Study Session 12 - Equity Valuation

Question 1

Which cash flow and rate used for firm valuation

Answer 1

FCFE @ required return on equity

Equity value= Firm value - market value of debt

Question 2

General FCFF calculation

Answer 2

NI + Noncash charges + Interest * (1-tax rate) - Fixed Capital investment (capex) - Working Capital investment

Question 3

1) General Fixed Capital Investment calculation
2) If no long-term assets were sold during the year
3) If long-term assets were sold during the year

Answer 3

1) capex - proceed from sales of long-term assets
2) capex = ending gross PP&E - beginning gross PP&E
3) capex - proceeds from sale of long-term assets OR ending net PP&E - beginning net PP&E + depreciation - gain on sale + loss on sale

Question 4

FCFF calculation starting with CFO

Answer 4

CFO + interes*t(1-tax rate) FCInv

Question 5

FCFE calculation starting with FCFF

Answer 5

FCFF - interest*(1-tax rate) + net borrowing

Question 6

Calculating FCFF from EBIT

Answer 6

EBIT*(1-tax rate) + dep - FCInv - WCInc

Question 7

Calculating FCFF from EBITDA

Answer 7

EBITDA(1-tax rate) + dep tax rate - FCInv - WCInv

Question 8

Calculating FCFE from CFO

Answer 8

CFO - FCInv + net borrowing

Question 9

What to do if the stock has preferred shares…

Answer 9

treat them just like debt, except preferred dividend are not tax deductible

Question 10

Which cash flow and rate used for firm valuation

Answer 10

FCFF @ WACC

Question 11

FCFE vs Dividend discount model

Answer 11

FCFE takes a control perspective that assumes that recognition of value should be immediate

DDM take a minority perspective, under which value may not be realized until the dividend policy accurately reflects the firm’s long-run profitability

Question 12

2 methods of forcasting FCFE

Answer 12

1- apply a growth rate

2- using a target debt-to-assets ratio (DR)
FCFE= NI-(1-DR)(FCInv-Dep) - (1-DR)WCInv

Question 13

Effect of dividend, share repurchases, share issues, and changes in leverage on the future FCFE and FCFF

Answer 13

dividends, share repurchases and issues have no effect on FCFF and FCFE. Changes in leverage have only a minir effect on FCFE and no effect on FCFF

FCFF and FCFE represent cash flow available to investors and shareholders, respectively, before any financing decision

Question 14

2 method for focasting the terminal value in a multistage valuation model

Answer 14

1) apply a stable growth rate FCF/(r-g)

2) use a valuation multiple like P/E
terminal value= trailing P/E* earning in year n
“””” = leading P/E * forecasted earnings in year n+1

Question 15

Rationale for using P/E

Answer 15

• earnings power
• popular in the investment community
• empirical research shiws that its differences are significantly related to long-run average stock returns

Question 16

Shortcomings of P/E ratio

Answer 16

• earnings can be negative
• the volatile, transitory portion
• management discretion within allowed accounting practices

Question 17

Trailing and leading P/E

Answer 17

Trailing: Market price per shre/EPS past 12 mo

Leading: Market price per share/forecasted EPS over next 12 months

Question 18

advantages of P/B

Answer 18

• Book value is a cumulative amount that is usually positive, even when loss occur and negative EPS
• more stable than EPS
• approriate value of NAV fir firms that primarily hold liquid assets
• approriate ratio for expected out of business firms

Question 19

disadvantage of P/B

Answer 19

• do not reflect the value of intangible economic assets
• different accounting convention
• inflation and technological change

Question 20

P/B ratio

Answer 20

market value of equity/Book value of equity

book value of equity=
common shareholder’s
= total assets - total liabilities - pref. stock

Question 21

advantage of P/S

Answer 21

• meaningful even for distressed firms. always positive
• not easy to manipulate sales
• not as volatile as P/E
• approriate for stocks in matire or cyclical industries and star-up with no records of earnings

Question 22

disadvantage of P/S

Answer 22

• high growth in sales does not necessaraily inducate high operating profit
• dies nor capture differences in cost structure

Question 23

advantage of P/CF

Answer 23

• CF harder to manipulate than earnings
• more stable than P/
• handkes tge provlem of differences ibthe quality of reported earnings, which is a probkem for P/E

Question 24

Advantage of dividend yield D/P

Answer 24

• commonly used for valuing indexes

- contributes to total investment return

Question 25

trailing D/P | leading D/P

Answer 25

trailing: 4*most recent quarterlu div/market price per share leading: forecasted dividends over next four quarters/market price per share

Question 26

two method to normalize earnings

Answer 26

1- historical average EPS 2- average return on equity: Normalized EPS is eastimated as average ROE*BVPS. prefered because account for size effects

Question 27

justified trailing P/E calculation

Answer 27

P_0/E_0 = D_0*((1+g)/E_0)/(r-g) | = (1-b)*(1+g)/(r-g)

Question 28

justified leading P/E calculation

Answer 28

P_0/E_1= D_1/E_1/(r-g) = (1-b)/(r-g) or Trailing P/E / (1+g)

Question 29

justified P/B calculation

Answer 29

(ROE-g)/(r-g)

Question 30

sustainable growth calculation

Answer 30

ROE*retention ratio NI/Sales*Sales/assets*assets/equity*ret. ratio

Question 31

justified P/S calculation

Answer 31

(E_0/S_0)*(1-b)*(1+b)/(r-g)

Question 32

justified P/CF calculation

Answer 32

FCFF_0*(1+g)/(r-g)

Question 33

justified yield calculation

Answer 33

(r-g)/(1+g)

Question 34

three main limitation of a predicted P/E estimated from linear regression

Answer 34

- The predictive power of the estimated P/E regression for a different time period and/or sample of stocks is uncertain - The relationship between P/E and fundame tal variables examines may change over time - multicollinearity is often a problem, difficult to interpret

Question 35

PEG ratio calculation

Answer 35

P/E ratio / g

Question 36

drawback of PEG

Answer 36

relationship between P/E and g is not linear, which makes comparisons difficult doest not account for risk

Question 37

terminal calue in year n based on: leading P/E trailing P/E

Answer 37

justified leading P/E * forecasted earnings in year n+1 justified trailing P/E * forecasted earnings in year n

Question 38

adjusted CFO calculation

Answer 38

CFO+ bet cash interest outflow*(1-tax rate)

Question 39

entreprise value calculation

Answer 39

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

Question 40

EV/EBITDA is useful for:

Answer 40

may be more useful than P/E when comparing firms with different degrees of financial levrage useful for valuing capital-intensive businesses with high levels of depreciatio/ amortization usually positive even when EPS is not

Question 41

drawback of EV/EBITDA

Answer 41

if working capital is growing, it will overstate CFO

Question 42

earning surprise calculation

Answer 42

reported EPS - expected EPS

Question 43

standardized unexpected earnings (SUE) calculation

Answer 43

earnings surprise/standard deviation of earnings surprise

Question 44

the portfolio or index P/E is best calculated as..... weighted harmonic, mean, arithmetic, harmonic mean???

Answer 44

weighted harmonic mean P/E. 1/sommation(weight/(P/E)) page 213 volume 3

Question 45

economic value added (EVA) calculation

Answer 45

NOPAT-(WACC*total capital) = EBIT*(1-t)-$$WACC

Question 46

market value added (MVA) calculation

Answer 46

market value - total capital

Question 47

Residual income per share in year t calculation

Answer 47

E_t-(r*B_t-1) = (ROE-r)*B_t-1

Question 48

Intrinsic value of stock at time 0 using residual income

Answer 48

V_0= Book value_0 + RI1/(1+r)^1 + RI2/(1+r)^2 + RI3/(1+r)^3+....+RIn/(1+r)^n

Question 49

Value tends to be recognized earlier in the RI approach than in other present value-based approach. why?

Answer 49

because, for the other approach like DDM, a large portion of the estimated intrinsic value comes from the present value of the expected terminal value

Question 50

general formula for valuation with residual incone approach

Answer 50

V_0= Book value_0 + [(ROE-r)*B_0/(r-g)]

Question 51

Continuing residual income concept and calculation

Answer 51

it is the residuak income that is expected over the lobg term (kind of terminal value) PV of continuing residual income in year t-1= RI_t/(1+r-w) where w= persistence factor (between 0, high persistence, and 1, no persistence)

Question 52

higher and lower persistence factor in the continuing residual income

Answer 52

higher: low dividend, historically high persistence in the industry lower: high ROE, high accounting accruals, significant levels of nonrecurring items

Question 53

strenghts of residual income models

Answer 53

- terminal value does not dominate the intrinsic value estimate - use easy-to-find accounting data - does not need dividend or positive and stable FCF in tge short run - focus on exonomic profitability

Question 54

weakness of residual income models

Answer 54

- accounting data can be manipulated by management - numerous nd significant adjustment on accounting data - the model assume that the clean surplus hold

Question 55

Residual income models are not appropriate when:

Answer 55

clean surplus accounting relation is violated significantly uncertainty concerning the estimates of book value abd return on equity

Question 56

accounting issues in applying residual income models

Answer 56

``` clean surplus violations variations from fair value intangible asset effects on book value nonrecurring items and other aggressive accounting practices international accounting differences ```

Question 57

Discount for lack of control (DLOC) calculation

Answer 57

1-(1/(1+control premium))

Question 58

when we apply discount for lack of marketability (DLOM)?

Answer 58

when a interest in a firm cannot be easily sold

Question 59

total discount with DLOC and DLOM

Answer 59

total discount = 1-[(1-DLOC)(1-DLOM)]