Equity

Question 1

Mispricing by analyst

Answer 1

IV_analyst − price = (IV_actual − price) + (IV_analyst − IV_actual)

Question 2

Investment value

Answer 2

Investment value is the value of a stock to a particular buyer. Investment value may depend on the buyer’s specific needs and expectations, as well as perceived synergies with existing buyer assets.

Question 3

Valuation

Answer 3

Valuation is the process of estimating the value of an asset by

1. Using a model based on the variables the analyst believes influence the fundamental value of the asset or
2. Comparing it to the observable market value of “similar” assets.

Question 4

5 elements of industry structure (Porter’s five forces)

Answer 4

1. Threat of new entrants in the industry.
2. Threat of substitutes.
3. Bargaining power of buyers.
4. Bargaining power of suppliers.
5. Rivalry among existing competitors.

Question 5

3 strategies to compete and generate profits

Answer 5

1. Cost leadership
2. Product differentiation
3. Focus

Question 6

Categories of quality of earnings issues

Answer 6

1. Accelerating or premature recognition of income
2. Reclassifying gains and nonoperating income
3. Expense recognition and losses
4. Amortization, depreciation, and discount rates
5. Off-balance-sheet issues

Question 7

Absolute vs. relative valuation model

Answer 7

• An absolute valuation model is one that estimates an asset’s intrinsic value, which is its value arising from its investment characteristics without regard to the value of other firms.
  
  • Dividend discount models estimate the value of a share based on the present value of all expected dividends discounted at the opportunity cost of capital.
  • Free cash flow approach and the residual income approach. Expand the measure of cash flow to include all expected cash flow to the firm that is not payable to senior claims.
  • Asset-based models. Estimates a firm’s value as the sum of the market value of the assets it owns or controls. Commonly used to value firms that own or control natural resources.
• Relative valuation model is to determine the value of an asset in relation to the values of other assets. This is the approach underlying relative valuation models. The most common models use market price as a multiple of an individual financial factor of the firm, such as earnings per share.

Question 8

Sum-of-the-parts valuation

Answer 8

Rather than valuing a company as a single entity, an analyst can value individual parts of the firm and add them up to determine the value for the company as a whole. The value obtained is called the sum-of-the-parts value, or sometimes breakup value or private market value. This process is especially useful when the company operates multiple divisions (or product lines) with different business models and risk characteristics (i.e., a conglomerate).

Question 9

Conglomerate discount

Answer 9

Conglomerate discount is thus the amount by which market value under-represents sum-of-the-parts value. It is based on the idea that investors apply a markdown to the value of a company that operates in multiple unrelated industries, compared to the value a company that has a single industry focus.

Three explanations for conglomerate discounts are:

• Internal capital inefficiency
• Endogenous (internal) factors
• Research measurement errors

Question 10

Bottom-up, Top-down, and Hybrid

Answer 10

• Bottom-up analysis starts with analysis of an individual company or its reportable segments.
• Top-down analysis begins with expectations about a macroeconomic variable, often the expected growth rate of nominal GDP.
• A hybrid analysis incorporates elements of both top-down and bottom-up analysis. A hybrid analysis can highlight any inconsistencies in assumptions between the top-down and bottom-up approaches. It’s the most common type.

Question 11

Primary determinants of gross interest expense

Answer 11

The primary determinants of gross interest expense are the level of (gross) debt and market interest rates.

Question 12

Net debt

Answer 12

Net debt is gross debt minus cash, cash equivalents, and short-term securities.

Question 13

Net Interest expense

Answer 13

Net interest expense is gross interest expense minus interest income on cash and short-term debt securities

Question 14

3 primary tax rates

Answer 14

• Statutory rate is the percentage tax charged in the country where the firm is domiciled
• Effective tax rate is income tax expense as a percentage of pretax income on the income statement
• Cash tax rate is cash taxes paid as a percentage of pretax income.

Question 15

Return on invested capital (ROIC)

Answer 15

ROIC is a return to both equity and debt and is preferable to return on equity (ROE) in some contexts because it allows comparisons across firms with different capital structures. Firms with higher ROIC (relative to their peers) are likely exploiting some competitive advantage in the production and/or sale of their products.

Return on capital employed, is similar to ROIC but uses pretax operating earnings in the numerator to facilitate comparison between companies that face different tax rates.

Question 16

Dividend discount models

Answer 16

• Advantage
  
  • It is theoretically justified
  • DIvidends are less volatile than other measures
• Disadvantage
  
  • It is difficult to implement for firms that don’t currently pay dividends
  • It takes the perspective of an investor who owns a minority stake in the firm and cannot control the dividend policy.
• Dividends are appropriate as a measure of cash flow when:
  
  • The company has a history of dividend payments.
  • The dividend policy is clear and related to the earnings of the firm.
  • The perspective is that of a minority shareholder.

Question 17

Free cash flow models

Answer 17

Free cash flow models are appropriate:

• For firms that do not have a dividend payment history or have a dividend payment history that is not clearly and appropriately related to earnings.
• For firms with free cash flow that corresponds with their profitability.
• When the valuation perspective is that of a controlling shareholder.

Question 18

Residual income approach

Answer 18

The residual income approach is most appropriate for:

• Firms that do not have dividend histories.
• Firms that have negative free cash flow for the foreseeable future (usually due to capital demands).
• Firms with transparent financial reporting and high quality earnings.

Question 19

Present value of growth opportunities (PVGO)

Answer 19

The value of a firm’s equity has two components:

1. The value of its assets in place (E₁/r), which is the present value of a perpetual cash flow of E₁ .
2. The present value of its future investment opportunities (PVGO)

A substantial portion of the value of growth companies is in their PVGO. Companies in slow-growth industries have low PVGO, and most of their value comes from their assets in place.

Question 20

Justified P/E

Answer 20

• Leading P/E: based on the earnings forecast for the next period
• Trailing P/E: based on the earnings or the previous period

Question 21

H-Model

Answer 21

the growth rate starts out high and then declines linearly over the high-growth stage until it reaches the long-run average growth rate.

Question 22

Growth Transition and Maturity Phase

Answer 22

Question 23

Firm value and equity value

Answer 23

• firm value = FCFF discounted at the WACC
• equity value = FCFE discounted at the required return on equity = firm value − market value of debt

Question 24

Two approaches to forecast future FCFF and FCFE

Answer 24

• 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.
• The second method is to forecast the underlying components of free cash flow and calculate each year separately. In forecasting FCFE with the second method, it is common to assume that the firm maintains a target debt-to-asset ratio for net new investment in fixed capital and working capital.

Question 25

Enterprise value multiples

Answer 25

Enterprise value multiples relate the 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 26

Momentum indicators

Answer 26

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

Question 27

P/E ratio pros & cons

Answer 27

Pros: * 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. Cons: * Earnings can be negative, which produces a meaningless P/E ratio. * The volatile, transitory portion of earnings makes the interpretation of P/Es difficult for analysts. * Management discretion within allowed accounting practices can distort reported earnings, and thereby lessen the comparability of P/Es across firms.

Question 28

P/B Ratio Pros and Cons

Answer 28

Pros * Book value is a cumulative amount that is usually positive, even when the firm reports a loss and EPS is negative. Thus, a P/B can typically be used when P/E cannot. * 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. Examples include finance, investment, insurance, and banking firms. * 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. Cons * P/Bs do not reflect the value of intangible economic assets, such as human capital. * P/Bs can be misleading when there are significant differences in the asset size of the firms under consideration because in some cases the firm’s business model dictates the size of its asset base. * Different accounting conventions can obscure the true investment in the firm made by shareholders, which reduces the comparability of P/Bs across firms and countries. * Inflation and technological change can cause the book and market values of assets to differ significantly, so book value is not an accurate measure of the value of shareholders’ investment.

Question 29

P/S Pros and Cons

Answer 29

Pros * P/S is meaningful even for distressed firms, since sales revenue is always positive. This is not the case for P/E and P/B ratios, which can be negative. * Sales revenue is not as easy to manipulate or distort as EPS and book value, which are significantly affected by accounting conventions. * 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. It is also often used to value investment management companies and partnerships. * Like P/E and P/B ratios, empirical research finds that differences in P/S are significantly related to differences in long-run average stock returns. Cons * High growth in sales does not necessarily indicate high operating profits as measured by earnings and cash flow. * P/S ratios do not capture differences in cost structures across companies. * While less subject to distortion, revenue recognition practices can still distort sales forecasts.

Question 30

P/CF Ratio Pros and Cons

Answer 30

Pros: * 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. Cons: * Items affecting actual cash flow from operations are ignored when the EPS plus noncash charges estimate is used. For example, noncash revenue and net changes in working capital are ignored. * From a theoretical perspective, free cash flow to equity (FCFE) is preferable to operating cash flow. However, FCFE is more volatile than operating cash flow, so it is not necessarily more informative.

Question 31

Dividend yield Pros and Cons

Answer 31

Pros * Contributes to total investment return * Dividends are not as risky as the capital appreciation component of total return Cons * Focus is incomplete because it ignores capital appreciation * 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

Molodovsky Effect

Answer 32

The countercyclical tendency to have high P/Es due to lower EPS at the bottom of the cycle and low P/Es due to high EPS at the top of the cycle is known as the Molodovsky effect.

Question 33

Normalized (or normal) earnings per share

Answer 33

Estimate of EPS in the middle of the business cycle; Two methods are used to normalize earnings: * Historical average EPS: average EPS over recent business cycle, ignores size effect. * Average return on equity: average ROE multiplied by the current book value per share, reflects the effect of firm size changes. Average return on equity approach is preferred, because it takes the firm size into account,

Question 34

Limitations of predicted P/E

Answer 34

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

Question 35

Fed Model

Answer 35

Fed model considers the overall market to be overvalued (undervalued) when the earnings yield (i.e., the E/P ratio) on the S&P 500 Index is lower (higher) than the yield on 10-year U.S. Treasury bonds.

Question 36

Yardeni Model

Answer 36

CEY = CBY − k × LTEG + ε_i where: CEY = current earnings yield of the market CBY = current Moody’s A-rated corporate bond yield LTEG = five-year consensus earnings growth rate

Question 37

P/E-to-growth (PEG) ratio

Answer 37

* = PE Ratio / g * Standardizes the P/E ratio for stocks with different expected growth rates. * Drawbacks: * The relationship between P/E and g is not linear, which makes comparisons difficult * The PEG ratio still doesn't account for risk * The PEG ratio doesn't reflect the duration of the high-growth period for a multistage valuation model, especially if the analyst uses a short-term high-growth forecast.

Question 38

4 definitions of cash flow available for calculating P/CF ratio

Answer 38

1. Earnings-plus-noncash-charges (CF) * CF = net income + depreciation + amortization 2. Adjusted cash flow (adjusted CFO) 3. Free cash flow to equity (FCFE) 4. Earnings before interest, taxes, depreciation, and amortization (EBITDA)

Question 39

EV/EBITDA pros and cons

Answer 39

Pros * The ratio may be more useful than P/E when comparing firms with different degrees of financial leverage. * EBITDA is useful for valuing capital-intensive businesses with high levels of depreciation and amortization. * EBITDA is usually positive even when EPS is not. Cons * If working capital is growing, EBITDA will overstate CFO. Further, the measure ignores how different revenue recognition policies affect CFO. * Because FCFF captures the amount of capital expenditures, it is more strongly linked with valuation theory than EBITDA. EBITDA will be an adequate measure if capital expenses equal depreciation expenses.

Question 40

Adjustments for calculating NOPAT and invested capital

Answer 40

* Capitalize and amortize research and development 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 deferred taxes and consider only cash taxes as an expense. * 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 41

Persistence factor

Answer 41

The projected rate at which residual income is expected to fade over the life cycle of the firm is captured by a persistence factor, ω, which is between zero and one. * Higher persistence factors will be associated with the following: * Low dividend payouts. * Historically high residual income persistence in the industry. * Lower persistence factors will be associated with the following: * High return on equity. * Significant levels of nonrecurring items. * High accounting accruals.

Question 42

Assumptions about continuing residual income at the end of the short-term period

Answer 42

* Residual income is expected to persist at its current level forever. ω = 1 * Residual income is expected to drop immediately to zero. ω = 0 * Residual income is expected to decline over time as ROE falls to the cost of equity (in which case residual income is eventually zero). ω is between 0 and 1. * Residual income is expected to decline to a long-run average level consistent with a mature industry.

Question 43

Common definitions of value

Answer 43

* Fair market value: used for tax purposes in the US and based on an arm's length transaction * Fair value for financial reporting or litigation: similar to fair market value and used for financial reporting or legal purposes. * Market value: use in real asset appraisals for a particular date characterized by well-informed parties * Investment value: in contrast to the previous definitions that were market-based, this is the value to a particular buyer * Intrinsic value: the "true value derived from investment analysis.

Question 44

Three major approaches to private company valuation

Answer 44

1. INcome approach: values a firm as the present value of its expected future income based on a variety of different assumptions and variations 2. Market approach: values a firm using the price multiples based on recent sales of comparable assets 3. Asset-based approach: values a firm's assets minus its liabilities.

Question 45

Strategic and nonstrategic transactions

Answer 45

* Strategic transaction: valuation of the firm is based in part on the perceived synergies with the acquirer's other asset * Financial (nonstrategic) transaction assumes no synergies, as when one firm buys another in a dissimilar industry.

Question 46

Excess earning method

Answer 46

* Firm value = value of working capital + value of fixed assets + value for the intangible assets * Value of the intangible assets = present value of the growing stream of excess earnings using the excess earnings and growing perpetuity formula * Excess earning = firm earnings - earnings required to provide the required rate of return on working capital and fixed assets.

Question 47

Guideline Public Company Method

Answer 47

* The guideline public company method (GPCM) uses price multiples from trade data for public companies, with adjustments to the multiples to account for differences between the subject firm and the comparables. * When evaluating a controlling equity interest in a private firm, the control premium (i.e., the value of control) should be estimated. When estimating a control premium, the following issues should be considered: * Transaction type: A financial transaction typically has a smaller price premium than a strategic transaction * Industry conditions * Type of consideration * Reasonableness