Equity

Question 1

Porters 5 forces

Answer 1

1. Understand the business
2. Forecast performance - quality of earnings
3. Select valuation model - Use of CAPM etc
4. Estimate intrinsic value
5. Make investment reccomendation

Question 2

Dividend discount model

Answer 2

D1 / r-g

Question 3

Mispricing

Answer 3

mispricing = estimated value - market price

Question 4

Equity Risk Premium

r

Answer 4

ERP = r - rf

r = (D1 / P0) + g

Question 5

Blume adjusted Beta

Answer 5

1/3 + (2/3 x unadjsuted raw beta)

Question 6

Unlevered beta of xyz

Relevered beta / estimated Beta of ABC

Answer 6

UB = (1 / 1 +D/E) x B

Be and D/E of a comparable stock!

RB = 1 + (D/E) x UB

D/E of own company! UB from comparable part 1 of question.

Question 7

Debt to Equity ration:

if Debt = 40%

If Debt to equity ratio is 50%

Answer 7

Debt = 40%
Equity = 60%
Total = 100%

D/E = 40/60 = 0.667

50% debt
50% equity
100% total
D/E = 1

30% debt
70% equity
total 100%

D/E = 0.429

Question 8

CAPM

Fama-French Multi factor Model CAPM

Pastor Stambough Model CAPM

Market factor Market beta High =
Size beta High =
Value beta Positive =

Answer 8

r = rf + B(Rm-Rf)

r = rf + B(Rm-Rf) + bSMB + bHML

bSMB = small minus big cap premium x beta
bHML = High minus Low value premium x beta

r = rf + B(Rm-Rf) + bSMB + bHML + bLIQ

bLIQ = Liquidity premium x beta

Market factor beta positive shows above average market risk
Size positive Beta shows SMALL cap stock
Value positive beta shows Value stock

Question 9

5 Factor BIRR Model ways to enhance CAPM

Answer 9

1. Confidence Risk
2. Time Horizon Risk
3. Inflation Risk
4. Business cycle risk
5. Market timing risk

Question 10

Build up Method for r =

Equity Risk Premium

Answer 10

r = rf + Equity risk premium +/- company specific risk premia

ERP = Rm-Rf (portion of CAPM)

ERP = Year ahead dividend Yield + g - Long term bond yield

Question 11

Bond Yield Plus Risk Premium

WACC =

Answer 11

BYPRP cost of equity = YTM of long term debt + risk premium

WACC = (W x Debt (1-t)) + (W x Return Common Equity) + (W X Return Preference shares)

Question 12

Holding period return =

Ibbotsen and Chen ERP =

Answer 12

HPR = Dividend yield + price appreciation

(1 + Expected Inflation) x (1 + Expected EPS growth) x (1+ Expected PE growth) - 1 + income - gov bond yield

Question 13

Return on invested capital ROIC =

ROCE =

Answer 13

ROIC = NOPAT / Invested capital

ROCE = basically ROIC before tax is taken away

NOPAT - Net operating profit less adjusted tax

Question 14

Inflation effect on inelastic products =

Selling to a country with high inflation =

What happens to margins as you pass on price increases?

Answer 14

Inelastic products benefit from inflation as they can pass on costs.

High inflation countries create currency losses due to money owed on credit now being worth less.

Margins fall as you now have the same profit but smaller relative to the COGS

Question 15

Porters 5 forces of profitability =

Answer 15

1. threat of substitutes
2. Rivalry
3. Bargaining power of suppliers
4. bargaining power of buyers
5. threat of new entrants.

Question 16

Organic growth =

Answer 16

Organic growth = (1 + price/mix growth rate) x (1 + volume growth) - 1

Question 17

When to use which valuation method:

Dividends

FCFF and FCFE

Residual Income

Answer 17

Dividends = mature stable companies

FCFF or FCFE = Non dividend paying companies FCF positive companies
FCFF = useful when you have high unstable leverage
FCFE = useful when there is a controlling interest or takeover likely

Residual income model = FCF negative companies and no dividends

Question 18

Valuing a share

Gordons growth model dividends

Preference shares

Present Value Growth Opportunites PVGO

Dividend given payout ratio

growth

Answer 18

D1 / r-g

D/r

Value = (E1 / r) + PVGO

D1 = dividend and can be found from payout ratio

g = RR x ROE

E = EPS 
RR = Retention ratio (inverse of payout ratio)

Question 19

Two stage H Model =

H model =

Answer 19

(D1/r-glong) + (D0 x H x (gshort - glong ) / r - glong)

H = Half life of growth period = 2H = linear decline to growth

Question 20

Leading Justified P/E =

Trailing Justified P/E =

1-b =

Leading PE > Trailing PE =

Answer 20

Leading Justified P/E = 1-b / r-g = Trailing PE / 1+g

Trailing Justified P/E = (1-b) x (1+g) / r-g

1-b = Payout ratio

Leading PE > Trailing PE = Overvalued

Question 21

Price to sales ratio =

Profit margin =

Answer 21

Price to sales = (e/s x (1-b) x (1+g)) / r-g

profit margine = Earnings/sales

Question 22

EPS =

Share price =

Terminal value using PE =

Answer 22

Dividend / payout ratio

Share price = PE x EPS

Terminal value = (D0 x (1+g)^n / (1-b)) x PE

Question 23

Firm value using WACC ie cash available to all investors?
How do you find equity value?

Equity value

Answer 23

Firm value = FCFF / (1+WACC)^t

Firm value = debt + equity (you would subtract one from the other)

FCFE / (1+rce)^t

Question 24

FCFF =

FCFF =

FCFF1 = (Using WACC)

FCFF =

FCFE =

FCFE =

FCFE =

Answer 24

FCFF = CFO + INT(1-t) - FC Inv

FCFF = NI + NCC + INT(1-t) - FC Inv - WC Inv + Pref shares

FCFF1 = FCFFo x 1+g / WACC - g

FCFF = EBIT (1-t) + NCC - FCInv - WCInv

FCFF = EBITDA (1-t) + Depr + NCC -FC FCinc - WC Inv

FCFE = NI + NCC - FCInv - WCInv + Net borrowing

FCFE = CFO - FC Inv + Net borrowing

FCFE = FCFF - INT (1-t) + Net borrowing

Question 25

FCInvestment: Increase in accounts receivable: Increase in accounts payable: Increase in inventory: Decrease in inventory: Non Cash Charges (NCC): Gains Losses WC Inv Gain on disposal

Answer 25

FCInvestment: *Increase in accounts receivable: add Increase in accounts payable: subtract *Increase in inventory: add Decrease in inventory: subtract Non Cash Charges (NCC): Gains - Subtract Losses - add WCInv gain on dispoal = subtract

Question 26

Leading PE = Trailing PE = Fundamental Justified PE (passthrough rate) = Higher inflation on PE?

Answer 26

Leading PE = P0 / E1 Trailing PE = P0/E0 P0/E1 = 1 / (real r + (1- pass-through rate) x Inflation) Higher inflation = lower PE

Question 27

Earnings Yield PEG ratio P/B value P/B given ROE

Answer 27

E/P (opposite of PE) PE / g assumes a linnear relationship of PE and growth. P/B value = Price / Equity BV per share = MV equity / BV equity P/B = ROE1 - g / r - g

Question 28

Molodovsky approach Default approach

Answer 28

PEs change according to cyclicality Next 4 quarters to calculate leading PE ratio

Question 29

Price to Sales Positives Disadvantages

Answer 29

P/S = Price per share / Sales per share = MV Equity / Total sales P/S = E/S x (1-b) x (1+g) / r-g Positives: sales usually positive, difficult to manipulate but still possible, Less volatile than PE. Disadvantage = growth in sales does not mean growth in profits.

Question 30

Price to Cash Flow = Cash flow = Advantages Disadvantages

Answer 30

P/CF = Price per share / Cashflow per share = MV Equity / Total cash flow CF = NI + depreciation + amortisation ``` Adv = Difficult to maniplulate, more stable than PE, Disadv = Non specified ie you dont know if to use CFO, CFI or CFF. ```

Question 31

EV = EV/EBITDA Adv Disadv

Answer 31

EV = MV common stock + MV of debt - cash & Investments Adv: useful for valuing firms with differnt financial leverage. Disadv = FCFF a better measure than EBITDA, a higher WACC gives a lower enterprise value ratio

Question 32

Standardised Unexpected Earnings

Answer 32

SUE = (EPSactual - EPSforecast) / SD(EPSactual - EPS forecast)

Question 33

Terminal value of a stock Adjusted CFO =

Answer 33

TV stock = P/EPS x future EPS estimate Adjusted CFO = CFO + net interest charge

Question 34

Residual income given B0 Price = RI = BV0 = Assumptions of RI Equity value given PVRI

Answer 34

P0 = B0 + (ROE - r / r - g ) x B0 ``` RI = (ROE - r ) x B0 B0 = NI - cost of capital ``` Assumptions = It will revert to zero, remain constant Eq0 = BV0 + PVRI / 1+r

Question 35

RI Value = No continuing residual income persistence factor = Residual income continues in perpetuity =

Answer 35

V0 = B0 + (sum ROE-r / 1+r^t) + (Pt - Bt / 1+ r ^t) No continuing residual income persistence factor = zero Residual income continues in perpetuity = one

Question 36

RI given NOPAT = NOPAT =

Answer 36

RI = NOPAT - WACC NOPAT = EBIT (1-t)

Question 37

Market Value Added (MVA) = Economic Value Added (EVA) =

Answer 37

MVA = Market value of company (debt + equity) - Total adjusted capital EVA = NOPAT - (WACC x capital)

Question 38

What causes a higher persistance factor in residual income?

Answer 38

Extreme levels of accruals, low dividend payout & high non-recurring items.

Question 39

TV of a stock in Y4 with persistance factor =

Answer 39

RI in Y5 / 1 + r - w w = persistence factor

Question 40

Market Value = Fair value = Investment value = Intrinsic value =

Answer 40

Market Value = Definition under International Valuation Standard Committee (IVSC) and similar to Fair value Fair value = Used in financial reporting and litigation Investment value = Value to the investor ie some people may see more value in a company than others. Intrinsic value = Value based on models such s GGM and DDM

Question 41

Lack of control discount given - control premium 30%= Two stage discounts method Control premium 40% Marketability discount 15%

Answer 41

Single stage = 1 - (1 / 1.30) = 23% Two stage: 1 - (1/1.4) = 28.5% 1 - (1- 0.285) x (1- 0.15) = 40%

Question 42

Ex ante alpha = Required return =

Answer 42

Ex ante alpha = Expected return - required return Required return = (1 + r^n) - 1