps in equity valuation (top-down approach):
A
- Understand the business
- Forecast company performance
- Select the appropriate valuation model
- Convert the forecasts into a valuation
- Apply the valuation conclusions
11
Q
Uses of equity valuation
A
- Stock selection
- Reading the market
- Projecting the value of corporate actions: value projected M&A, MBOs, etc.
- Fairness opinions: is the price in M&A fair to all sides
- Planning and consulting: evaluate the effects of proposed corporate strategies on the firm’s stock price, in order to pursue those that have the greatest value to shareholders
- Communication w/ analysts and investors
- Valuation of private firms
- Portfolio mgmt
12
Q
Porter’s five elements of industry structure
A
- Threat of new entrants
- Threat of substitutes
- Bargaining power of buyers
- Bargaining power of suppliers
- Rivalry among existing competitors
13
Q
3 generic strategies companies use to compete and generate profits:
A
- Cost leadership: Being the lowest-cost producer of a good.
- Product differentiation: creating a specialized product so that it will command a premium
- Focus: firms can target segment(s) of an industry using either #1 or #2
Cost leadership DOES NOT mean decreasing quality!
14
Q
Quality of financial statement analysis
A
Since the basic building blocks of equity valuation comes from useful accounting info, analysts must investigate the issues associated with the accuracy & detail of a firm’s disclosures
15
Q
True or false: An analyst can often only discern important results of management discretion through a detailed examination of the footnotes accompanying the financial reports?
A
True
16
Q
Quality of earnings issues can be broken down into several categories:
A
- Accelerating or premature recognition of income: firms use a variety of techniques to justify the recognition of income before it traditionally would have been recognized (ex: bill & hold).
- Reclassifying gains & nonoperating income: this involves reclassifying extraordinary gains as operating income.
- Expense recognition & losses: Delaying the recognition of expenses, capitalizing expenses, and classifying operating expenses as nonoperating expenses.
- Amortization, depreciation, and discount rates: these can reduce current expenses.
- Off b/s issues
17
Q
Warning signs of poor earnings quality:
A
- Past SEC violations
- Related-party transactions
- Excessive loans to employees.
- Poor accounting disclosures.
- High mgmt and/or director turnover.
- Consulting services provided by an audit firm.
- Disputes w/ or changes in auditors.
- Executive compensation tied to stock price.
- Declining margins or market share.
- Pressure to meet debt covenants or earnings expectation.
18
Q
Absolute valuation models
A
A model that estimates a firm’s intrinsic value w/o comparing it to other firms.
- Examples of models include FCFs, residual income models, DDMs, or asset-based models that estimates a firm’s value as the sum of the market value of the assets it owns or controls. Asset-based models are commonly used for natural resource firms.
19
Q
Relative valuation models
A
Models that determine the value of an asset in relation to the values of other assets.
- These models are based on the Law of One Price.
20
Q
Dividend discount model (DDM)
A
Estimates the value of a firm’s stock today as the PV of all expected dividends discounted at the opportunity cost of capital.
- This is a type of absolute valuation model.
21
Q
Sum-of-the-parts value/Breakup value/Private market value
A
Estimates the value of a firm by valuing individual parts of the firm and adding them up to determine the value for the company as a whole.
- Useful when the company operates multiple divisions/product lines w/ different business models & risk characteristics
22
Q
Conglomerate discount
A
The idea that investors apply a markdown to the value of a company that operates in multiple unrelated industries, compared to the value a company that has a single industry focus. It is the amt by which MV under-represents sum-of-the-parts value.
23
Q
3 explanations for conglomerate discounts:
A
- Internal capital inefficiency: The firm’s allocation of capital to different divisions may not have been based on sound decisions.
- Endogenous (internal) factors
- Research measurment errors: Some hypothesize that conglomerate discounts do not exist, but rather are a result of incorrect measurement.
24
Q
Criteria for choosing an approach to value a company
A
An analyst must determine whether the approach fits the characteristics of the company, has appropriate input data, and is suitable for the purpose of the analysis.
- An analyst may use multiple models and see if there are major discrepancies w/ results.
25
3 definitions of future cash flows (FCFs) for valuation purposes
* Dividends
* Free CFs
* Residual income
26
Pros and cons of considering dividends as FCF
pros: Dividends are the most tangible form of CF. Also, if a firm is sold, investors will often receive a premium for expected future dividends. Dividends are also less volatile than the other definitions.
cons: Difficult for firms that do not currently pay dividends. Also, these models are more beneficial for minority shareholders. Lastly, some firms may keep dividends small for tax purposes and utilize stock buybacks.
27
When are dividends appropriate to be considered FCF?
* The company has a history of dividend payments.
* The firm's dividend policy is clear and tied to earnings performance. The $ value of dividends should increase as earnings performance increase.
* When the valuation perspective is that of a minority shareholder.
28
Free CF to the firm (FCFF)/Unlevered FCFs
The CF generated by the firm's CORE OPERATIONS that is in excess of the capital investment required to sustain the firm's current productive capacity.
| FCFF considers debt and equity holders, whereas FCFE is only equity.
## Footnote
* Net borrowings from bondholders IS NOT considered a part of FCFF since it's not a part of core operations.
29
Free CF to equity (FCFE)/Levered FCFs
The cash available to stockholders after funding capital requirements and expenses associated with debt financing
30
Pros and cons of considering free CFs as FCF
Pros: Free CF models can be applied to many firms, regardless of dividend policies or capital structures. It is also a good model for controlling and minority shareholders.
Cons: negative free cash flow complicates the cash flow forecast and makes the estimates less reliable.
31
When are free CFs appropriate to be considered FCF?
* For firms that do not pay dividends or dividends are not related to earnings.
* For firms that have positive free CFs.
* When the valuation perspective is that of a controlling shareholder.
32
Residual income
The amount of earnings that exceeds the investors' required return.
33
Pros and cons of considering residual interest as FCF
Pros: can be applied to firms with negative free cash flow and to dividend- and non-dividend-paying firms.
Cons: requires in-depth analysis of the firm's accounting accruals. Management discretion in establishing accruals for both income and expense may obscure the true results for a period. If the accounting is not transparent or if the quality of the firm's reporting is poor, the accurate estimation of residual income is likely to be difficult.
## Footnote
* Accruals are revenues earned or expenses incurred that impact a company's net income, although cash has not yet exchanged hands.
34
When is residual interest appropriate to be considered FCFs?
* For firms that do not pay dividends.
* Firms that have negative free CFs
* Firms w/ transparent financial reporting and high-quality earnings
35
True or false: Typically for younger companies, considering dividends as FCFs is more appropriate?
False, typically more mature companies benefit from considering dividends as FCFs.
36
Steps to dividend discount model (DDM)
1. Estimate future dividends.
2. Determine the required rate of return.
3. Discount #1 using #2 as the discount rate.
37
One period DDM
DDM for one period. If current market price < V0, the stock is undervalued. If opposite, it's overvalued.
calculation: V0= (D1 + P1) ÷ (1 + r)
## Footnote
* V0 = value of stock today
* D1= expected dividend in next period
* P1 = price expected upon sale at end of period 1.
* r = required return on equity
38
Two period DDM
DDM for two periods.
calulation: V0 = [ D1 ÷ (1 + r)^1 ] + [ (D2 + P2) ÷ (1 + r)^2 ]
39
Multi-period DDM
DDM for any number of periods
calculation: V0 = (D1 ÷ (1 + r)^1) + (D2 ÷ (1 + r)^2) ... + ((Dn + Pn) ÷ (1 + r)^n)
40
How to forecast dividends for future periods?
We use models that assume some growth pattern in dividends, such as:
* Gordon Growth model
* H-model
* Two-stage growth model
* Three-stage growth model
41
Gordon Growth Model (GGM)/constant growth model
Assumes the dividends grow at a constant rate indefinitely.
Calculation: [ D0 * (1 + g) ] ÷ (r - g) OR D1 ÷ (r - g)
## Footnote
* g = dividend growth rate
* A perpetual dividend growth rate >= 5% should cause an analyst to raise their eyebrows
42
Assumptions of GGM
1. The firm expects to pay a dividend in one year (D1)
2. Dividends grow at a constant rate
3. The growth rate < the required return on equity
43
Weaknesses to using constant growth model
* Value is sensitive to required return on equity and constant growth rate
* The model cannot easily be applied to non-dividend paying firms
* Unpredictable growth patterns of some firms would make using the model difficult and the resulting valuations unreliable.
44
Situations where constant growth rate is appropriate:
* Mature firm
* Valuing a broad-based equity index
* Terminal value in more complex models
* International valuation
* Can be used to supplement other, more complex valuation methods.
45
How to calculate implied growth rate given market price?
g = r - (D1 ÷ P0)
46
How to value a firm that pays out dividends but also has excess returns that are kept in RE?
V0 = (E1 ÷ r) + PVGO
## Footnote
* E1 = earnings in the next period
* PVGO = PV of growth opportunities
47
PVGO example: Firm A's stock trades at $60 and has an expected earnings next year of $5 per share. The required return is 10%. Calculate the PVGO and the portion of the leading P/E related to PVGO.
$60 = ($5 ÷ .1) + PVGO
=
PVGO = $60 - ($5 ÷ .1) = $10
P/E = $60 ÷ $5 = 12X
$10 ÷ $5 = 2X = leading P/E related to PVGO.
48
Leading P/E
P/E based on the earnings forecast of the next period.
calculation: [ market price per share ÷ EPS over the next 12 months ] OR P0 ÷ E1 OR (D1 ÷ E1) ÷ (r - g) OR (1 - b) ÷ (r - g) OR (trailing P/E ÷ (1 + g))
49
Trailing P/E
P/E based on the previous earnings
calculation: [ market price per share ÷ EPS over the previous 12 months ] OR P0 ÷ E0 OR [ (D0 * (1 + g)) ÷ E0 ] ÷ (r - g) OR [ (1 - b) * (1 + g) ] ÷ (r - g) OR [ P/S ÷ net profit margin ]
| Do not take the avg. EPS, add the last 4 quarters of EPS together
## Footnote
* b = retention ratio
* (1 - b) = dividend payout ratio
* P0 = V0 derived from GGM
50
True or false: If earnings are expected to grow then the leading P/E will be smaller than the trailing P/E?
True
51
How to value a non-callable fixed-rate perpetual preferred stock
This is when a firm has no additional opportunities to earn returns in excess of the required rate of return should distribute all of its earnings to shareholders in the form of dividends. Under this assumption the growth rate would be zero.
Calculation: Dp ÷ rp
## Footnote
* Dp = $ value of preferred dividend
* rp = cost of preferred equity
52
What are the 3 phases of growth?
1. Initial phase= Rapid EPS growth and negative FCFs. No dividends and heavy reinvestment. ROE > r. Use a three-stage model for this.
2. Transitional phase= EPS and sales growth slows, dividends increase. ROE approaching r. Use 2-stage model or H-model for this.
3. Mature stage= Growth at economy-wide rate, positive FCF. ROE = r. Use GGM for this.
53
Terminal value/future sales price
Forecasted value at beginning of the final mature growth phase
54
How to estimate terminal value
There are two approaches:
1. Trailing P/E multiple * forecasted EPS
2. GGM: assume a constant growth rate
55
Example:
Firm A will not pay a dividend until 10 years from now. Then, it will pay a dividend of $1.25 and increase dividends 4% thereafter. If required rate of return is 12%, what is the current value?
V9 = $1.25 ÷ (.12 - .04)^9 = $15.63
V0 = $15.63 ÷ (1.12)^9
56
True or false: There is a mean reverting level of long-term growth rates for companies?
True
57
Two-stage DDM
Assumes there are two stages of growth: a first stage of supernormal growth and a second stage of indefinite growth at a constant level. Use this in cases when growth is expected to drop suddenly. To calculate a 2-stage DDM, we must estimate individual supernormal growth figures and then estimate a terminal value.
Calculation: V0 = [ (D0 * (1 + gs)^1) ÷ (1 + r)^1 ] + [ (D2 * (1 + gs)^2) ÷ (1 + r)^2 ] ... + [ (D0 * (1 + gs)^n * (1 + gl)) ÷ ((1 + r)^n * (r - gl)) ]
## Footnote
* n= length of high growth period
58
Two-stage DDM example:
Firm A currently pays a $1 dividend, which will grow 10% for 3 years and then have a perpetual growth rate of 4%. The required return on equity is 12%. What is the current value of the company?
D1 = 1 * (1 + .1) = 1.1
D2= 1.1 * (1 + .1) = 1.21
D3 = 1.21 * (1 + .1) = 1.33
P4 = D4 ÷ (r - g)
P4 = (1.33 * (1 + .04)) ÷ (.12 - .04) = $17.29
Now we can plug #s into calculator: CF 1 = 1.1 ; CF 2 = 1.21 ; CF 3 = 1.33 + 17.29 ; I = 12% ; NPV = $15.20
59
H-Model
Similar to a 2-stage DDM, except this model assumes the growth rate starts out high and then declines linearly over the high-growth stage until it reaches the long-run average growth rate. This is often a more realistic approach compared to the 2-stage DDM since most firms don't suddenly drop from high growth to a perpetual growth rate.
Caclulation: [ (D0 * (1 + gl)) ÷ (r - g) ] + [ (D0 * H * (gs - gl)) ÷ (r -g) ]
## Footnote
* gs = short-term high growth rate
* gl = long-term perpetual growth rate
* H = length of gradual decline ÷ 2
60
H-model example: Firm A currently pays a $2 dividend. Stage-one growth rate is 20%. Growth is expected to decay over 10 years. There is a constant growth rate of 5% thereafter. Required return on equity is 12%. Calculate the intrinsic value.
[ (2 * (1 + .05)) ÷ (.12 - .05) ] + [ ($2 * 5 * (.2 - .05)) ÷ (.12 - .05)
61
Three-stage DDM
These models are appropriate for firms that are expected to have three distinct stages of earnings growth.
62
Spreadsheet models
Spreadsheet models allow us to model any pattern of dividend growth we'd like with different growth rates for each year because the spreadsheet does all the calculations for us. Spreadsheet modeling is applicable to firms about which you have a great deal of information and can project different growth rates for differing periods
63
How to calculate rate of return w/ an H-model given market price
r = [ (D0 ÷ P0) * { (1 + gl) + ( H * (gs - gl)) } ] + gl
64
Calculating terminal value example:
Firm A expects a $12 EPS in ten years, has a dividend payout ratio of 50%, and a required return of 11%. The dividend growth rate is expected to fall to 4% in perpetuity and the trailing P/E will be 8X earnings. Estimate the terminal value at the end of ten years using the Gordon growth model and the P/E multiple
Terminal value in year 10 = [ D10 * (1 + g) ] ÷ (r - g)
$12 * .5 = 6
6 * .04 = .-24
($6 * ($1 + $0.24)) ÷ (.11 - .04) = $89.14
Using the P/E multiple: $12 * 8 = $96
65
Valuing a non-dividend paying stock formula:
Firm A pays no dividends, earns $1.50 per share, and is expected to grow at 15% over the next 4 years. Beginning in year 5, the firm will begin to distribute a dividend worth 20% of its earnings and grow at 5%. The required rate of return is 12%. What is today's value?
$1.50 * (1.15)^4 = $2.62
$2.62 * 1.05 = $2.75
$2.75 * 20% = $0.55
V4 = 0.55 ÷ (.12 - .05) = $7.86
V0 = $7.86 ÷ (1.12)^4 = $5.00
66
Pros and cons of multi-period models
Pros: Ability to model several growth patterns and we can solve for V, g, and r
Cons: requires good inputs, values are sensitive to g & r, and choosing the right model is essential.
67
Three-stage DDM example:
Firm A has a current annual dividend of $0.75. The dividend growth rate over the next 3 years is 12%, decline to 4% for the 6 years after that, and have a perpetual growth rate of 4%. The required return is 9%. What is the value of the company?
Start by valuing the last two phases using the H-model.
D3 = $0.75 * (1.12)^3 = $1.0537
V3 = [ ($1.0537 * (1 + 0.04)) ÷ (.09 - .04) ] + [ ($1.0537 * 3 * (0.12 - 0.04) ÷ (0.09 - 0.04) ] = $26.97
Now we can enter the CFs into our calculator:
CF0 = $0.75 ; CF1 = $0.75 * (1.12) = $0.84 ; CF2 = $0.75 * (1.12)^2 = $0.94 ; CF 3 = $1.0537 + $27.97 = $28.02 ; I = 9. NPV = $23.2
68
Steps to forecasting dividends and a firm's value using spreadsheets
1. Establish the base level of CFs or dividends.
2. Estimate changes in the firm's dividends for the foreseeable future and project future cash dividends based on these estimates.
3. Since an equity security has an infinite life, a perpetual growth rate (terminal value) must be made.
4. Discount the projected dividends and terminal value back into today's terms.
69
Sustainable growth rate (SGR)/PRAT Model
The rate where earnings and dividends can continue to grow indefinitely, assuming that the firm's D/E ratio is unchanged and no new equity is issued. In other words, SGR says a firm can't grow unless it's retaining some portion of its earnings to finance the growth.
Calculation: SGR = b * ROE
## Footnote
* b = retention rate = (1 - dividend payout ratio)
70
True or false: For the equity portion of CFA L2, we use beginning-of-year balance sheet values for mixed ratios (e.g., total asset turnover) unless otherwise specified in the question?
True
| Don't get confused because FSA teaches to use average-year values
71
3 Part Du Pont equation
ROE = (NI ÷ sales) * (sales ÷ assets) * (assets ÷ equity) OR profitability * operating margin * financial leverage
72
True or false: Inventory is a part of PP&E?
False, inventory is an aspect of working capital. Receivables is also a part of WC.
PP&E is comprised of long-term investments.
73
True or false: Taxes paid are included in the definition of cash operating expenses for purposes of defining free cash flow?
True
74
True or false: After a company has made payments to its bondholders, the amount that's left after the firm has met all its obligations to its other investors is called FCFE?
True
75
True or false: In a DCF, the value of the firm's operating assets is the PV of expected future FCFE discounted at the COE?
True or false: In a DCF, the value of the firm's operating assets is the PV of expected future **FCFF** discounted at the WACC.
## Footnote
* Nonoperating assets (typically only significant ones) are added to this value, which will give us total firm value.
76
How to value a firm's equity value?
Equity value is the FCFE discounted at the required return on equity OR firm value - market value of debt
77
Adjusted Present Value (APV) approach
We use this approach when a firm's capital structure is volatile. Under the APV approach, the firm's unlevered CFs (CFs assuming no impact of leverage) are discounted at the firm's unlevered cost of equity. NPV of debt (the value of the tax shield - the cost of financial distress) is then added to the unlevered value.
78
Reasons analysts often prefer to use free cash flow models rather than dividend-based valuation:
* Many firms pay low or no dividends.
* Dividends are paid at the discretion of the BOD, which may not align with the firm's long-term profitability.
* If a company is viewed as an acquisition target, free cash flow is a more appropriate measure because the new owners will have discretion over its distribution (control perspective).
* Free CFs may be more related to a firm's long-term profitability.
79
Limitations of Free Cash Flow valuation
* Companies can have negative free CFs (especially new companies)
* Requires detailed understanding of accounting principles
* Info is not always readily available
80
True or false: Often analysts will value FCFE if there is a stable capital structure, but if there are high or changing levels of debt, then they will stick to FCFF modeling?
True
81
Net borrowings
Calculation: Net debt - repayments
## Footnote
* ONLY AFFECT FCFE
82
Noncash charges (NCC)
Adjustments for noncash increases or decreases based on accrual accounting.
## Footnote
* No outflow of cash.
* If noncash charges decrease NI, add them back to NI.
* If noncash charges increase NI, subtract them from NI.
* Applies to both FCFF and FCFE
* Accruals are revenues earned or expenses incurred that impact a company's net income, although cash has not yet exchanged hands.
83
Common noncash charges
Remember DIGRAT
* Depreciation →add back
* Impairments → add back
* Extraordinary gains/losses → add/subtract
* Restructuring expense/income→add/subtract
* DTLs → Add back **if unlikely to reverse**
* Amortization of bond discount/premium → add/subtract back
84
Restructuring expenses
Provisions companies make when they expect to restructure the firm (ex: get out of a certain business line).
85
True or false: FCFF can be derived starting with NI, EBIT, EBITDA, or CFO?
True
86
How to calculate FCFF from NI
NI + NCC + (interest * (1 - T)) - FCinv - WCinv
## Footnote
* FCinv = fixed capital investment
* WCinv= working capital investment
87
Fixed capital investment (FCinv)
A firm's investment in fixed assets. This is not reported on the IS but it does represent cash leaving the firm. FCinv reduces FCFF and FCFE.
Calculation: CAPEX - proceeds from sales of long-term assets
OR
ending net PP&E - beginning net PP&E + depreciation -/+ gain/loss on sale of fixed assets.
88
True or false: An increase in liabilities represents an outflow of cash and a decrease in liabilities represents a source of cash?
False, an increase in a liability account is a source of cash and a decrease in a liability is an outflow of cash.
89
How to calculate FCFE from NI
NI + NCC - WCinv - FCinv + net borrowings
90
How to calculate FCFE from FCFF
FCFF - interest * (1 - T) + net borrowings
91
How to calculate CFO from NI
NI + NCC - WCinv
## Footnote
* CFO is an after-interest figure
92
How to calculate NI provided EBIT
NI = (EBIT * (1 - T)) - (interest * (1 - T))
93
How to calculate FCFF given EBITDA
EBITDA * (1 - T) + NCC * T - WCinv - FCinv
94
How to calculate net change in cash from FCFE
FCFE - dividends +/- common stock issues/repurchases
95
How to calculate FCFE from CFO
FCFE = CFO - FCinv + net borrowings
96
True or false: The FCFF and FCFE formulas learned in L2 take into account preferred stock?
False, PS should be treated like debt, except it's not tax deductible.
Any preferred dividends should be added back to FCFF. The WACC must also be revised.
97
Working capital investments
Calculation: Current assets - current liabilities
Typically: (EOY accts receivable - BOY accts receivable) + (EOY inventory - BOY inventory) - (EOY accts payable - BOY accts payable)
98
How to calculate FCFF provided CFO
FCFF = CFO - FCinv - interest expense * (1 - T)
99
How to forecast FCFF
There are 2 methods. One, you can use historical free CFs and apply some growth rate under the assumption that growth will be constant. The growth rate for FCFF is usually different than FCFE.
Two, we can forecast each individual component of free CF. This often ties sales forecasts to future capital expenditures, depreciation expenses, and changes in working capital.
## Footnote
* If using the second method, it's important the firm maintains a target debt-to-asset ratio for net new investment in fixed and working capital.
100
How to forecast FCFE
We can use a formula ONLY IF CAPITAL STRUCTURE IS CONSTANT/FIXED.
Formula: NI - [ (1 - DR) * (FC - depreciation) ] - [ (1 - depreciation) * WCinv ]
## Footnote
* DR = debt-to-asset ratio
101
Debt-to-asset ratio
D/E ÷ (1 + D/E)
## Footnote
* DE= debt-to-equity
102
True or false: Dividends, share issues, and share repurchases may have no impact on FCFF and FCFE but changes in leverage have a major impact?
False, dividends, share issues and share repurchases have no impact on FCFF and FCFE but changes in leverage may have a minor impact on FCFE only.
Dividends, share issues, and share repurchases are a use of CFs, not a source.
If leverage increases, FCFE will be higher in current year (net borrowing) but lower in future years (due to interest expense)
103
Recognition of value in DDM vs free CF models
The FCFE approach takes a control perspective that assumes that recognition of value should be immediate. DDMs take a minority perspective, under which value may not be realized until the dividend policy accurately reflects the firm's long-run profitability
104
True or false: NI and EBITDA are poor proxies of FCFE?
True. Recall, there are additional components to FCFE: FCFE = NI + NCC − FCInv − WCInv + net borrowings. EBITDA doesn't reflect the cash taxes paid by the firm, and it ignores the cash flow effects of the investments in working capital and fixed capital. EBITDA also ignores the effects of the depreciation tax shield.
## Footnote
* NI is an accrual concept, not a cash concept.
105
Sensitivity analysis
Allows analysts to test how different inputs would affect a model's output.
## Footnote
* On the exam, it is unlikely that you will be asked to conduct a comprehensive sensitivity analysis that includes numerous calculations. However, a few key calculations and/or an interpretation of a sensitivity analysis are quite possible.
106
What are the two main sources of error in sensitivity analysis?
1. Estimating growth in FCFF & FCFE
2. The chosen base year for FCFF & FCFE forecasts
107
What components of an FCFF or FCFE model do we apply sensitivity analysis to?
* The base year value
* Future growth rate
* CAPM components
## Footnote
Beta and future growth rate are the most sensitive.
108
Single Stage FCFF Model
This model is useful for stable firms in mature industries since g is constant. The model assumes where FCFF grows at a constant rate (g) forever, and the growth rate is less than the WACC.
Value of the firm = FCFF1 ÷ (WACC - g)
OR
Value of the firm = (FCFF0 * (1 + g)) ÷ (WACC - g)
## Footnote
* g = constant growth rate in FCFF
* Analysts usually use target capital structure weights rather than actual weights. On the exam, use target weights if they are given in the problem; otherwise use actual market-value weights.
109
Single Stage FCFE Model
This model is the same concept as the Single Stage FCFF Model, except it values equity. This model is often used in international valuation.
Calculation: FCFE1÷ (r - g)
OR
(FCFE0 * (1 + g)) ÷ (r - g)
## Footnote
* r = required rate of return on equity.
* g = constant growth rate in FCFE. This value will often differ from g in FCFF models.
* The assumption of gorwth should be consistent w/ assumptions of other variables.
110
Assumptions in two-stage and three-stage free CF models
two-stage: Use a two-stage model for a firm with two stages of growth: a short-term supernormal growth phase and a long-term stable growth phase.
three-stage: Use a three-stage model for a firm that we expect to have three distinct stages of growth (ex: a growth phase, a mature phase, and a transition phase).
* Recall, we must also calculate a terminal value w/ each of these models using either the GGM or a multiple
111
WACC caclulation
(We * Re) + [ Wd * Rd * (1 - T) ] + (Wps * Rps)
112
True or false: If a company is closely held, relative valuation is more appropriate than absolute valuation?
False
113
Going concern value
The PV of all FCFs
114
True or false: The Terminal value in two-stage DDM is most sensitive to estimates of growth and required rate of return?
True
115
If firm A establishes a dividend and issues additional debt, the most likely effect on FCFF will be:
A. no effect
B. a decrease in FCFF
C. a increase in FCFF
A.
Dividends are a return of capital and although additional debt will increase int. expense, than in turn will decrease NI.
