CFA L2 Equity Valuation (Part 2)

Question 1

Price multiples

Answer 1

Ratios of a stock’s market price to some measure of fundamental value per share. These are commonly used in equity valuation.

Question 2

Enterprise value multiples

Answer 2

Ratios of the total value of a company to a measure of operating earnings generated (ex: EBITDA)

Question 3

Momentum indicators

Answer 3

Compare a stock’s price or a company’s earnings to their values in earlier periods.

• Relative strength is generally considered a momentum valuation indicator.

Question 4

Comparables method to equity valuation

Answer 4

Values a stock based on the average price multiple of the stock of similar companies. This is a form of RELATIVE valuation so we say that a stock is RELATIVELY overvalued or RELATIVELY undervalued compared to a benchmark.

• The economic rationale for the method of comparables is the Law of One Price, which assets that two similar assets should sell at comparable price multiples

Question 5

Steps to comparables approach

Answer 5

1. Select & calculate the multiple being used.
2. Select the benchmark and calculate the mean or median of its multiple over a group of comparable stocks.
3. Compare #1 to #2
4. Examine whether any observed difference between the multiples of the stock and the benchmark are explained by the underlying determinants of the multiple, and make appropriate valuation adjustments.

Question 6

Method of comparables example:
Firm A’s shares are selling for $50. Earnings for the last 12 months were $2 per share, and the average industry trailing P/E ratio was 32X. Determine whether firm A is overvalued or undervalued using the method of comparables.

Answer 6

Firm A’s trailing P/E ratio = $50 ÷ $2 = 25X.

Firm A’s 25X < industry average 32X → Firm A is RELATIVELY undervalued

Question 7

Method of forecasted fundamentals

Answer 7

Values a stock based on the ratio of its DCF value to some fundamental variable (ex: EPS).

• The economic rationale is that the value used in the numerator of the justified price multiple is derived from a DCF model: value is equal to the PV of expected FCFs discounted at the appropriate risk-adjusted rate of return.

Question 8

Method of forecasted fundamentals example:
Firm A’s shares are selling for $30. The average analyst EPS forecast is $4.00. The long-run growth rate is 5%, firm A’s dividend payout ratio is 60%, and the required return is 14%. Calculate the fundamental value of Firm A using the GGM and determine whether Firm A’s shares are over- or undervalued using the method of forecasted fundamentals.

Answer 8

V0 = D1 ÷ (r - g)
V0 = ($4 * .6) ÷ (.14 - .05) = $26.67
Firm A’s MV P/E ratio = ($26.67 ÷ $4)= 6.67X
The observed P/E ratio= ($30 ÷ $4) = 7.5X
Firm A is relatively overvalued

Question 9

What is a justified price multiple/intrinsic multiple?

Answer 9

What the price multiple should be if the stock is fairly valued.

Question 10

True or false: If the actual multiple is < than the justified price multiple, the stock is overvalued; if the actual multiple is > than the justified multiple, the stock is undervalued?

Answer 10

False, if the actual multiple is > than the justified price multiple, the stock is overvalued; if the actual multiple is < than the justified multiple, the stock is undervalued

Question 11

Pros and cons of using P/E ratio in valuation

Answer 11

Pros: P/E ratio is a popular metric. Earnings power is the primary determinent of an investment’s value. Empirical research shows that P/E differences are significantly related to long-run average stock returns. Lastly, the P/E ratio can be used as a proxy for risk & growth.

Cons: Negative earnings makes P/E ratios meaningless. Different accounting practices can make it hard to compare P/E ratios. If earnings are volatile, P/E ratios can become meaningless. Lastly, solely relying on this ratio means that the analyst does not take into account risk, growth, CF, etc.

Question 12

True or false: Typically, analysts leave noncrecurring items in P/E multiples?

Answer 12

False, typically analysts want to subtract large nonrecurring gains out of earnings (ex: large gain/loss on sale, impairments, loss provisions, etc.) before calculating P/E.

Question 13

How to adjust EPS to remove cyclical components of earnings and capture mid-cycle or an average of earnings under normal conditions?

Answer 13

There are two methods to normalize earnings:
1. Use average ROE * BVPS of most recent year
2. Use average EPS

Question 14

How to adjust for negative earnings when calculating P/E?

Answer 14

Using the inverse, earnings yield (E/P). Since price is never negative, there is no issue. A high E/P suggests a cheap security and vice versa.

• A common pitfall of earnings yield is look-ahead bias.

Question 15

What is the main driver between differences in P/E ratios between companies?

Answer 15

Growth

Question 16

PEG ratio

Answer 16

Calculates a stock’s P/E ratio per unit of expected growth

Calculation: (P/E) ÷ g

• Lower PEG = more attractive valuation
• Higher PEG= less attractive valuation
• PEG ratio isn’t perfect, it doesn’t take into account risk tolerances or duration of growth. Also, growth and value are not perfectly linear.

Question 17

P/B ratio

Answer 17

(MVE ÷ BV of equity) OR (market price per share ÷ BV per share) OR [ (ROE - g) ÷ (r - g) ]

• If P/B = 1, the company is earning exactly its required rate of return
• Low P/B = undervalued
• Usually based on trailing BVs

Question 18

BV of equity

Answer 18

Common shareholders’ equity OR (TA - TL) - PS

Question 19

Advantages of using P/B ratio

Answer 19

• P/B is a cumulative value, and thus ALMOST ALWAYS positive.
• BV is more stable than EPS
• BV is an appropriate measure of net asset value for firms that primarily hold liquid assets.
• P/B can be useful in valuing companies that are expected to go out of business.
• Empirical research shows that P/B differences are significantly related to long-run average stock returns.

Question 20

Disadvantages of using P/B ratio

Answer 20

• P/B does not reflect the value of intangible economic assets, such as human capital.
• P/B can be misleading when it comes to asset size. (ex: a firm that oursources a lot of its production will have lower assets and higher P/B)
• Different accounting practices can make it hard to compare firms using P/B.
• Inflation and tech change can cause BV and MV of assets to differ significantly,

Question 21

What adjustments need to be made to BV when comparing firms using P/B?

Answer 21

Analysts often use tangible BV, which is BV of equity - intangible assets. Firms should also adjust for off b/s assets and liabilities. Lastly, firms using FIFO or LIFO often have to be restated to a consistent method.

Question 22

True or false: Earnings are more easily manipulated than BV, BV is more easily manipulated than sales, and sales are more easily manipulated than CF?

Answer 22

True

Question 23

P/S ratio

Answer 23

MVE ÷ total sales OR market price per share ÷ sales per share OR [ (E0 ÷ S0) * (1 - b) * (1 + g) ] ÷ (r - g) OR net margin * trailing P/E

*Usually based on trailing sales
* E0 ÷ S0 = profit margin
* r = required return
* g= sustainable growth rate
* b = dividend payout ratio
* low P/S = undervalued

Question 24

Advantages of P/S

Answer 24

• Sales revenue is ALWAYS positive.
• Not as easily manipulated as P/B or P/E.
• Sales is less volatile compared to earnings.
• P/S ratios are often used for valuing stocks in mature or cyclical industries and start-up companies w/ no record of earnings. It’s also often used to value investment management companies and partnerships. It’s also used for zero-income stocks.
• Empirical research shows that P/S differences are significantly related to long-run average stock returns.

Question 25

Disadvantages of P/S

Answer 25

* High growth in sales doesn't necessarily indicate high operating profits as measured by earnings and CF. * P/S ratios do not capture differences in cost structures across companies. * While less vulnerable to distortion, revenue recognition practices can still distort sales forecasts.

Question 26

Justified P/S ratio Firm A has a dividend payout ratio of 40%, an ROE of 8.3%, an EPS of $4.25, sales per share of $218.75, and an expected growth rate in dividends and earnings of 5%. The required rate of return on equity is 10%. What is the justified P/S?

Answer 26

P/S = [ ($4.25 ÷ $218.75) * (.4) * (1 + .05) ] ÷ (.1 - .05) = 0.16X

Question 27

P/CF ratio

Answer 27

How much cash a firm generates relative to its stock price Calculation: MVE ÷ CFO OR [ FCFE0 * (1 + g) ] ÷ (r - g) ## Footnote * Low P/CF means undervalued

Question 28

Advantages of P/CF

Answer 28

* CF is difficult for mgmt to manipulate * P/CF is stable * Using P/CF mitigates the issue of quality of reporting. * Empirical research shows that P/CF differences are significantly related to long-run average stock returns.

Question 29

Disadvantages of P/CF

Answer 29

* There are four definitions of CF on the exam: (1) earnings + NCC- this definition ignores some key CF items (ex: changes in NWC), (2) Adjusted CFO- IFRS and GAAP have different reporting standards making it difficult to compare firms, (3) FCFE- more volatile than regular CF, (4) EBITDA- is a pretax, pre-interest measure that represents a flow to both equity and debt. Thus, it is better suited as an indicator of total company value than just equity value * From a theoretical perspective, free cash flow to equity (FCFE) is preferable to CFO. However, FCFE is more volatile than CFO and more difficult to compute, so it is not necessarily more informative. * FCFE can be negative if there are large investments in CAPEX ## Footnote * Assume in an exam question that we need to use FCFE. If there's not enough info to calculate FCFE, then use CFO.

Question 30

Dividend yield (D/P)

Answer 30

The ratio of the common dividend to the market price. It is most often used for valuing indexes. Trailing D/P: (4 * most recent quarterly dividend) ÷ market price per share Leading D/P: (forecasted dividend over the next four quarters) ÷ market price per share Justified D/P = (r - g) ÷ (1 + g)

Question 31

Pros and cons of D/P:

Answer 31

Pros: dividends contribute to total investment return and are not as risky as the capital appreciation component of total return. Cons: D/P ignores capital appreciation. Also, The dividend displacement of earnings concept argues that dividends paid now displace future earnings, which implies a trade-off between current and future cash flows.

Question 32

Underlying earnings

Answer 32

Core earnings that are considered sustainable. When analysts are forecasting earnings, they focus on these.

Question 33

Molodovsky Effect

Answer 33

The countercyclical tendancy for companies to have high P/Es due to lower EPS at the bottom of the business cycle and low P/Es due to high EPS at the top of the business cycle

Question 34

Justified EV/EBITDA

Answer 34

Enterprise value ÷ EBITDA ## Footnote * EBITDA is a proxy for CF * Lower actuals than benchmark indicates undervalued. * Positively related to the growth rate in FCFF and EBITDA. * Negatively related to the firm's overall risk level and WACC

Question 35

Pros and cons of EV/EBITDA

Answer 35

Pros: Controls for different interest and D&A between firms. Also, EBITDA is usually positive when EPS is negative. Cons: This ratio ignores changes in WC and also ignores FCFF, which is closely tied to firm value.

Question 36

Enterprise value

Answer 36

MV of common stock + MV of debt + MV preferred - cash & investments

Question 37

What is the rationale for subtracting cash and investments in enterprise value?

Answer 37

The rationale for subtracting cash and investments is that an acquirer's net price paid for an acquisition target would be lowered by the amount of the target's liquid assets. Thus, enterprise value indicates the value of the overall company, not equity.

Question 38

True or false: P/E can be estimated by using a linear regression of historical P/Es on its fundamental variables, including expected growth and risk?

Answer 38

True

Question 39

What are the 3 limitations of using regression analysis to estimate P/E?

Answer 39

1. The predictive power of the estimated P/E regression for a different time period and/or sample of stocks is uncertain. 2. The relationships between P/E and the fundamental variables may change over time. 3. Multicollinearity is often a problem in these time series regressions, which makes it difficult to interpret individual regression coefficients.

Question 40

True or false: Firms with multiples below the benchmark are undervalued, and firms with multiples above the benchmark are overvalued?

Answer 40

True

Question 41

The FED Model

Answer 41

A valuation model used to determine whether the overall stock market is overvalued. This model that says the overall market is overvalued (undervalued) when the earnings yield (E/P ratio) on the S&P 500 Index is lower (higher) than the yield on 10-year U.S. Treasury bonds.

Question 42

Yardeni Model

Answer 42

A valuation model used to determine whether the overall stock market is overvalued. Formula: CEY = CBY - (k * LTEG) + εi ## Footnote - CEY = Current earnings yield of the market - CBY= Current yield on A-rated Moody's bond - k = constant assigned by the market to earnings growth (about 0.20 in recent years) - LTEG= long-term earnings growth rate

Question 43

Reciprocol of Yardeni Model

Answer 43

P/E = 1 ÷ (CBY - k * LTEG) This shows that the P/E ratio is negatively related to interest rates and positively related to growth.

Question 44

True or false: No matter which ratio is used, terminal value is calculated as the quotient of the price multiple (ex: P/E ratio) and the fundamental variable (ex: EPS)?

Answer 44

False, product

Question 45

Total invested capital/market value of invested capital

Answer 45

The value of a firm. It is the market value of the company's equity and debt. Unlike enterprise value, TIC includes cash and short-term investments.

Question 46

Sources of differences in cross-border valuation comparisons:

Answer 46

* Accounting differences * Cultural differences * Economic differences * Differences in risk * Different growth opportunities

Question 47

Unexpected earnings/earnings surprise

Answer 47

The difference between reported earnings and expected earnings Formula: reported EPS − expected EPS

Question 48

Standardized unexpected earnings (SUE)

Answer 48

Earnings surprise ÷ standard deviation of earnings surprise

Question 49

True or false: the price-to-earnings multiple for a stock index is equal to the weighted arithmatic mean?

Answer 49

False, the price-to-earnings multiple for a stock index is equal to the weighted harmonic mean

Question 50

Weighted harmonic mean

Answer 50

1 ÷ [ (W1 ÷ X1) + (W2 ÷ X2) ... + (Wn ÷ Xn) ]

Question 51

Rationale for the residual income approach

Answer 51

This approach recognizes the cost of equity capital in the measurement of income, which is not done in other approaches. **Residual income deducts all costs of capital**

Question 52

Difference between standard accounting net profit and economic profit

Answer 52

Traditional accounting NI reflects earnings available to shareholders. NI includes an interest expense to represent the cost of debt capital. Economic profit is NI minus a charge that measures stockholders' opportunity cost of capital

Question 53

Economic value added (EVA)

Answer 53

The value added for shareholders by mgmt during a given year. Positive EVA signals mgmt is adding value. Calculation: NOPAT - (WACC * total capital) OR [ EBIT * (1 - T) ] - $WACC ## Footnote * NOPAT = Net operating profit after taxes * $WACC = Dollar cost of capital * Use BOY total capital

Question 54

NOPAT calculation

Answer 54

EBIT * (1 - T)

Question 55

Market Value Added (MVA)

Answer 55

The PV of future expected EVA. The difference between the MV of a firm's long-term debt and equity and the BV of invested capital supplied by investors. It measures the value created by mgmt's decisions since the firm's inception. Calculation: MV of total capital - BV of total capital ## Footnote * Use EOY total capital

Question 56

EVA and MVA example: Firm A reports NOPAT of $2,100, a WACC of 14.2%, and invested capital of $18,000 at the BOY and $21,000 at the EOY. The market price (year-end) of the firm's stock is $25 per share, and there are 800 shares outstanding. The market value (year-end) of the firm's long-term debt is $4,000. Calculate VBM's EVA and MVA.

Answer 56

EVA = $2100 - (.142 * $18,000) = -456 MV of company = ($25 * 800) + 4000 = $24,000 MVA = $24,000 - $21,000 = $3,000

Question 57

What adjustments must be made to the financial statements before calculating NOPAT and invested capital?

Answer 57

* Capitalize and amortize R&D charges (rather than expense them), and add them back to earnings to calculate NOPAT. * Add back charges on strategic investments that will generate returns in the future. * Eliminate any deferred taxes. * Treat operating leases as capital leases and adjust nonrecurring items. * Add LIFO reserve to invested capital and add back change in LIFO reserve to NOPAT.

Question 58

How to forecast residual income?

Answer 58

RI = EPSt - (r * B_t-1) OR RI = (ROE - r) * B_t-1 ## Footnote * EPSt = expected EPS for year t * r= required return on equity * B_t-1 = BV per share in year t-1 *

Question 59

How to forecast BV per share

Answer 59

Recall, ending BV = BOY BV + NI - Dividends Dividend forecast = EPS forecast * payout ratio

Question 59

Residual income approach to estimating the intrinsic value of a stock

Answer 59

Says that the intrinsic value of a stock equals its current book value plus the PV of expected residual income Calculation: V0 = B0 + [ (RI1 ÷ (1 + r)^1) + (RI2 ÷ (1 + r)^2) ... + (RIn ÷ (1 + r)^n) ] ## Footnote * B0 = Current BV of equity * This approach is a poor indicator of terminal value.

Question 60

Residual income approach example Firm A has a required rate of return of 14%. The current book value is $6.50 & earnings forecasts for 2025, 2026, and 2027 are $1.10, $1.00, and $0.95, respectively. Dividends in 2025 and 2026 are forecasted to be $0.50 and $0.60, respectively. The dividend in 2027 is a liquidating dividend, which means that the firm will pay out its entire BV in dividends and stop doing business at the end of 2027. Calculate the value of the firm's stock using the residual income model.

Answer 60

*2025* BOY BV = $6.50 EPS forecast = $1.10 Dividend per share forecast = $0.50 EOY BV = $6.50 + $1.10 - $0.50 = $7.10 (r * B_t-1) = (.14 * $6.50) = $0.91 RI = $1.10 - $0.91 = $0.19 *2026* BOY BV = $7.10 EPS forecast = $1.00 Dividend per share forecast = $0.60 EOY BV = $7.10 + $1.00 - $0.60 = $7.50 (r * B_t-1) = (.14 * $7.10) = $0.994 RI = $1.00 - $0.994= $0.01 *2027* BOY BV = $7.50 EPS forecast = $0.95 Dividend per share forecast= all BOY BV and this year's earnings = $7.50 + $0.95 = $8.45 EOY BV = $0 (r * B_t-1) = (.14 * $7.5) = $1.05 RI = $0.95 - $1.05 = -$0.1 V0 = 6.50 + [ (0.19 ÷ (1 + .14)) + (0.01 ÷ (1 + .14)^2) + (-0.1 ÷ (1 + .14)^3) ] = $6.61 We can also use a calculator and use the NPV function: CF0 = 6.50 ; C01= 0.19 ; C02 = 0.01 ; C03 = -0.1 ; I = 14 ; NPV = 6.61

Question 60

True or false: Valuation with residual income models is relatively less sensitive to terminal value estimates, which reduces forecast error compared to FCF models and dividend models?

Answer 60

True, in residual income models, the current BV is NOT the most influential input, whereas in the other two models the terminal value is usually the most influential input. There is a larger forecast error w/ terminal values.

Question 61

Single-stage residual income valuation model

Answer 61

General residual income valuation formula that assumes constant dividends and earnings growth. Calculation: V0 = B0 + [ ((ROE - r) * B0) ÷ (r - g) ] ## Footnote * This model is actually just another version of the Gordon growth model, so if you can use the same inputs, both models will give you the same value estimates. * If ROE = r, the justified MV = BV. When ROE > r, the firm will have positive RI and MV > BV.

Question 62

Tobin's Q

Answer 62

The ratio between a physical asset's market value and its replacement value. Formula: (MV of debt + MV of equity) ÷ replacement cost of TA

Question 63

True or false: Residual income valuation is a type of DCF?

Answer 63

True

Question 64

True or false: Residual income models cannot be used to compute justified price multiples?

Answer 64

False, they can. Residual income models are closely tied with P/B and Tobin's Q.

Question 65

Example: The PV of firm A's residual income plus BOY BV is $75 per share for the next five years. The firm is expected to maintain a future residual income after 5 years of $11.25 per share. The COE is 10%. What is the justified value of firm A's common stock?

Answer 65

Terminal value= $11.25 ÷ 0.1 = $112.5 PV of terminal value = $112.5 ÷ (1.10)^5 = $69.85 Justified intrinsic value = $69.85 + $75 = $144.85

Question 66

Growth rate calculation- how to calculate g

Answer 66

retention ratio * ROE OR r - [ (B0 * (ROE - r)) ÷ (V0 - B0) ] retention ratio= 1 - dividend payout ratio

Question 67

True or false: It's impossible to project residual income indefinitely into the future?

Answer 67

False, it's difficult, however we can forecast residual income over the short-term (typically 5 years) and then use **continuing residual income** for long-term forecasts.

Question 68

Continuing residual income

Answer 68

The residual income that is expected over the long term.

Question 69

Persistence factor (ω)

Answer 69

The projected rate at which residual income is expected to fade over the life cycle of the firm. Values closer to one indicate that less residual income will fade. ## Footnote * This is always a value between zero and one. * The strength of the persistence factor will depend partly on the sustainability of the firm's competitive advantage and the structure of the industry. The more sustainable the competitive advantage and the better the industry prospects, the higher the persistence factor.

Question 70

To simplify the model, an analyst must make one of these assumptions about continuing residual income immediately after the end of the short-term period:

Answer 70

* Residual income is expected to persist at its current level forever: Probably indicates that there is a high competitive advantage: Terminal value = RI ÷ (1 + r - 0) * Residual income is expected to drop immediately to zero: Probably indicates that there is little competitive advantage: Terminal value = RI ÷ (1 + r - 1) * Residual income is expected to decline over time as ROE falls to the cost of equity (in which case residual income is eventually zero): Terminal value = RI ÷ (1 + r - ω) * Residual income is expected to decline to a long-run average level consistent with a mature industry: Terminal value = [ (Pt - Bt) + RI ] ÷ (1 + r) * Pt= stock value * Bt= BV | * (Pt - Bt)= PV of continuing residual income ## Footnote * Pt = Bt * forecasted P/B

Question 71

What are high persistence factors associated with?

Answer 71

* Low dividend payouts * Historically high residual income persistence in the industry.

Question 72

What are low persistence factors associated with?

Answer 72

* High ROE * Significant levels of nonrecurring income * High accounting accruals

Question 73

Continuing residual income example: Firm A will have an ROE of 15% over each of the next 5 years. Current BVPS is $5. No dividends are paid. The required return on equity is 10%. Forecasted earnings in Years 1 through 5 are equal to ROE times beginning book value. What is the intrinsic value of the company using a residual income model, assuming that after five years, continuing residual income falls to zero?

Answer 73

*Year 1* EPS → x ÷ 5 = .15 → EPS = $.75 EOY BVPS = $5 + $0.75 + 0 (no dividends)= $5.75 ROE = 15% r * B_t-1 = (.1 * 5) = 0.5 RI = $0.75 - $0.5 = $0.25 *Year 2* EPS → x ÷ 5.75 = .15 → EPS = $.8625 EOY BVPS = $5.75 + $0.8625 = $6.6125 ROE = 15% r * B_t-1 = (.1 * 5.75) = .575 RI = $0.8625 - $0.575 = $0.29 ... Year 3 RI = 0.33 ; Year 4 RI = 0.38 ; Year 5 RI = 0.44 Terminal value in year 5 = 0.44 ÷ (1 + .1)^5 Assuming that w = 0; intrisic value today= $5 + [ (0.25 ÷ (1 + 1.1)) + (0.29 ÷ (1.1)^2) + (0.33 ÷ (1.1)^3) + (.038 ÷ (1.1)^4) + (0.44 ÷ (1.1)^5) ] = $6.25

Question 74

Continuing residual income example 2: Same as the previous example, but assume this time that the firm's residual income after five years remains constant. What is the current intrinsic value?

Answer 74

Year 1 RI = 0.25 ; Year 2 RI = 0.29 ; Year 3 RI = 0.33 ; Year 4 RI = 0.38 ; Year 5 RI = 0.44 Terminal perpeturity value = 0.44 ÷ .1 = 4.4 V0 = 5 + [ (0.25 ÷ (1.1)) + (0.29 ÷ (1.1)^2) + (0.33 ÷ (1.1)^3) + ((0.38 + 4.4) ÷ (1.1)^4) ] = $8.98

Question 75

Continuing residual income example 3: Same as the previous example, but assume this time that the firm's residual income will decline over time to zero with a persistence factor of 0.4. What is the current intrinsic value?

Answer 75

Year 1 RI = 0.25 ; Year 2 RI = 0.29 ; Year 3 RI = 0.33 ; Year 4 RI = 0.38 ; Year 5 RI = 0.44 Terminal perpetuity value = 0.44 ÷ (1 + .1 - 0.4) = 0.62857 V0 = 5 + [ (0.25 ÷ (1.1)) + (0.29 ÷ (1.1)^2) + (0.33 ÷ (1.1)^3) + ((0.38 + 0.62857 ÷ (1.1)^4) ] = $6.4

Question 76

Continuing residual income example 4: Same as the previous example, but assume this time that the firm's ROE falls to a long-run average level and the price-to-book ratio falls to 1.2. BVPS at year-5-end is $10.05. What is the current intrinsic value?

Answer 76

Terminal value = [ (Pt - Bt) + RI ] ÷ (1 + r) Pt = $10.05 * 1.2 = 12.06 [ (12.06-10.05) + 0.44 ] ÷ (1.1) = 2.23 V0 = 5 + [ (0.25 ÷ (1.1)) + (0.29 ÷ (1.1)^2) + (0.33 ÷ (1.1)^3) + ((0.38 + 2.23 ÷ (1.1)^4) ] = $7.50

Question 77

Advantages of using residual income models model to value a company's common stock:

Answer 77

* Terminal value IS NOT the most dominant input. * Uses accounting data- readily available * Applicable to firms with no dividends and negative free CFs/volatile CFs * The models focus on economic profitability rather than just on accounting profitability.

Question 78

Disadvantages of using residual income models residual income model to value a company's common stock:

Answer 78

* Accounting data can be manipulated by mgmt * Reliance on accounting data requires numerous and significant adjustments. * The models assume that the clean surplus relation holds or that its failure to hold has been properly taken into account.

Question 79

Clean surplus relationship

Answer 79

A relationship that states EOY BV of equity = BOY BV of equity + NI - dividends, excluding ownership transactions. ## Footnote * Any accounting charges that bypasses the IS and goes directly to the equity accounts (such as currency translation gains and losses) will cause the clean surplus relation not to hold. * The risk in applying the residual income model when the clean surplus relation doesn't hold is that the ROE forecast will not be accurate if the clean surplus violations are not expected to offset in future years * When clean surplus is violated, we should not use residual income models.

Question 80

Common accounting issues that cause the clean surplus relationship NOT to hold

Answer 80

* Foreign currency gains/losses * Certain pension adjustments * Gains/losses on hedging instruments * B/S adjustments to MV * URG/URL on AFS securities

Question 81

Common adjustments to MV of an asset/liability:

Answer 81

* Operating leases should be capitalized by increasing assets and liabilities by the present value of the expected future operating lease payments. * SPEs: may need to be consolidated. * Reserves & allowances should be adjusted. * Inventory that use LIFO should be adjusted to FIFO by adding the LIFO reserve to inventory and equity, assuming no deferred tax impact. * Pension assets and liabilities should be adjusted to reflect the funded status of the plan. * Deferred tax liabilities should be eliminated and reported as equity if the liability is not expected to reverse.

Question 82

What are the effects of intangible assets recognized at acquisition and R&D expenditures on the residual income model?

Answer 82

The recognition of an identifiable intangible asset in the group account that was not recognized in the investee account will disort the model by reducing ROE- lower valuation. To remove this distortion, the amortization of intangibles capitalized during acquisition should be removed prior to computing the ROE used for residual income valuation. Productive R&D expenditures increase ROE and residual income, and unproductive expenditures reduce ROE and residual income.

Question 83

True or false: Nonrecurring items should be included in residual income models?

Answer 83

False

Question 84

True or false: It can be difficult to apply the residual income model in an international context w/ different accounting standards?

Answer 84

True. Analysts must ensure that EPS forecasts are reliabile, that clean surplus is followed, and financial statements reflect reality.

Question 85

Company-specific factors that that distinguish private and public companies:

Answer 85

1. Stage of life cycle: pvt firms are typically less mature. 2. Size: pvt firms are typically smaller and can be riskier. 3. Quality & depth of mgmt: Pvt firms may not be able to attract the same level of talent. 4. Mgmt/shareholder overlap: In most private firms, mgmt has a substantial ownership position, reducing principal-agent conflict. 5. Short-term investors: Since shareholders often focus on short-term measures of performance, mgmt may take a shorter-term view compared to private firms where managers are long-term holders of significant equity interests. 6. Quality of financial & other info: A potential creditor or equity investor in a private firm will have less information than is available for a public firm. This leads to greater uncertainty, higher risk, and it reduces private firm valuations. 7. Taxes: pvt firms may be more concerned with taxes than public firms

Question 86

Stock-specific factors that that distinguish private and public companies:

Answer 86

1. Liquidity: Since pvt firms' shares don't sell as much (less liquidity), there is often a liquidity discount to pvt firms. This has a negative impact on valuation since its harder for investors to get out of their investment. 2. Restrictions on marketability: Pvt firms often have agreements that prevent shareholders from selling, and thus reducing the marketability of shares. This has a negative effect on valuation. 3. Concentration of control: This has a negative effect on valuation for minority shareholders.

Question 87

True or false: Private firms are often valued using greater risk premiums and greater required returns compared to public firms?

Answer 87

True, since pvt firms are typically smaller (less capital, fewer assets, less employees), they can be risker and are thus valued using a greater risk premium.

Question 88

True or false: in general there is more heterogenity w/ public companies?

Answer 88

False, there is more w/ pvt companies.

Question 89

What are the three uses of valuing total capital and/or equity capital for pvt companies?

Answer 89

1. Transactions 2. Compliance 3. Litigation

Question 90

When are transaction valuations necessary for private companies?

Answer 90

* Venture capital financing * IPO * Firm sale * Bankruptcy: accurate valuation can help determine whether the firm should be liquidated or reorganized * Stock-based compensation: valuation is necessary for both accounting and tax purposes. * Debt-financing: Lenders may be interested in valuation as part of their underwriting process.

Question 91

When are compliance valuations necessary for private companies?

Answer 91

* Financial reporting * Tax reporting

Question 92

When are litigation valuations necessary for private companies?

Answer 92

* Shareholder lawsuits * Damage claims * Lost profits * Divorces

Question 93

Normalized earnings

Answer 93

A firm's earnings if that firm was being acquired. Nonrecurring items should be removed. With pvt firms, sometimes there are discretionary or tax-motivated expenses that need to be removed.

Question 94

Common normalized earnings adjustments

Answer 94

* Nonrecurring income * Discretionary expenses * Nonmarket compensation level: If the acquiring firm is looking to replace mgmt, it may look to normalize compensation expenses. * Personal expenses * Real estate expenses: sometimes firms have unrelated RE * Nonmarket lease rates * Strategic vs nonstrategic buyers

Question 95

True or false: FCFE valuation is more appropriate when a firm anticipates volatility to its capital structure?

Answer 95

False, FCFF is more appropriate since the discount rate is WACC.

Question 96

Issues in CF estimation

Answer 96

* Controlling vs noncontrolling interests: We need to be aware. Recall, free CF is appropraite for controlling and dividend is appropriate for noncontrolling. * Scenario analysis * Life cycle stage * Mgmt biases * Capital structure changes

Question 97

True or false: Venture capital valuations are usually based on negotiations?

Answer 97

True, in venture capital financing, the private company valuations are usually subject to negotiation and are informal due to the uncertainty of future cash flows

Question 98

What adjustments are required when estimating the discount rate for private companies?

Answer 98

* Size premiums: Size premiums are often added to the discount rates used for small private companies * Availability and COD: Pvt firms often have less access to debt financing. COD is usually higher since there is typically more operating risk. * Acquirer vs target: Sometimes, when valuing a pvt company, analysts will use the acquirer's cost of capital, which can lead to a higher valuation price. This is incorrect. The target firm's cost of capital should be used. * Projection risk: The lower availability of info about pvt firms may make it appropriate for an analyst to apply a higher discount rate. * Life cycle stage: It's difficult to apply a discount rate to a firm in the early stages of its life. ## Footnote * To get the size premium, the appraiser may use data from the smallest cap segment of public equity. This however may include a distress premium that is not applicable to the private firm.

Question 99

True or false: WACC is typically high for public companies?

Answer 99

False, since private companies have less access to debt financing and because operating risk is higher for smaller companies, COD rises and thus WACC rises.

Question 100

Models used to estimate the required return on equity for private companies

Answer 100

1. CAPM 2. Expanded CAPM 3. Build-up Approach

Question 101

CAPM for private companies

Answer 101

Although we typically use public firm data for the CAPM method, many pvt firms will never go public or be acquired by a public firm. So, we can use a comparable firm's beta and then delever and relever it.

Question 102

How to calculate the unlevered beta

Answer 102

βunlevered = β of public firm ÷ [ 1 + (1 - t) * D/E ]

Question 103

How to calculate the levered beta

Answer 103

βlevered = βunlevered * [ 1 + (1 - t) * D/E ]

Question 104

Expanded CAPM for private firms

Answer 104

includes additional premiums for size and firm-specific (unsystematic) risk.

Question 105

Build-up approach for private firms

Answer 105

Used when it's impossible to find comparable public firms for beta estimation. In this approach, size premiums, industry-factor premiums, and company-specific-factor premims are added to the sum of the market risk premium and risk-free rate. Calculation: (Rf + ERP) + size premium + industry-factor premium + firm-specific premium

Question 106

True or false: A transaction may be strategic or nonstrategic?

Answer 106

True, a firm can make a transaction for strategic or financial (nonstrategic) reasons.

Question 107

Difference between strategic transactions and nonstrategic transactions?

Answer 107

Strategic transactions: Valuation of the firm is based in part on the perceived synergies with the acquirer's other assets. Nonstrategic transactions: A financial transaction assumes no synergies, such as when one firm buys another in a dissimilar industry. ## Footnote * When estimating normalized earnings for a strategic transaction, the analyst should incorporate synergies as an increase in revenues, or as a reduction in costs.

Question 108

Discount for lack of control (DLOC)

Answer 108

An adjustment made in valuation to account for the absence or limitation of control over an asset. The purpose of applying a DLOC is to reflect the reduced liquidity and control rights associated with a minority interest. Calculation: 1 - [ 1 ÷ (1 + control premium) ]

Question 109

Discount for lack of marketability (DLOM)

Answer 109

An adjustment applied in valuation to account for the illiquidity or limited marketability of an asset. If an interest in a firm cannot be easily sold, a DLOM should be applied. ## Footnote * It is often the case that if a DLOC is applied, a DLOM will also be appropriate.

Question 110

How to estimate DLOM

Answer 110

There are 3 methods: 1. The price of the restricted shares is compared to the price of the publicly traded shares. 2. The price of pre-IPO shares is compared to the post-IPO shares. 3. Estimates the DLOM as the value of an at-the-money put option of a comparable public company, divided by its stock price. The time to maturity of the option should correspond to the time to the IPO. ## Footnote * One complicating factor in #2 is that post-IPO firms are generally thought to have more certain cash flows and lower risk, so the estimated DLOM may not purely reflect changes in marketability. * An advantage to #3 is that the estimated risk of the private company can be factored into the option price. The drawback of this approach is that a put option indicates a certain selling price—not actual liquidity.

Question 111

Factors that impact DLOM

Answer 111

* An impending IPO or firm sale will decrease the DLOM. * Contractual restrictions on selling stock will increase the DLOM. * A larger pool of buyers will decrease the DLOM. * Greater ownership concentration will increase the DLOM.

Question 112

Total discount for DLOC and DLOM for private companies

Answer 112

1 - [ (1 - DLOC) * (1 - DLOM) ]

Question 113

Calculating the value of minority interest example: A minority shareholder holds 15% of a private firm's equity, and the CEO holds the other 85%. DLOM is 5% and there is no DLOC. The value of the firm's equity is $10MM. What is the value of the minority shareholder's equity interest?

Answer 113

Value of minority interest w/o discounts = .15 * $10,000,000= $1,500,000 Total discount = 1 - [ (1 - 0) * (1 - .05) ] = .05 $1,500,000 * .05 = $75,000 Value of equity interest = $1,500,000 - $75,000= $1,425,000

Question 114

What are the 3 main approaches to private company valuation?

Answer 114

1. Income approach: The PV of expected future income 2. Market approach: multiples from recent sales of comparable assets. 3. Asset-based approach: The value of a firm's MV of assets minus liabilities | income approach = DCF ## Footnote * The income approach and the asset-based approach are absolute valuation models. * The asset-based approach is generally not used for going concerns, but is appropriate for troubled firms, finance firms, investment companies, firms with few intangible assets, and natural resource firms. * Because it is difficult to find data for individual intangible assets and specialized assets, the asset-based approach can be difficult to apply.

Question 115

Which private firm valuation models are appropriate given the moment in the business cycle?

Answer 115

Income approach- appropriate for firms in a high growth phase. Market approach- appropriate for mature firms Asset-based approach- appropriate to firms w/ a lot of uncertainty in its CFs (typically early stages)

Question 116

True or false: A valuation of a private firm based on income or earnings multiples would not attach a value to nonoperating assets, but if these assets represent a significant portion of firm value, they should be separately added when valuing a firm.

Answer 116

True

Question 117

Types of income approach methods:

Answer 117

1. Free CF model 2. Capitalized CF model 3. Excess earnings model

Question 118

Free Cash Flow Model

Answer 118

This is a two-stage approach. Future CFs and a terminal value are projected and then discounted at the appropriate rate. ## Footnote * The terminal value represents the point of time in the future at which growth is expected to level off and remain constant. * The terminal value can be estimated by using the Gordon Growth Model or a price multiples approach. * If the price multiple is for a firm in a high growth industry, the price multiple applied will often reflect both high growth and normal growth. In this case, the high growth is double counted—once in the price multiple and once in the periodic cash flow forecasts. * CFs are usually projected out five years.

Question 119

Capitalized Cash Flow Model (CCM)/Capitalized Income Method/Capitalization of Earnings Method

Answer 119

A single-stage approach. Under this method, a single measure of economic benefit is divided by a capitalization rate. This is a growing perpetuity model that assumes stable growth and is most often used for valuing small pvt companies. If growth is nonconstant, the FCF method should be used instead. Calculation: Value of the firm= FCFF1 ÷ (WACC - g) OR [ EBIT * (1 - T) * (1 - b) ] ÷ (WACC - g) Value of equity = FCFE1 ÷ (r - g) ## Footnote * b = retention rate/reinvestment rate = g ÷ WACC * (r - g) = capitalization rate

Question 120

CCM example: Firm A expects FCFF of $12.1MM over the next year, a growth rate of 4%, a WACC of 15%, and has a MV of debt of $4MM. Value the firm and the firm's equity using CCM.

Answer 120

Value of the firm: $12,100,000 ÷ (.15 - .04) = $110,000,000 Value of equity = $110,000,000 - $4,000,000 = $106,000,000

Question 121

Excess Earnings Method (EEM)

Answer 121

Excess earnings are firm earnings minus the earnings required to provide the required rate of return on working capital and fixed assets. The value of intangible assets can be estimated as the PV of the stream of excess earnings (using the excess earnings and the growing perpetuity formula from the CCM). This value for the intangible assets is added to the values of working capital and fixed assets to arrive at firm value. ## Footnote * The required return estimate is subject to estimation error.

Question 122

EEM example: Firm A has WC of $300M, fixed assets of $1MM, normalized earnings of $130M, required return on WC of 6%, required return on fixed assets of 10%, growth rate of residual income of 5%, and discount rate for intangible assets of 14%. Calculate the value of the firm using EEM.

Answer 122

Required return on WC = $300,000 * .06 = $18,000 Required return on fixed assets = $1,000,000 * .1 = $100,000 Excess earnings = $130,000 - $18,000 - $100,000 = $12,000 Value of intangible assets = ($12,000 * 1.05) ÷ (0.14 - 0.05) = $140,000 Firm value = $300,000 + $1,000,000 + $140,000 = $1,440,000

Question 123

Types of market approach methods:

Answer 123

1. Guideline public company method 2. Guideline transactions method

Question 124

What to look for when creating a peer group under the market approach?

Answer 124

Commonalities in industry, operations, size, and life cycle ## Footnote * large private firm valuation is usually based on enterprise value multiples. This is done because similar companies can have different levels of leverage, so we want to use multiples that are pre-leverage.

Question 125

Guideline public company method (GPCM)

Answer 125

Uses EV multiples from public firms & makes adjustments to the multiples to account for differences in size, leverage, and life cycle stage between the peer group.

Question 126

Pros and cons of GPCM

Answer 126

Pros: There is plenty of data Cons: The data may not be comparable

Question 127

Control premium

Answer 127

The difference between the pro rata value of a controlling interest and the pro rata value of a noncontrolling interest. When evaluating a controlling equity interest in a private firm, the control premium should be estimated. To estimate a control premium, a public transaction should be used where a firm was acquired and transaction type (strategic vs nonstrategic), industry conditions, type of consideration (did the acquirer pay w/ stock or cash: estimates of the control premium will be overstated when acquisitions are made with shares trading at inflated values), and reasonableness should be taken into account.

Question 128

GPCM example: Firm A derives 70% of its value from computers, 20% of its value from defense, and 10% of its value from telecom. The average EV/EBITDA multiple among peer for computers is 1.18, 1.02 for defense, and 2.45 for telecom. Firm A's EBITDA is $12.8MM. What is an appropriate EV/EBITDA multiple to be used for firm A?

Answer 128

.7(1.18)+.2(1.02)+.1(2.45) = 1.275

Question 129

Guideline transactions method (GTM)

Answer 129

Uses multiples from historical sales of entire public or pvt firms to value the pvt firm. These acquisition values already reflect any control premiums, so no additional adjustment for a controlling interest is necessary. When looking at historical data, analysts should look at transaction type, contingent consideration, and type of consideration to see if the historical sale is appropriate to use.

Question 130

Pros and cons of GTM

Answer 130

Pros: Cons: Availability of info about the sale of private firms can be limited

Question 131

GTM example: Firm A is evaluated for acquistion using GTM and EV/EBITDA multiples. The average company multiple is 7.2 but should be deflated by 30% to account for the higher risk of the other company. Firm A's EBITDA is $18.2MM. What is firm A's EV?

Answer 131

adjusted average multiple = 7.2 * (1 - .3) = 5.04 EV / $18,200,000 = 5.04 5.04 * $18,200,000 = $91,728,000 = EV

Question 132

True or false: Historical information used to determine the long-term average returns from equity markets may suffer from survivorship bias, resulting in inflating the mean return?

Answer 132

True

Question 133

True or false: EV/EBITDA is a good tool for comparing stocks w/ different degrees of financial leverage?

Answer 133

True

Question 134

True or false: A higher earnings yield signals an overpriced stock?

Answer 134

False, a high earnings yield signals a cheaper stock

Question 135

True or false: P/B is a meaningful ratio for service industries?

Answer 135

False

Question 136

True or false: The estimate of value from FCFE models will always be different from the value obtained using DDM, if the FCFE is greater than dividends, and the excess cash is not invested in zero NPV projects?

Answer 136

True

Question 137

True or false: The RI valuation approach can provide a check of consistency between competing approaches like free cash flow of equity (FCFE) and dividend discount model (DDM)?

Answer 137

True

Question 138

Should dividend-based and free cash flow from equity (FCFE) based valuations result in different equity values for a firm?

Answer 138

Technically, if the underlying input assumptions are all the same, we should get the same exact valuation except for one detail- the control premium of free cash flow models. A control premium would cause the valuation to be higher.

Question 139

True or false: Net borrowings refer to principal borrowings not interest?

Answer 139

True

Question 140

True or false: EBITDA is a pre-interest variable, so it is available to all suppliers of capital, not just common shareholders?

Answer 140

True. This is why we use EV/EBITDA instead of equity/EBITDA

Question 141

True or false: In free CF valuation it's common to assume that WC will be financed at the target debt ratio?

Answer 141

True

Question 142

True or false: Changes in the # of shares outstanding will not affect FCFF but will slightly affect FCFE?

Answer 142

False, it will not affect FCFF or FCFE