Equities Flashcards
1
Q
Define valuation and intrinsic value and explain sources of perceived mispricing.
A
Intrinsic value: is the value of an asset or security estimated by someone who has complete understanding of the characteristics of the asset or issuing firm.
To the extent that market prices are not perfectly (informationally) efficient, they may diverge from intrinsic value.
2
Q
Explain the going concern assumption and contrast a going concern value to a liquidation value.
A
The going concern assumption: is simply the assumption that a company will continue to operate as a business as opposed to going out of business.
The liquidation value: is the estimate of what the assets of the firm would bring if sold separately, net of the company’s liabilities.
3
Q
Describe definitions of value and justify which definition of value is most relevant to public company valuation.
A
Fair market value: is the price at which a hypothetical willing, informed, and able seller would trade an asset to a willing, informed and able buyer.
Investment value: is the value to a specific buyer after including any additional value attributable to synergies.
4
Q
Describe applications of equity valuation.
A
Equity valuation models are used by analysts by:
- stock selection
- reading the market
- projecting the value of corporate actions
- fairness opinions
- planning and consulting
- communication with analysts and investors
- valuation of private business
- portfolio management
5
Q
What are Porter’s 5 elements of industry structure “forces”?
A
- Threat of new entrants in the industry.
- Threat of substitutes.
- Bargaining power of buyers.
- Bargaining power of suppliers.
- Rivalry among existing competitors.
6
Q
What are some of the Quality of earnings issues?
A
Quality of earnings issues can be broken down into several categories:
- Accelerating or premature recognition of income.
- Reclassifying gains and nonoperating income.
- Expense recognition and losses.
- Amortization, depreciation, and discount rates.
- Off-balance-sheet issues.
It may be that these issues are addressed only in the footnotes and disclosures to the financial statements.
7
Q
Contrast absolute and relative valuation models and describe examples of each type of model.
A
Absolute valuation model: is one that estimates an asset’s intrinsic value (DDM).
Relative valuation models: estimate an asset’s investment characteristics compared to the value of other firms (P/E ratios).
8
Q
Describe sum-of-the-parts valuation and conglomerate discounts.
A
Sum-of-the-parts valuation: is the process of valuing the individual components of a company and then adding these values together to obtain the value of the whole company.
Conglomerate discount: refers to the amount by which market price is lower than the sum-of-the-parts value.
9
Q
Explain broad criteria for choosing an appropriate approach for valuing a given company.
A
When selecting an approach for valuing a given company, an analyst should consider whether:
- the model fits the characteristics of the company
- is appropriate based on the quality and availability of input data
- is suitable, given the purpose of the analysis
10
Q
Contrast realized holding period return, expected holding period return, required return, return from convergence of price to intrinsic value, discount rate, and internal rate of return.
A
Holding period return: is the increase in price of an asset plus any cash flow received from that asset, divided by the initial price of the asset.
Asset’s required return: is the minimum expected return an investor requires given the asset’s characteristics. If expected return is greater (less) than required return, the asset is undervalued (overvalued).
Discount rate: is a rate used to find the present value of an investment.
Internal rate of return (IRR): is the rate that equates the discounted cash flows to the current price. If markets are efficient, then the IRR represents the required return.
11
Q
Calculate and interpret an equity risk premium using historical and forward-looking estimation approaches.
A
Equity risk premium: is the return over the risk-free rate that investors require for holding equity securities.
Forward-looking or ex ante estimates: use current information and expectations concerning economic and financial variables.
There are 3-types of forward-looking estimates of the equity risk premium:
- Gordon growth model
- Macroeconomic models, only appropriate for developed countries
- Survey estimates, which are easy to obtain, but can have a wide disparity between opinions.
12
Q
Determine the required return on an equity investment using the capital asset pricing model, the Fama–French model, the Pastor–Stambaugh model, macroeconomic multifactor models, and the build-up method?
A
Fama-French model = RF + βmkt,j × (Rmkt − RF) + βSMB,j × (Rsmall − Rbig) + βHML,j × (RHBM − RLBM)
where:
(Rmkt − RF) = market risk premium
(Rsmall − Rbig) = a small-cap risk premium
(RHBM − RLBM) = a value risk premium
The Pastor-Stambaugh model: adds a liquidity factor to the Fama-French model.
Macroeconomic multifactor models: use factors associated with economic variables that would affect the cash flows and/or discount rate of companies.
The build-up method: is similar to the risk premium approach. One difference is that this approach does not use betas to adjust for the exposure to a factor. The bond yield plus risk premium method is a type of build-up method.
13
Q
Explain beta estimation for public companies.
A
A regression of the returns of a publicly traded company’s stock returns on the returns of an index provides an estimate of beta.
For forecasting required returns using the CAPM: an analyst may wish to adjust for beta drift using an equation such as:
adjusted beta = (2/3 × regression beta) + (1/3 × 1.0)
14
Q
Explain beta estimation for thinly traded public companies, and non-public companies.
A
An analyst can estimate beta using a 4-step process:
- identify publicly traded benchmark company
- estimate the beta of the benchmark company
- unlever the benchmark company’s beta
- relever the beta using the capital structure of the thinly traded/nonpublic company
15
Q
Describe strengths and weaknesses of methods used to estimate the required return on an equity investment.
A
CAPM: is simple but may have low explanatory power.
Multifactor models: have more explanatory power but are more complex and costly.
Build-up models: are simple and can apply to closely held companies, but they typically use historical values as estimates that may or may not be relevant to the current situation.
16
Q
Explain international considerations in required return estimation.
A
Analyst should adjust the required return to reflect expectations for changes in exchange rates.
A premium should be added for the risk present regarding emerging markets.
2-methods for estimating the size of the risk premium:
- The country spread model: uses a corresponding developed market as a benchmark and adds a premium for the emerging market risk. The premium can be estimated by taking the difference between the yield on bonds in the emerging market minus the yield of corresponding bonds in the developed market.
- The country risk rating model: estimates an equation for the equity risk premium for developed countries and then uses the equation and inputs associated with the emerging market.
17
Q
Explain and calculate the weighted average cost of capital (WACC) for a company.
A
The weighted average cost of capital (WACC) is the required return averaged across all suppliers of capital.
The term (1 − tax rate) is an adjustment to reflect the fact that, in most countries, corporations can take a tax deduction for interest payments.
The tax rate should be the marginal rate.
18
Q
Evaluate the appropriateness of using a particular rate of return as a discount rate, given a description of the cash flow to be discounted and other relevant facts.
A
The discount rate should correspond to the type of cash flow being discounted:
- cash flows to the entire firm at the WACC.
- cash flows toe quity at the required return on equity.
Analysts discount nominal cash flows with nominal discount rates. However, an analyst may wish to measure the present value of real cash flows, and a real discount rate should be used in that case.
19
Q
Compare top-down, bottom-up, and hybrid approaches for developing inputs to equity valuation models.
A
Bottom-up analysis: starts with analysis of an individual company or reportable segments of a company.
Top-down analysis: begins with expectations about a macroeconomic variable, often the expected growth rate of nominal GDP.
Hybrid analysis: incorporates elements of both top-down and bottom-up analysis.
20
Q
Compare “growth relative to GDP growth” and “market growth and market share” approaches to forecasting revenue.
A
When forecasting revenue with a
“growth relative to GDP growth” approach: the relationship between GDP and company sales is estimated, and then company sales growth is forecast based on an estimate for future GDP growth.
“market growth and market share” approach: begins with an estimate of industry sales (market growth), and then company sales are estimated as a percentage (market share) of industry sales. Forecast revenue then equals the forecasted market size multiplied by the forecasted market share.
21
Q
Evaluate whether economies of scale are present in an industry by analyzing operating margins and sales levels.
A
A company with economies of scale will have lower costs and higher operating margins as production volume increases, and should exhibit positive correlation between sales volume and margins.
22
Q
Demonstrate methods to forecast cost of goods sold (COGS), R&D, and selling general and administrative costs (SG&A).
A
COGS: is primarily a variable cost and is often modeled as a percentage of estimated future revenue.
The R&D and corporate overhead components of SG&A: are likely to be stable over the short term, while selling and distribution costs will tend to increase with increases in sales.
23
Q
Demonstrate methods to forecast financing costs.
A
The primary determinants of gross interest expense: are the amount of debt outstanding (gross debt) and interest rates.
Net debt: is gross debt minus cash, cash equivalents, and short-term securities.
Net interest expense: is gross interest expense minus interest income on cash and short-term debt securities owned.
24
Q
Demonstrate methods to forecast income taxes.
A
The expected effective tax rate times the forecasted pretax income provides a forecast of income tax expense.
Any expected change in the future effective tax rate should be included in the analysis.
25
Describe approaches to balance sheet modeling (pro forma).
Net income less dividends declared will flow through to retained earnings.
Working capital items can be forecast based on turnover ratios. In a simple
Items such as inventory, receivables, and payables will all increase proportionately to revenues.
Property, plant and equipment (PP&E) on the balance sheet is determined by depreciation and capital expenditures (capex).
Historical depreciation should be increased by the inflation rate when estimating capital expenditure for maintenance.
26
Describe the relationship between return on invested capital and competitive advantage.
ROIC: is net operating earnings adjusted for taxes (NOPLAT), divided by invested capital (operating assets minus operating liabilities)
It is a return to both equity and debt.
Firms with ROIC consistently higher than those of peer companies are likely exploiting some competitive advantage in the production and sale of their products.
27
Explain how a firm's competitive environment affects prices and costs.
There are no formulas or clear rules on how a firm's competitive environment affects its future revenue and costs, but expectations of a firm's future competitive success are important factors in forecasting future revenue and financial statements.
28
Evaluate the competitive position of a company based on a Porter's five forces analysis.
1. Companies have less (more) pricing power when the threat of substitute products is high (low) and switching costs are low (high).
2. Companies have less (more) pricing power when the intensity of industry rivalry is high (low).
3. Company prospects for earnings growth are lower when the bargaining power of suppliers is high.
4. Companies have less pricing power when the bargaining power of customers is high, and when switching costs are low.
5. Companies have more pricing power and better prospects for earnings growth when the threat of new entrants is low (no significant barriers to entry into an industry)
29
Explain how to forecast industry and company sales and costs when they are subject to price inflation or deflation.
Increases in input costs will increase COGS unless the company has hedged the risk of input price increases with derivatives or contracts for future delivery.
Vertically integrated companies are likely to be less affected by increasing input costs.
30
Evaluate the effects of technological developments on demand, selling prices, costs, and margins.
Some advances in technology decrease costs of production, which will increase profit margins, at least for early adopters.
Other advances in technology will result in either improved substitutes or wholly new products.
**cannibalization factor:** the percentage of a new product's sales that are stolen from an existing product's sales.
31
Explain considerations in the choice of an explicit forecast horizon.
For highly cyclical companies, the forecast horizon should include the middle of a cycle so that the analyst can forecast normalized earnings.
When there have been recent impactful events, such as acquisitions, mergers, or restructurings, these events should be considered temporary, and the forecast horizon should be long enough that the perceived benefits of such events can be realized.
32
Explain an analyst's choices in developing projections beyond the short-term forecast horizon.
Earnings projections over a forecast period beyond the short term are often based on the historical average growth rate of revenue over the previous economic cycle.
An analyst will typically estimate a terminal value for a stock at the end of the forecast horizon, using either a price multiple or a discounted cash flow approach.
Small changes in the estimated (perpetual) growth rate of future profits or cash flows can have large effects on the estimates.
33
What are the steps of a sales-based pro forma company model.
The development of sales-based pro forma financial statements includes the following steps:
1. Estimate revenue growth and future expected revenue.
2. Estimate COGS.
3. Estimate SG&A.
4. Estimate financing costs.
5. Estimate income tax expense and cash taxes, taking into account changes in deferred tax items.
6. Model the balance sheet based on items that flow from the income statement and estimates for important working capital accounts.
7. Use historical depreciation and capital expenditures to estimate future capital expenditures and net PP&E for the balance sheet.
8. Use the completed pro forma income statement and balance sheet to construct a pro forma cash flow statement.
34
Dividends are appropriate to value a stock when?
Dividends are appropriate when:
1. The company has a history of dividend payments.
2. The dividend policy is clear and related to the earnings of the firm.
3. The asset is being valued from the position of a minority shareholder.
35
Free cash flows are appropriate to value a stock when?
Free cash flow is appropriate when:
1. The company does not have a dividend payment history or has a dividend payment history that is not related to earnings.
2. The free cash flow corresponds with the firm's profitability.
3. The asset is being valued from the position of a controlling shareholder.
36
Residual income is appropriate to value a stock when?
Residual income is most appropriate for firms that:
1. Do not have dividend payment histories.
2. Have negative free cash flow for the foreseeable future.
3. Have transparent financial reporting and high-quality earnings.
37
What is a stock valuation using the dividend discount model (DDM)?
Stock valuation can be approached using DDMs for single periods, two periods, and multiple holding periods.
The stock price is the present value of the forecasted dividends plus the present value of the estimated terminal value, discounted at the required return.
38
The Gordon growth model assumes that?
The Gordon growth model assumes that:
1. Dividends grow at a constant growth rate.
2. Dividend policy is related to earnings.
3. Required rate of return r is greater than the long-term constant growth rate g.
39
Describe strengths and limitations of the Gordon growth model.
Advantages:
* Very applicable to stable, mature dividend-paying firms.
* Can be applied to indices very easily.
* Easily communicated and explained because of its straightforward approach.
* Useful in determining price-implied growth rates, required rates of return, and value of growth opportunities.
* Can be added to other more complex valuations.
Disadvantages:
* Valuations are very sensitive to estimates of growth rates and required rates of return, both of which are difficult to estimate with precision.
* The model cannot be easily applied to non-dividend-paying stocks.
* Unpredictable growth patterns of some firms would make using the model difficult.
40
Explain the growth phase, transition phase, and maturity phase of a business.
Most firms go through a pattern of growth that includes three stages:
1. An initial growth stage, where the firm has rapidly increasing earnings, little or no dividends, and heavy reinvestment.
2. A transition stage, in which earnings and dividends are still increasing but at a slower rate as competitive forces reduce profit opportunities and the need for reinvestment.
3. A mature stage, in which earnings grow at a stable but slower rate, and payout ratios are stabilizing as reinvestment matches depreciation and asset maintenance requirements.
41
Describe terminal value and explain alternative approaches to determining the terminal value in a DDM.
No matter which dividend discount model we use, we have to estimate a terminal value.
The Gordon growth model assumes that in the future, dividends will begin to grow at a constant, long-term rate. Then the terminal value at that point is just the value derived from the Gordon growth model.
Using market price multiples to estimate the terminal value is done by forecasting earnings and a ratio at the forecast horizon and then estimating the terminal value as the ratio multiplied by the earnings estimate.
42
Explain the assumptions and justify the selection of the two-stage DDM, the H-model, the three-stage DDM, or spreadsheet modeling to value a company's common shares.
There are several multistage growth models, with the most appropriate being the one that most closely matches the firm's actual growth pattern. The terminal value for multistage models is estimated using the Gordon growth model or market price multiples.
1. The two-stage model has two distinct stages with a stable rate of growth during each stage.
2. The H-model also has two stages but assumes that the growth rate declines at a constant linear rate during the first stage and is stable in the second stage:
3. The three-stage model can either have stable growth rates in each of the three stages or have a linearly declining rate in the second stage.
4. The spreadsheet model can incorporate any number of stages with specified rates of growth for each stage. This is most easily modeled with a computer spreadsheet.
43
What are the strengths and limitations of a Multistage growth model?
Strengths:
1. Multiple-stage DDMs are flexible.
2. The models can be used to estimate values given assumptions of growth and required return or to derive required returns and projected growth rates implied by market prices.
3. The models enable the analyst to review all of the assumptions built into the models and to consider the impact of different assumptions.
4. The models are very easily constructed and computed with the use of spreadsheet software.
Limitations:
1. The estimates are only as good as the assumptions and projections used as inputs.
2. A model must be fully understood in order for the analyst to arrive at accurate estimates. Without a clear understanding of the model, the effects of assumptions cannot be determined.
3. The estimates of value are very sensitive to the assumptions of growth and required return.
4. Formulas and data input can lead to errors that are difficult to identify.
44
Explain the use of spreadsheet modeling to forecast dividends and to value common shares.
In practice, financial analysts are much more likely to use a spreadsheet than any of the stylized models present here when valuing equity securities. The reason for this is the inherent flexibility and computational accuracy of spreadsheet modeling.
Steps include:
1. Establish the base level of cash flows or dividends.
2. Estimate changes in the firm's dividends for the foreseeable future.
3. Estimate what normalized level of growth will occur at the end of the supernormal growth period, allowing for an estimate of a terminal value.
4. Discount and sum all projected dividends and the terminal value back to today.
45
Estimate a required return based on any DDM, including the Gordon growth model and the H-model.
Given all of the other inputs to the Gordon growth model or H-model, we can rearrange the formula to back into the expected return that makes the present value of the forecasted dividend stream equal to the current market price.
46
Calculate and interpret the sustainable growth rate of a company and demonstrate the use of DuPont analysis to estimate a company's sustainable growth rate.
**Sustainable growth rate SGR:** the rate that earnings (and dividends) can continue to grow indefinitely, assuming that a firm's debt-to-equity ratio is unchanged and it doesn't issue any new equity. You can use the Dupont ROE method for this.
This has also been called the PRAT model, where SGR is a function of the:
* (P) profit margin
* (R) the retention rate
* (A) the asset turnover
* (T) the degree of financial leverage
Use beginning-of-period balance sheet values unless otherwise instructed.
47
Evaluate whether a stock is overvalued, fairly valued, or undervalued by the market based on a DDM estimate of value.
If the model price is lower than (higher than, equal to) the market price, the stock is considered overvalued (undervalued, fairly valued).
48
What is free cash flow to the firm (FCFF)?
FCFF is the cash available to all of the firm's investors, including stockholders and bondholders, after the firm buys and sells products, provides services, pays its cash operating expenses, and makes short- and long-term investments.
The value of the firm is the present value of the expected future FCFF discounted at the WACC.
If a company has negative FCFE and significant debt outstanding, FCFF is generally the best choice.
49
What is free cash flow to equity (FCFE)?
FCFE is the cash available to common shareholders after funding capital requirements, working capital needs, and debt financing requirements.
The value of the firm's equity is the present value of the expected future FCFE discounted at the required return on equity.
FCFE is easier and more straightforward to use in cases where the company's capital structure is not particularly volatile.
50
Explain the ownership perspective implicit in the FCFF and FCFE approach and when should they be used?
Analysts prefer to use either FCFF or FCFE as a measure of value if:
1. The firm does not pay dividends.
2. The firm pays dividends, but the dividends do not reflect the company's long-run profitability.
3. The analyst takes a control perspective.
The use of free cash flows reflects a control perspective while the use of dividends reflects a minority common stockholder's perspective.
The ownership perspective in the free cash flow approach is that of an acquirer who can change the firm's dividend policy, which is a control perspective.
51
Explain the appropriate adjustments to net income, earnings before interest and taxes (EBIT), earnings before interest, taxes, depreciation, and amortization (EBITDA), and cash flow from operations (CFO) to calculate FCFF and FCFE. Calculate FCFF and FCFE.
FCFF and FCFE may be calculated starting either from net income, cash flows from operations, EBIT, or EBITDA.
FCFF = NI + NCC + [Int × (1 − tax rate)] − FCInv − WCInv
FCFF = [EBIT × (1 − tax rate)] + Dep − FCInv − WCInv
FCFF = [EBITDA × (1 − tax rate)] + (Dep × tax rate) − FCInv − WCInv
FCFF = CFO + [Int × (1 − tax rate)] − FCInv
FCFE = FCFF − [Int × (1 − tax rate)] + net borrowing
FCFE = NI + NCC − FCInv − WCInv + net borrowing
FCFE = CFO − FCInv + net borrowing
52
Describe approaches for forecasting FCFF and FCFE.
For forecasting FCFE, use:
FCFE = NI − [(1 − DR) × (FCInv − Dep)] − [(1 − DR) × WCInv]
53
Compare the FCFE model and dividend discount models.
The free cash flow to equity approach takes a control perspective, which assumes that recognition of value should be immediate.
Dividend discount models take a minority perspective, under which value may not be realized until the dividend policy accurately reflects the firm's long-run profitability.
54
Explain how dividends, share repurchases, share issues, and changes in leverage may affect future FCFF and FCFE.
Dividends, share repurchases, and share issues have no effect on FCFF and FCFE.
Changes in leverage have only a minor effect on FCFE and no effect on FCFF.
55
Evaluate the use of net income and EBITDA as proxies for cash flow in valuation.
**Net income is a poor proxy for FCFE.** Net income includes noncash charges that have to be added back to arrive at FCFE. In addition, it ignores cash flows that don't appear on the income statement, such as investments in working capital and fixed assets as well as net borrowings.
**EBITDA is a poor proxy for FCFF.** 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.
56
Explain the single-stage, two-stage, and three-stage FCFF and FCFE models and justify the selection of the appropriate model given a company's characteristics.
**The single-stage free cash flow models:** are useful for stable firms in mature industries. The models assume free cash flows grow at a constant rate, g, forever and that the growth rate is less than the required return.
**We'd use a two-stage model** for a firm with two stages of growth:
* a short-term supernormal growth phase
* a long-term stable growth phase.
**We'd use a three-stage model** for a firm that we expect to have three distinct stages of growth:
* a growth phase
* a mature phase
* a transition phase
57
Explain the use of sensitivity analysis in FCFF and FCFE valuations.
Sensitivity analysis shows how sensitive an analyst's valuation results are to changes in each of a model's inputs.
Some variables have a greater impact on valuation results than others.
The importance of various forecasting errors can be assessed through comprehensive sensitivity analysis.
58
Describe approaches for calculating the terminal value in a multistage valuation model.
There are 2 basic approaches for calculating terminal value:
* single-stage model
* multiple approach
The multiple approach uses valuation multiples (like P/E ratios) to estimate terminal value.
59
Evaluate whether a stock is overvalued, fairly valued, or undervalued based on a free cash flow valuation model.
If a stock's model price is lower than (higher than, equal to) the market price, the stock is considered overvalued (undervalued, fairly valued).
60
Contrast the method of comparables and the method based on forecasted fundamentals as approaches to using price multiples in valuation and explain economic rationales for each approach.
The method of comparables uses a price multiple for a similar firm or the average price multiple for a portfolio of stocks or an index as a benchmark value. The value of a dollar of earnings or a dollar of book value, should be the same across similar stocks or stocks in the same industry. Valuation based on the method of comparables is relative, based on the current market values of other stocks.
Rather than using current price multiples for other stocks, the method of forecasted fundamentals uses price multiples based on forecasted values for fundamental characteristics. Under this method, we are assuming that a particular valuation model gives the stock's intrinsic value.
61
Calculate and interpret a justified price multiple.
A justified price multiple can be "justified" by either the method of comparables or by the method of forecasted fundamentals.
Stocks with price multiple less than their justified price multiple, based on forecasts of the fundamental variables involved, are judged to be undervalued. A similar argument can be made for stocks with price multiple less than that for a similar stock or benchmark price multiple determined by the method of comparables.
62
Describe rationales for and possible drawbacks to using price-to-earnings (P/E) ratio.
**Rationales for using price-to-earnings (P/E) ratio in valuation:**
* Earnings power, as measured by earnings per share (EPS), is the primary determinant of investment value.
* The P/E ratio is popular in the investment community.
* Empirical research shows that P/E differences are significantly related to long-run average stock returns.
**Disadvantages of using the price-to-earnings ratio include:**
* Earnings can be negative.
* The volatile, transitory portion of earnings makes interpretation difficult.
* Management discretion distorts reported earnings.
63
Describe rationales for and possible drawbacks to using price-to-book (P/B) ratio.
**Rationales for using price-to-book (P/B) ratio in valuation:**
* Book value is a cumulative amount that is usually positive, even when the firm reports a loss and EPS is negative.
* Book value is more stable than EPS, so it may be more useful than P/E when EPS is particularly high, low, or volatile.
* Book value 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/Bs help explain differences in long-run average stock returns.
**Disadvantages of using the price-to-book ratio include:**
* P/Bs do not recognize the value of nonphysical assets.
* P/Bs can mislead when there are significant size differences.
* Different accounting conventions can obscure the true investment in the firm made by shareholders.
* Inflation and technological change can cause the book and market value of assets to differ significantly.
64
Describe rationales for and possible drawbacks to using price-to-sales (P/S) ratio.
**Rationales for using price-to-sales (P/S) ratio in valuation:**
* P/S is meaningful even for distressed firms.
* Sales revenue is not as easy to manipulate or distort as EPS and book value.
* P/S ratios are not as volatile as P/E multiples.
* P/S ratios are particularly appropriate for valuing stocks in mature or cyclical industries and start-up companies with no record of earnings.
* Empirical research finds that differences in P/S are significantly related to differences in long-run average stock returns.
**Disadvantages of using the price-to-sales ratio include:**
* Higher sales do not necessarily indicate higher operating profits.
* P/S ratios do not capture differences in cost structures across companies.
* While less subject to distortion than earnings, revenue recognition practices can distort sales forecasts.
65
Describe rationales for and possible drawbacks to using price-to-cash flow (P/CF) ratio.
**Rationales for using price-to-cash flow (P/CF) ratio in valuation:**
* Cash flow is harder for managers to manipulate than earnings.
* Price to cash flow is more stable than price to earnings.
* Reliance on cash flow rather than earnings handles the problem of differences in the quality of reported earnings, which is a problem for P/E.
* Empirical evidence indicates that differences in price to cash flow are significantly related to differences in long-run average stock returns.
**Disadvantages of using the price to cash flow include:**
* The EPS plus noncash charges estimate ignores items affecting actual cash flow from operations.
* FCFE is preferred but is more volatile than operating cash flow.
66
Describe rationales for and possible drawbacks to using the dividend yield in valuation.
**Rationales for using dividend yield in valuation:**
* Dividend yield contributes to total investment return.
* Dividends are not as risky as the capital appreciation component of total return.
**Disadvantages of using dividend yield include:**
* Dividend yield is only one component of the return on a stock.
* All else equal, higher dividends will lead to slower growth, which drives the other component of returns, price appreciation.
67
Calculate and interpret alternative price multiples and dividend yield.
**The trailing P/E ratio:** is market price per share divided by earnings per share over the last four reported quarters.
**The leading P/E ratio:** is market price per share divided by estimated earnings per share for the next four quarters.
**The price/sales ratio:** is the market price per share divided by sales per share.
**The price/book ratio:** is the market price per share divided by the book value (shareholders' equity) per share.
**The price/cash flow ratio:** is the market price per share
divided by cash flow per share, which can be calculated in various ways.
**The (expected) dividend yield:** is the expected dividend over the next four quarters divided by the current market price per share.
**_For all of these price ratios, a higher value indicates a greater relative stock value_**.
68
Describe fundamental factors that influence alternative price multiples and dividend yield.
**All else equal:
The price-to-earnings ratio:**will be higher the greater the growth rate of earnings and the lower the required rate of return.
**The price-to-sales ratio:** will be higher the greater the net profit margin and the lower the required rate of return.
**The price-to-cash flow ratio:** will be higher the greater the growth rate of free cash flow to equity and the lower the required rate of return.
**The price-to-book ratio:** will be higher the greater the spread between ROE and the required rate of return.
**The dividend yield:** will be higher the greater the required rate of return and the lower the growth rate of earnings.
69
Calculate and interpret a predicted P/E, given a cross-sectional regression on fundamentals, and explain limitations to the cross-sectional regression methodology.
Predicted P/E can be estimated from linear regression of historical P/Es on its fundamental variables. In such a case, P/E is the dependent variable and company fundamentals are independent variables.
70
Calculate and interpret underlying earnings, explain methods of normalizing earnings per share (EPS), and calculate normalized EPS.
**Underlying earnings:** are earnings that exclude nonrecurring components.
**Normalized earnings:** are earnings adjusted for the business cycle using either:
* the method of historical EPS
* method of average ROE (this is the preferred method)
71
Explain and justify the use of earnings yield (E/P).
A high earnings yield (E/P) suggests a cheap security.
A low E/P suggests an expensive security, so securities can be ranked from cheap to expensive based on E/P ratios.
72
Evaluate a stock by the method of comparables and explain the importance of fundamentals in using the method of comparables.
When using the method of comparables to identify attractively priced stocks, the analyst must account for differences in the stocks' fundamentals.
A stock with a high P/E ratio may still be attractive because of its rapid growth.
A stock with a high dividend yield (low price-to-dividend) may be unattractive because earnings do not support the dividend and no growth is anticipated.
73
Calculate and interpret the P/E-to-growth (PEG) ratio and explain its use in relative valuation.
The price earnings-to-growth (PEG) ratio is calculated as
PEG ratio = P/E ratio ÷ g
Lower PEGs are more attractive than stocks with higher PEGs, all else equal.
74
Calculate and explain the use of price multiples in determining terminal value in a multistage discounted cash flow (DCF) modeldiscounted cash flow (DCF) model.
Analysts often use price multiples such as P/E, P/B, P/S, and P/CF to estimate terminal value. No matter which ratio we use, terminal value is calculated as the product of the expected price multiple (e.g. P/E ratio) and the terminal value of the fundamental variable (e.g., EPS).
75
Explain sources of differences in cross-border valuation comparisons.
Using relative valuation methods that require the use of comparable firms is challenging in an international context due to differences in accounting methods, cultures, risk, and growth opportunities.
76
Describe momentum indicators and their use in valuation.
Momentum indicators relate either the market price or a fundamental variable-like EPS to the time series of historical or expected value.
Common momentum indicators include:
* earnings surprise
* standardized unexpected earnings
* relative strength
77
Explain the use of the arithmetic mean, the harmonic mean, the weighted harmonic mean, and what should you use with a portfolio?
When calculating the P/E or other price multiple for an index or portfolio, the arithmetic mean may be misleading. The most appropriate measure is the weighted harmonic mean of the individual asset P/Es using the portfolio or index weights.
78
Evaluate whether a stock is overvalued, fairly valued, or undervalued based on comparisons of multiples.
The basic idea of the method of comparables is to compare a stock's price multiple to the benchmark. Firms with multiples below the benchmark are undervalued, and firms with multiples above the benchmark are overvalued.
79
Calculate and interpret residual income, economic value added, and market value added.
Residual income is net income less a charge for common stockholders' opportunity cost of capital.
EVA and MVA are alternatives to residual income as measures of economic profit. These models are typically used in the measurement of managerial effectiveness and executive compensation.
EVA = NOPAT – (WACC × total capital) = EBIT × (1 − t) − $WACC
MVA = market value − total capital
80
What is the residual income model and compare value recognition in residual income and other present value models.
The residual income model breaks the intrinsic value of a stock into two elements:
1. current book value of equity
2. present value of expected future residual income:
Valuation with residual income models is relatively less sensitive to terminal value estimates than dividend discount and free cash flow models. This is because intrinsic values estimated with residual income models include the firm's current book value, which usually represents a substantial percentage of the estimated intrinsic value.
81
Explain fundamental determinants of residual income.
The fundamental drivers of residual income are:
* ROE in excess of the cost of equity
* the earnings growth rate.
82
Explain the relation between residual income valuation and the justified price-to-book ratio based on forecasted fundamentals.
If ROE is equal to the required return on equity, the justified market value of a share of stock is equal to its book value.
When ROE is higher than the required return on equity, the firm will have positive residual income and will be valued at more than book value.
In that case, the P/B ratio will be greater than one.
83
Compare residual income models to dividend discount and free cash flow models.
DDM and FCFE models estimate value as the discounted present value of expected future cash flows.
The residual income model estimates value as book value plus the present value of the expected stream of annual residual income.
Residual income models may be used to assess the consistency of other valuation models.
84
Describe the uses of residual income models.
Residual income and related models are used for:
* equity valuation
* tests for goodwill impairment
* measurement of managerial effectiveness
* calculation of executive compensation
85
Explain continuing residual income and justify an estimate of continuing residual income at the forecast horizon, given company and industry prospects.
In the residual income model, intrinsic value is the sum of three components:
V0 = B0 + (PV of interim high-growth RI) + (PV of continuing residual income)
For multistage residual income models, first forecast residual income over a short-term horizon, and then make some simplifying assumptions about the pattern of residual income growth over the long term.
Continuing residual income is the residual income that is expected over the long term. The present value of continuing residual income in year T − 1.
Another way to estimate continuing residual income without using the persistence factor is to assume residual income is expected to decline to a normal long-run level consistent with a mature industry. Then the premium over book value (PT − BT) is equal to the present value of continuing residual income in year T, and the present value of continuing residual income in year T − 1.
86
Explain strengths and weaknesses of residual income models.
**The following are strengths of residual income models:**
* Terminal value does not dominate the intrinsic estimate.
* Residual income models use accounting data, which is usually easy to find.
* The models are applicable to firms that do not pay dividends or that do not have positive expected free cash flows in the short run.
* The models are applicable even when cash flows are volatile.
* The models focus on economic rather than just on accounting profitability.
**The following are weaknesses of the residual income models:**
* The models rely on accounting data that can be manipulated by management.
* 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.
87
When would you select a residual income model to value a company's common stock and when would you not?
**Residual income models are appropriate under the following circumstances:**
* A firm does not pay dividends, or the stream of payments is too volatile to be sufficiently predictable.
* Expected free cash flows are negative for the foreseeable future.
* The terminal value forecast is highly uncertain, which makes dividend discount or free cash flow models less useful.
**Residual income models are not appropriate under the following circumstances:**
* The clean surplus accounting relation is violated significantly.
* There is significant uncertainty concerning the forecast of book value and return on equity.
88
Describe accounting issues in applying residual income models.
In applying the residual income valuation approach, analysts often must take into account the following:
1. Violations of the clean surplus relationship.
2. Balance sheet adjustments for fair value.
3. Intangible assets.
4. Nonrecurring items.
5. Other aggressive accounting practices.
6. International accounting differences.
89
Evaluate whether a stock is overvalued, fairly valued, or undervalued based on a residual income model.
If model price is lower than (higher than, equal to) the market price, the stock is considered overvalued (undervalued, fairly valued).
90
Compare public and private company valuation.
Both company-specific and stock-specific factors distinguish private and public companies.
Company-specific factors can have positive or negative effects on private company valuations while stock-specific factors are usually negative.
There is more heterogeneity ii private firm:
* risk
* discount rates
* valuation methods
91
What are some of the company-specific factors for private firms?
Company-specific factors for private firms may include the degree to which they:
* Are less mature.
* Have less capital.
* Have fewer assets.
* Have fewer employees with less depth of management.
* Are riskier.
* Have higher managerial ownership.
* Have a longer-term focus.
* Provide less disclosure of information about the firm.
* Have greater tax concerns.
92
What are some of the stock-specific factors for private firms?
Stock-specific factors for private firms may include the degree to which they:
* Have less liquidity in the equity interests.
* Often have restrictions on liquidity.
* Have concentration of control to the possible detriment of noncontrolling shareholders.
93
What are the 3-types of private business valuation and when would they each be used?
**Transaction-related valuations:** are performed when there is
* venture capital financing
* an IPO
* a sale of the firm
* bankruptcy
* performance-based managerial compensation.
**Compliance-related valuations:** are performed for
* financial reporting
* tax purposes
**Litigation-related valuations:** may be required for
* shareholder suits
* damage claims
* lost profits
* divorces
94
What are the 3-major approaches to private company valuation and what should be considered?
The three major approaches to private company valuation are:
1. the income approach
2. the market approach
3. the asset-based approach
The valuation should consider the firm's:
* operations
* lifecycle stage
* size
* risk
* growth
95
Explain cash flow estimation issues related to private companies.
When estimating free cash flow to value the firm or equity, the following issues should be considered:
* Estimates may vary for controlling and noncontrolling equity interests.
* Several scenarios of future cash flows should be examined.
* The scenarios should consider the lifecycle stage of the firm.
* Management biases should be anticipated.
* FCFF would be used when there will be capital structure changes.
96
Explain adjustments required to estimate normalized earnings related to private companies.
Normalized earnings are calculated by adjusting for:
* Nonrecurring and unusual items.
* Discretionary expenses.
* Non-market levels of compensation.
* Personal expenses charged to the firm.
* Real estate expenses based on historical cost.
* Non-market lease rates.
The normalized earnings for a strategic buyer incorporate acquisition synergies, whereas a financial (nonstrategic) transaction does not.
97
Calculate the value of a private company using free cash flow, capitalized cash flow, and/or excess earnings methods.
The three methods of valuation using the income approach:
**1. Free cash flow method:** discounts a series of discrete cash flows plus a terminal value. It is a 2-stage model.
**2. Capitalized cash flow method:** discounts a single cash flow by the capitalization rate. It is a single-stage model.
**3. Excess earnings method:** values tangible and intangible assets separately and is useful for small firms and when there are intangible assets to value.
98
Explain factors that require adjustment when estimating the discount rate for private companies.
**Size premiums:** the appraiser may use data from small cap public firms, but these may include a distress premium not applicable to the private firm.
**Availability and cost of debt:** compared to a public firm, a private firm may not be able to obtain as much debt financing or at as cheap a rate.
**Acquirer vs. target:** the WACC used should be that for the target, not the acquirer.
**Projection risk:** projecting cash flows for private firms is riskier given the lower availability of information and reliance on management for projections.
**Lifecycle stage:** it is difficult to estimate the discount rate for early stage firms.
99
Compare discount rate models used to estimate the required rate of return to private company equity.
Using discount rate models for private firms includes the following:
**CAPM:** may not be appropriate for private firms because beta is usually estimated from public firm returns.
**Expanded CAPM:** adds premiums for size and firm-specific risk.
**Build-up method:** adds an industry risk and other risk premiums to market rate of return and is used when betas for comparable public firms are not available.
100
What are the 3-methods to value of a private company based on market approach methods?
The three market approach methods are as follows:
1. The guideline public company method (GPCM)
2. The guideline transactions method (GTM)
3. The prior transaction method (PTM)
101
What is the guideline transactions method (GTM) and describe advantages and disadvantages.
The guideline transactions method (GTM): uses the price multiples from the sale of whole public and private companies with adjustments for risk differences.
The following issues regarding the comparable data should be considered:
* transaction type
* contingent consideration
* type of consideration
* availability of data
* date of data
102
What is the guideline public company method (GPCM) and describe advantages and disadvantages.
The guideline public company method (GPCM): uses price multiples from traded public companies with adjustments for risk differences.
The advantage is that there are usually numerous public company transactions available, but the public firms may not be comparable.
When estimating a control premium for a controlling interest you should consider:
* the transaction type
* industry conditions
* type of consideration
* reasonableness
103
What is the prior transaction method (PTM) and describe advantages and disadvantages.
The prior transaction method (PTM): uses historical stock sales of the subject company.
It is best when using recent, arm's-length data of the same motivation.
104
Describe the asset-based approach to private company valuation.
The asset-based approach is usually not used for going concerns but is used for:
* troubled firms
* finance firms
* investment companies
* firms with few intangible assets
* natural resource firms
It values equity as the asset value minus the debt value of a firm.
105
Explain and evaluate the effects on private company valuations of discounts and premiums based on control and marketability.
The application of discounts and premiums to comparable company values depends on differences between the characteristics of the interest in the comparable company (companies) that serves as the benchmark value and the characteristics of the interest in the target company to be valued.
There are 2 discounts:
* Discount for lack of control (DLOC)
* Discounts for lack of marketability (DLOM)
The DLOC and DLOM are applied multiplicatively using:
total discount = 1 − [(1 − DLOC) x (1 − DLOM)]
106
What is a discount for lack of control (DLOC)?
A discount for lack of control (DLOC) is applied when the comparable values are for the sale of an entire company (public or private), and the valuation is being done for a minority interest in the target company.
A control premium is added when the comparable company values are for public shares or other minority interests, and the target company valuation is for a controlling interest.
A DLOC can be estimated using valuations based on reported earnings rather than normalized earnings or as a formula.
107
What is a discount for lack of marketability (DLOM)?
Discounts for lack of marketability (DLOM) are applied when the comparables are based on highly marketable securities, such as public shares, and the interest in the target company is less marketable, as in the case of a minority interest in a private firm.
The DLOM can be estimated using:
* restricted share versus publicly traded share prices
* pre-IPO versus post-IPO prices
* put prices
