Equity - part 1

Question 1

Value of the firm’s equity

Answer 1

Present value of the expected future FCFE discounted at the required return on equity

Question 2

Value of the firm

Answer 2

FCFF discounted at the WACC

Question 3

Why is free cash flow preferred rather than dividend-based valuation

Answer 3

• Many firms pay no, or low, cash dividends
• Dividends are paid at the discretion of the BOD. Could be poorly aligned with firm’s long-run profitability
• If firm viewed as acquisition target, free cashflow is more appropriate measure, since new owner have discretion over its distribution (control perspective)
• Free cash flows may be more related to long-run profitability of firm as compared to dividends (ownership perspective implicite in FCFE approach)

Question 4

FCFF from net income

Answer 4

FCFF = NI + NCC + (Int* (1 - tax rate)) - FCInv - WCInc

Question 5

Non cash charges examples:

Answer 5

Expense that did not result in outflow of cash:

• Amortization of intangibles
• Provisions for restructuring charges and losses
• Income from restructuring charge reversals, gains
• amortization of bond discount
• Deffered taxes, if expected to increase, deffered tax asset added back to net income

Question 6

Fixed capital investments

Answer 6

equal to the difference between capital expenditures (investments in long-term fixed assets) and the proceeds from the sale of long-term assets

Question 7

Fixed capital investments

Answer 7

If no long-term assets were sold during the year:

FCInv = ending net PP&E − beginning net PP&E + depreciation

If long-term assets were sold during the year, then:

Determine capital expenditures from either (1) an item in the statement of cash flows called something like “purchase of fixed assets” or “purchases of PP&E” under cash flow from investing activities, or (2) data provided in the vignette.
Determine proceeds from sales of fixed assets from either (1) an item in the statement of cash flows called something like “proceeds from disposal of fixed assets,” or (2) data provided in the vignette.
Calculate FCInv = capital expenditures − proceeds from sale of long-term assets.
If capital expenditures or sales proceeds are not given directly, find gain (loss) on asset sales from the income statement and PP&E figures from balance sheet. Calculate FCInv = ending net PP&E − beginning net PP&E + depreciation − gain on sale. If there is a loss on sale of assets, add that instead of deducting it.

Question 8

Working capital investment

Answer 8

Change in working capital, excluding cash, cash equivalents, notes payable, and the current portion of long-term debt.

Question 9

Interest expense

Answer 9

Represents cashflow, available to bondholders, before it makes any payments to its capital suppliers, add it back the after-tac interest cost

Question 10

With preferred stock

Answer 10

FCFF and FCFE assumptions: company only used debt and common equity to raise funds

Preferred stock -> treated like debt, but not tax deductible.

Added back to FCFF (pref dividends)
FCFE: modify net borrowing to reflect new debt borrowing and net issuance by amount of preferred stock.

Question 11

2 approaches used to forecast FCFF and FCFE

Answer 11

1. The first method is to calculate historical free cash flow and apply a growth rate under the assumptions that growth will be constant and fundamental factors will be maintained.
2. The second method is to forecast the underlying components of free cash flow and calculate each year separately.

Capital expenditures have two dimensions: outlays that are needed to maintain existing capacity and marginal outlays that are needed to support growth

The first type of outlay is related to the current level of sales, and the second type depends on the predicted sales growth.

Question 12

FCFEE second method of forecasting

Answer 12

Assume maintains a target debt-to-asset ratio for net new investment in fixed capital and working capital.

FCFE = NI − [(1 − DR) × (FCInv − Dep)] − [(1 − DR) × WCInv]

where:

DR = target debt-to-asset ratio

Question 13

FCFF and FCFE impact, with change in dividends, share repurchases, share issues, and changes in leverage may affect future FCFF and FCFE.

Answer 13

None

Except, leverage changes FCFE: Offset -> if leverage increases, FCFE higher in current year (net borrowing) and lower in future years (interest expense).

Question 14

Compare FCFE model and dividend discount model

Answer 14

• FCFE takes control perspective, assuming recognition of value should be immediate
• DDM takes minority perspective, value may not be realized until dividend policy reflects long-run profitability.

Question 15

Why’s EBIDTA not a good proxy for FCFF?

Answer 15

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.

Question 16

Why Net income not a good proxy for FCFE

Answer 16

Net income includes noncash charges like depreciation 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.

Question 17

What is a sensitivity analysis

Answer 17

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.

Question 18

2 main sources of error in valuation analysis?

Answer 18

• Estimating future growth in FCFF and FCFE: depends on future profitability which depends an a million factors.
• Chosen base years for the FCFF or FCFE growth forecasts. , all of subsequent analysis and valuation will be flawed

Question 19

the 3 ways, multistage models can differs?

Answer 19

1. FCFF versus FCFE: value of firm = PV(FCFF) discounted at WACC. value of equity = PV(FCFE) discounted at required return on equity.
2. 2 versus 3 stage model
3. Forecasting growth in total free cash flow (FCFF or FCFE) versus forecasting the growth rates in the components of free cashflow

Question 20

What tare the assumptions for the 2 and 3 stage free cashflow.

Answer 20

Assumption about the projected pattern of growth in free cashflow

We would use a three-stage model for a firm that we expect to have three distinct stages of growth (e.g., a growth phase, a mature phase, and a transition phase).

Question 21

Prices multiple

Answer 21

Compare stock price multiple, help judge if overvalued, undervalued or properly valued in terms of measures such as earnings, sales, cashflow, or book value per share.

Question 22

Enterprise value multiples

Answer 22

Total value of a company, as reflected in the market value of its capital from all sources, to a measure of operating earnings generated, such as earnings before interest, taxes, depreciation, and amortization.

Question 23

Momentum indicators

Answer 23

Momentum indicators compare a stock’s price or a company’s earnings to their values in earlier periods.

Question 24

What is the formula for Dividend Yield (D/P) using trailing dividends?

Answer 24

Trailing D/P =
(4 × Most recent quarterly dividend) / Market price per share

Question 25

What is the formula for leading dividend yield (D/P)?

Answer 25

Leading D/P = Forecasted dividends over next 4 quarters / Market price per share

Question 26

What are two advantages of using dividend yield in valuation?

Answer 26

Contributes to total investment return Dividends are generally less risky than capital appreciation

Question 27

What are two disadvantages of relying solely on dividend yield?

Answer 27

Ignores capital appreciation Dividends may displace future earnings (Dividend Displacement Concept)

Question 28

: How is total return on an investment calculated?

Answer 28

Total Return = Dividend Yield + Capital Appreciation

Question 29

What does the justified dividend yield depend on?

Answer 29

Justified D/P = Required return (r) – Expected growth rate (g) → It is positively related to the required return → Negatively related to dividend growth rate

Question 30

How do you interpret a stock’s dividend yield relative to peers?

Answer 30

A higher dividend yield suggests the stock might be undervalued, assuming similar risk and growth expectations.

Question 31

What assumption is made about risk when comparing dividend yield to capital appreciation?

Answer 31

That dividends are less risky than capital gains—but this assumes market misjudgment in assessing return components.

Question 32

: What does a higher D/P imply in a value vs growth strategy context?

Answer 32

A higher D/P stock is generally seen as a value investment, while low or no D/P stocks are often growth-oriented.

Question 33

What is the formula for the trailing P/E ratio?

Answer 33

Trailing P/E = Market Price per Share / EPS over the past 12 months

Question 34

What is the leading P/E ratio?

Answer 34

Market Price per Share / Forecasted EPS over next 12 months

Question 35

What is the Molodovsky effect in P/E ratios?

Answer 35

P/Es are high during recessionary periods (low earnings) and low during booms (high earnings), creating a countercyclical pattern.

Question 36

What are normalized earnings and why are they important?

Answer 36

They estimate EPS in the middle of the business cycle, adjusting for cyclical fluctuations to reflect sustainable earning power.

Question 37

: What are the two methods to calculate normalized EPS?

Answer 37

Historical average EPS Average ROE × current BVPS (preferred due to size adjustments)

Question 38

When do analysts use Earnings Yield (E/P) instead of P/E?

Answer 38

When EPS is negative or volatile, making P/E meaningless.

Question 39

What does a high E/P ratio suggest?

Answer 39

The stock may be cheap/undervalued. A low E/P suggests the stock may be expensive.

Question 40

What are the two key variables that influence justified P/E?

Answer 40

Growth rate (g) — positively related Required return (r) — inversely related

Question 41

What is the formula for justified leading P/E using payout ratio?

Answer 41

Justified leading P/E = (Dividend payout ratio) / (r − g)

Question 42

What is the formula for justified trailing P/E?

Answer 42

Justified trailing P/E = (Payout ratio × (1 + g)) / (r − g)

Question 43

What’s the formula for justified P/B?

Answer 43

P/B = (ROE − g) / (r − g)

Question 44

What influences P/B the most?

Answer 44

Spread between ROE and r Higher ROE increases justified P/B

Question 45

What is the formula for justified P/S?

Answer 45

P/S = Net profit margin × (1 − b) / (r − g)

Question 46

What increases justified P/S?

Answer 46

Higher profit margin Higher growth Lower required return

Question 47

What is the formula for PEG ratio?

Answer 47

PEG = P/E / growth rate (in whole % form, not decimal)

Question 48

What is a “good” PEG ratio?

Answer 48

Generally, lower PEG = more attractive, assuming similar risk profiles.

Question 49

What are the limitations of PEG?

Answer 49

Assumes linear P/E-to-growth relationship Doesn’t account for risk Ignores duration of growth

Question 51

What is the formula for Enterprise Value (EV)?

Answer 51

EV = Market value of equity + market value of debt + preferred equity + minority interest - cash and investments

Question 52

What is EBITDA used for in valuation?

Answer 52

EBITDA is a pre-tax, pre-interest measure representing recurring operating performance; useful for capital-intensive firms.

Question 53

Formula for EV/EBITDA ratio

Answer 53

EV/EBITDA = Enterprise Value / EBITDA

Question 54

Why use EV/EBITDA over P/E?

Answer 54

EV/EBITDA is better for comparing firms with different financial leverage; EBITDA is usually positive even when EPS is not.

Question 55

Limitations of EV/EBITDA

Answer 55

Ignores working capital growth and capital expenditures; not linked as closely to valuation theory as FCFF.

Question 56

What are four definitions of cash flow used in P/CF?

Answer 56

1) Earnings + Noncash charges, 2) Adjusted CFO, 3) FCFE, 4) EBITDA

Question 57

What is FCFE?

Answer 57

Free Cash Flow to Equity = CFO - FCInv + Net Borrowing

Question 58

Formula for P/CF ratio

Answer 58

P/CF = Market Price per Share / Cash Flow per Share

Question 59

What is the Method of Comparables?

Answer 59

Valuation approach that compares a stock's multiple to a benchmark or peer group multiple.

Question 60

Key steps in using the method of comparables

Answer 60

1) Select the multiple, 2) Select the benchmark, 3) Compare, 4) Adjust for differences in fundamentals

Question 61

What does a lower P/E than the benchmark suggest?

Answer 61

The stock may be undervalued — if fundamentals like growth and risk are comparable.

Question 62

Importance of fundamentals in comparables

Answer 62

Only comparable if growth, risk, and other fundamentals are similar — otherwise, comparisons can mislead.

Question 63

How is terminal value calculated with a justified multiple?

Answer 63

Terminal Value = Justified P/E × Forecasted EPS

Question 64

How is terminal value calculated using comparables?

Answer 64

Terminal Value = Benchmark P/E × Forecasted EPS

Question 65

Strength of comparables approach for terminal value

Answer 65

Relies on market data, no need to estimate growth or discount rate.

Question 66

Weakness of comparables approach for terminal value

Answer 66

If the benchmark is mispriced, the terminal value will inherit the error.

Question 67

Main issues in cross-border valuation comparisons

Answer 67

Differences in accounting standards, risk profiles, cultures, and growth opportunities

Question 68

Which price multiple is least affected by accounting differences?

Answer 68

P/FCFE

Question 69

Which multiples are most affected by accounting choices?

Answer 69

P/B, P/E, EV/EBITDA, P/EBITDA

Question 70

What is an earnings surprise?

Answer 70

Earnings Surprise = Reported EPS − Expected EPS

Question 71

What is standardized unexpected earnings (SUE)?

Answer 71

SUE = Earnings Surprise / Standard deviation of earnings surprise

Question 72

What is a relative strength indicator?

Answer 72

A metric comparing a stock's price performance to its own history or to peers

Question 73

What is the rationale for momentum indicators?

Answer 73

Positive surprises or price momentum may lead to abnormal future returns

Question 74

What is the arithmetic mean of P/E ratios?

Answer 74

Sum of P/E ratios / Number of observations

Question 75

Why is arithmetic mean not suitable for portfolios?

Answer 75

It’s distorted by outliers and does not reflect actual portfolio valuation.

Question 76

Best measure of central tendency for portfolio P/E

Answer 76

Weighted Harmonic Mean of P/E ratios

Question 77

Formula for weighted harmonic mean of P/Es

Answer 77

1 / [Sum of (Weight_i / P/E_i)]

Question 78

When is the harmonic mean most appropriate?

Answer 78

When there are extreme values; it gives more weight to smaller ratios

Question 79

When are harmonic and weighted harmonic mean equal?

Answer 79

In an equally weighted portfolio