# CFA 3.txt

### Card Set Information

 Author: Anonymous ID: 165544 Filename: CFA 3.txt Updated: 2012-08-10 10:40:07 Tags: CFA Folders: Description: CFA 3 Show Answers:

Home > Flashcards > Print Preview

The flashcards below were created by user Anonymous on FreezingBlue Flashcards. What would you like to do?

1. Rationale for D0/P0 (2 good, 2 bad)
Good

1) dividend yield is a component of total return

2) dividends are a less riksy component of total return than capital apprec

1) just one component of total return

2) dividends paid now displace earnings in all future periods (dividend displacement of earnings)
2. Market Dividend Yield (D/P) trailing and leading equs
trailing D/P = [4 x most recent quarterly DIV] / market price per share

leading D/P = [next 4 quarters forecasted DIV] / market price per share

*for practical purposes, D/P is preferred over P/D (zero dividends a problem)
3. Justified Dividend Yield equ
D0/P0 = (r-g) / (1+g)
4. Fundamental factors affecting (3+)
increases

required return increaeses (price falls)

high growth rate decreases the firms payout and therefore the firm is less able to pay dividends which results in a lower D/P ratio

high D/P strategy = value strategy
5. momentum indicators (def and Equ)
momentum indicators based on price, such as the relative strength indicator, have also been referred to as technical indicators

unexpected earnings (also called earnings surpise) is the difference between reported earnings and expected earnings

UEt = EPSt - E(EPSt)
6. Standardized Unexpected Earnings equ
SUEt = (EPSt - E(EPSt)) / [EPSt - E(EPSt)]σ

unexpected earning / usual expected earnings
7. simple harmonic mean (def)
harmonic mean: less affected by large, more by small, outliers

-lower value than arithmetic mean (unless all observations are the same value)

-used when market weight information unavailable
8. Weighted harmonic mean def + advantage
weighted harmonic mean: effect of outliers dependson market value weight

major advantage: corresponds to portfolio value
9. stock screens ( def, benefits 1 and limitations 2)
applies set of criteria to narrow possible investments to those meeting criteria

fundamental criteria: multiples, momentum indicators

individual securities, industries, economic sectors

benefit: efficient means of narrowing investment universe

limits: 1) little control over calc of inputs in most commericial screening software

2) lack of qualitative factors
10. Residual income (def 4)
Equivalent to economic profit

RI = net income less opportunity cost of equity capital

RI = Net income - (equity capital x cost of equity) [for equity]

alternatively, using a pre-levered figure:

RI = EBIT (1-t) - (total capital x WACC%) [for entire firm]

accounting income will overstate returns from equity investor perspective because it ignores cost of equity

residual income explicitly deducts all capital costs of both debt and equity
alternative RI measure

EVA = NOPAT - (WACC% - total cap)

recall, NOPAT = EBIT (1-t)

positive EVA - management is adding value
alternative RI measure

MVA measures the effect on value of management's decisions since the firm's inception

MVA = market value of firm - invested capital

evaluate the change in MVA over time
13. RI Approach to Valuation
14. Future RI (3 methods)
15. Difference in value recognition: RI vs. DCF model (3)
value is recognized earlier in RI. Therefore less sensitive to terminal value estimates

BV0 usually represents a large percentage of intrinsic value

in the DDM or FCF model, terminal value is most of the value estimate, which is subject to substantial forecasting risk due to the forecast horizon and the relationship between r and g
16. value drivers of residual income (2)
main point: if ROE > required return

RI will be positive

justified market to book >1

If ROE = returned return

justified market value = book value

market-to-book ratio = 1
17. Single-Stage RI valuation (2 assumptions and equ)
• single-stage RI assumes:

-constant ROE

-Constant earnings growth
18. Continuing Residual Income (Def)
expected RI beyond the estimation horizon

depends on firm's ability to generate ROE > r, premium over BV

Measured by persistance

persistance factor = ω, between 0 and 1

higher persistance (closer to 1) means longer period where ROE > r

Higher ω means higher firm valuation
19. factors of ω (2 up, 3 down)
higher ω:

low dividend payout

high RI industry persistence

lower ω:

High ROE

Large special items

large accounting accruals
20. multi-stage residual income model
instrinsic value = sum of 3 components

v0 = b0 + (PV high-growth RI) + (PV cont. RI)

1) calc current BV

2) calc RI for years 1 through T-1

3) calc continuing RI as:

PV (cont RI in yr T-1) = RIT / [1 + r - ω]
21. Continuing RI if ω = 1
calc in perpituity

PV (cont RI in year T-1) = RIT / r
22. Continuing RI if mature industry
market value = value + PV (cont RI in yr. T)

PV (cont RI in yr. T) = PT - BT

PV (cont RI in yr. T-1) = [(PT - BT) + RIt ]/ (1+r)
23. 5 strenghts of residual income model
1) terminal value does not dominate intrinsic value estimate

2) accounting data usually accessible

3) applicable even without dividends or positive cash flow

4) applicable even when cash flows are volatile or unpreditable

5) focus on economic profitability
24. 3 weaknesses of residual income model
1) accounting data can be manipulated by management (book value)

-off balance sheet items

-non-recurring items on income statement

- aggressive accounting practices

- international accounting differences

3) assumes clean surplus relation holds or that its failure to hold has been taken into account:
25. Clean surplus (def and violations (5)
Bt = Bt-1 + Et - Dt

book value today = book value yesterday + earnings - dividends

problem: that equ is not always true

1) FX translation gains/losses

2) balance sheet adjustments to fair value

3) pension liability

4) unrecognized g/s on available for sale securities

5) deferred g/l on cash flow hedges
26. Private vs. Public companies - Company specific factors -7
Stage of lifecycle

size

quality/depth of management

management/shareholder overlap

short-term investors

quality of information

taxes
27. Private vs. Public companies - firm specific factors -3
liquidity

restrictions of liquity

concentration of control
28. Reasons for valuing private companies 3
transactions - venture cap, IPO, sale, bankruptcy, stock-based comp

Compliance - financial reporting, taxes

litigation - shareholder suits, damage claims, lost profits, divorces
29. 3 approaches to valuation
income: PV of future income (DCF)

market: price multiples of comps

asset-based: assets - liabilities
30. 7 normalized earnings adjustments for private firms
1) nonrecurring and unusual items

2) discretionary expenses

3) non-market comp levels

4) personal expenses

5) real estate expenses

6) non-market lease rates

31. 5 issues in cash flow estimation - private
1) controlling vs. noncontrolling interests

2) scenario analysis

3) life cycle stage

4) management biases

5) capital structure changes
32. 3 income approach methods
Free cash flow

capitalized cash flow

excess earnings
33. Free cash flow method - private valuation
PV (discrete CFs plus a terminal value)

terminal value

-constant growth model

- price multiple approach

potential double counting of high growth
34. capitalized cash flow method - 2 equ
Gordan growth model variation

value of the firm = FCFF1 / (WACC - g)

value of equity = FCFE1 / (r-g)
35. excess earnings method
working capital + fixed assets + value of residual income going forward
36. discount rate estimation elements 5

available and cost of debt

acquirer vs target

projection risk

lifecycle stage
37. Discount rate models
CAPM

expanded CAPM

build-up approach

-size

-company-specific risk

-industry risk
38. estimating WACC (2)
Current vs. optimal capital structure (probably optimal)

public vs. private firm debt capacity and cost
39. Market approaches to valuation - 3
1) guideline public company method - multiples of public firms

value of firm = multiple x EBITDA

Value of equity = Value of Firm - Debt

2) guideline transactions method - use multiples of sales of entire firms

-data may not be available or accurate

3) prior transaction method - historical sales from subject firm

- same motivations, arms-length transactions, etc.
40. Asset-based approach - def and when used
not used for going concerns

usually lowest valuation

difficulties in valution of special assets, intangibles, etc

used for troubled firms, finance firms, investment companies, firms with few intangibles, natural resource firms
41. Discount for Lack of Control (DLOC) equ
estimate using Reported Earnings instead of normalized earnings or:

DLOC = 1 - [ 1/1+ control premium]

ex) if control prem is 22%

DLOC = 1- 1/1.022 = 18%
42. DLOM (marketing) varies with 5 things
likelihood of IPO, firm sale, dividends

asset duration

contractual restrictions

asset risk
43. estimating DLOM

pre-IPO vs post-IPO prices

put prices
44. Total discount of DLOM and DLOC (equ)
total discount = 1- [(1-DLOC)(1-DLOM)]
45. valuing real estate investments (equ)
46. 1) main value determinants

2) investment characteristics

3) principal risks

4) most likely investor

Raw land
apartments
office buildings
warehouses
shopping centers
hotel/motel
47. 3 steps to calc CFAT
1) compute taxes payable

taxes = (NOI - deprec - interest) x tax rate

2) compute CFAT

CFAT = NOI - debt service - taxes

3) compute equity reversion after taxes

ERAT=selling price - selling costs - mortgate balance - taxes on sale

2 kinds of taxes on sale: capital gains and depreciation reversion
48. Problems with IRR (2)
Multiple IRRs: due to changing signs of cash flows very common with property repairs

Ranking conflicts due to : size differences/timing of cash flows

solution: use the NPV mothod and select with positive NPV
49. Income Property - Market Value equ
MV0=NOI1/R0 where R0=market cap rate or (r-g)
50. 3 ways to find capitalization rate
1) Market extraction method (comparables)

2) band-of-investment method

-BOI method uses a WACC as an estimate

-uses a sinking fund factor

3) build-up method
51. BOI Method (equ)
52. Gross income multiplier technique
multiplier (M) from comp properties

M = sales price / gross income

MV = gross income x income multiplier
53. Limitations of Gross income multiplier technique
infrequent sales data

lack of info

use of gross rent
54. sources of value creation in PE
reengineer firm for more efficient operations

parallel goal alignment between management and PE owners
55. Alignment of economic interests
comp tied closely to performance and promote goal achievement

tag-along clause-mgmt has exit rights if firm sells its stake
56. Components of performance from a leverage buyout
exit value = investment cost + earnings growth + multiple expansion + reduction in debt

not valuation but max price determination to pay upfront and forecasted exit value

earnings growth due to operataional efficiencies

increase in price multiple due to increased growth

apply scenario analysis to forecasts
57. Exit routes for PE (3)
1) IPO

highest exit value, higher liquidity

less flexible, more costly and complex

2) secondary market sale: sale from one firm to another

3) management buyout: firm sold to management with significant use of leverage

4) liquidation: outright sale of firm's assets, firm no longer viable
58. DCF (equ)
V0 = sum of CFt/(1+r)^r
59. free cash flow (def)
cash available to pay shareholders
60. residual income (def)
economic profit, earnings in excess of the investors' required return on the beginning-of-period investments
less volatile than other cash flow measures

theoretically justified - dividends are what you receive when you buy a stock

accounts for reinvested earnings to provide a basis for increased future dividends
non-dividend paying firms

dividends artifically small for tax reasons

dividends may not reflect th control perspective desired by the investor
63. DDM suitability (4)
company has history of paying dividends

board has dividend policy that has an understandable and consistent relationship to profitability

minority shareholder takes a non-control perspective

mature firms, profitable but not fast growth
64. FCFF (def)
cash available to shareholders and bondholders after taxes, capital investment, and WC investment
65. FCFE (def)
cash available to equity holders after payments to and inflows from bondholders
66. DDM (3 steps to use)
process: discount the future dividends at the required rate of return

step 1: estimate future dividends

step 2: determine required return

step 3: value = PV (expectd dividends)
67. single period DDM (equ)
68. Multiple-period DDM (equ
69. DDM assumptions for future growth (4)
1. constant growth (gordan model)

2. two stage growth

3. h-model

4. other assumptions
70. PVGO (def and equ)
PV of Growth opportunities

equity value has two components

1. value of no growth firm (E1/r) (i.e. assets/earnings currently in place)

2. PV of future growth opportunties (PVGO)

model: P0 = E1/r +PVGO

or

P0/E1=1/r + PVGO/E1
71. Gordan growth for P/E (equ)
P0/E1 = (1-b)/(r-g)
72. PV of preferred stock (equ)
CF/r
73. 3 phases of growth (DDM)
1)initial growth phase - use 3-stage model

rapid EPS growth, negative FCF

2) transitional phase - use 2-stage/H model

sales and EPS growth slow, div increase

ROE approaching r, positive FCF

3) mature phase - Use GGM

growth at economy-wide rate, positive FCF

ROE = r, high competition, saturation
74. Terminal Value (def, 2 methods)
terminal value = forecasted value at beginning of the inal mature growth phase, aka future sales price

2 estimation methods

1) apply trailing multiple (P/E) x forecasted EPSt in year t

2) GGM
75. 2 stage DDM (assumptions)
first: fixed period of supernormal growth

then: indefinite growth at normal level

patent expiration, etc.

assumes drop-off in growth
76. h-model (def and equ)
77. 3-stage with h-model (def)
high-growth phase + h-model pattern
78. strengths and weaknesses of multi-period models (5)
strengths

ability to model many growth patterns

solve for V, g, and r

weaknesses:

require high quality inputs

value estimates sensitive to g and r

model suitability very important
79. 3.5 ways to find require return ®
CAPM

APT

GGM (half)

build up
80. growth rate ®
g = rr x roe

retention rate (rr) x NI/SE
81. 3-part ROE equ
Net profit margin x asset turnover x equity multiplier

net income/sales x sales/assets x assets/equity
82. Firm value (equ)
Firm value = FCFF discounted at WACC
83. equity value (equ)
equity value = FCFE discounted at required return on equity - r
84. Ownership perspective (FCFE vs. DDM)
FCFE = control perspective

-ability to change dividend policy

-used in control perspective

DDM = minority owner

-no control

-used in valuing minority position in publicly traded shares
85. NI, NCC, Int(1-t), FCInv, Wcinv, Net borrowing (define all)
Net income to common shrholders, after preferred div, but before common dividends

non-cash charges, depreciation, and amortization

after tax expense

net fixed capital investment (proceeds from sales less CapEx)

working capital investment

net borrowing = new debt - repayments
86. calculating FCF chart
87. Non-cash charges (def)
represent adjustment for non-cash decreases and increases in net income based on accrual accounting, but did not result in an outflow of cash

-if non-cash charges decrease net income, add back to net income

-if non-cash charges increase net income, subract from net income
88. Increase in WCInv -> decrease FCF

assets

liabilities

Inventory

A/R

A/P

Accrued taxes & expenses
89. Change in net PP&E
Beginning net PP&E

-depreciation

+ Assets purchased (solve)

-Book value of assets sold

Ending net PP&E

*gross ignores depreciation
90. FCFF equ
FCFF = NI + NCC + Int(1-t) - WCInv - FCInv
91. FCFE equ x 5
FCFE = FCFF - Int(1-t)+net borrowing

FCFE = EBITDA(1-t)-INT(1-t)+NCC(t)-WCInv-FCInv+net borrowings

FCFE=EBIT(1-t)-Int(1-t)+NCC-WCInv-FCInv+Net borrowings

FCFE=CFO - FCInv + net borrowings

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

there is only one value for FCFF and only one value for FCFE

the various equations are all different ways to get to same value
92. 2 approaches to forecast FCF
1)historical: most common

estimate FCF for current period

apply growth rate FCF x (1+g)^n

2) forecast components of FCF

-forecast each underlying component

-realistic and flexible but time consuming
93. 3 reasons why NI is poor proxy for FCFE
NI is an accrual concept not cash flow

net income recognizes non-cash charges such as depreciation, amortization, and gains on sale of equipment

NI fails to recognize the cash flow impact of investments in working capital and net fixed assets and net borrowings
94. 3 reasons why EBITDA is a poor proxy for FCFF
EBITDA doesn't reflect taxes paid

EBITDA ignores effect of depcreciation tax shield

EBITDA does not account for needed investments in working capital and net fixed assets for going concern viability
95. Single Stage FCFF model
useful for stable firms in mature industries

analogous to gordan growth model

Firm value0=FCFF1/(WACC-g)
96. Single stage FCFE model
similar to FCFF/GGM

often used with int'l firms, especially in high-inflation

equity value = FCFE1/(r-g)
97. Multi-stage models (four variations)
1) FCFF or FCFE?

2) 2 stages or 3

3) total FCF or components of FCF?

4) Terminal value via GGM or P/E
98. P/E Ratio Rationale as Valuation (4 good 4 bad)
Earnings power key to investment value

focal point for wall street

diff in P/E may be related empirically to diff in long-run stock returns

ratio can be used as a proxy for risk and growth

Drawbacks:

negative and very low earnings makes P/E useless

volatile or transitory earnings make interpretation difficult

managemnet discretion on accounting choices can distort earnigns

solely using the ratio avoids addressing the fundamentals
99. Trailing P/E0
Uses EPS from last year

p0/e0 = market price per share / EPS last 12 months
uses forecasted earnings for coming year

P0/E1=Market price per share / forecast EPS next 12 months
101. Problems with Trailing P/E (4)
1) transitory, non-recurring components of earnings that are company-specific

2) cyclicality components of earnings due to business or industry trends

3) differences in accounting methods

4) potential dilution of EPS
102. Underlying earnings (def and 4 steps)
Remove nonrecurring items from earnings for forecasting purposes

1) gains/losses on asset sales

2) asset write-downs - impairment

3) loss provisions

4) changes in accounting estimates

result: persistent, continuing and core earnings
103. normalized earnings (def and 2 methods)
adjust EPS to remove cyclical component of earnings and capture mid-cycle or an average of earnings under normal market conditions

1) method of historical average EPS - just take average of EPS each year

2) method of average ROE: average ROE x current Book Value per share
104. Earnings Yield - problem and solution
problem: negative earnings make P/E ratio meaningless

solution: substitute E/P (inverse)

-price is never negative

-high E/P suggests cheap security

- low E/P suggests expensive security
105. Justified price multiple
justified multiple = the ratio of value from any DCF model to earnings, book value, sales or cash flow

use gordan growth model to derive justified multiples and identify determinants

P0 = D1 / (r-g)

justified leading P0/E1 = (D1/E1) / (r-g) = (1-b) / (r-g)

higher payout (1-b), greater multiple

higher growth, higher multiple

higher risk, lower multiple
107. Justified Trailing P/E0
[(1-b)*(1+g)] / (r-g)
108. Fundamental factors affecting justified P/E (2)
P/E positively related to growth rate and payout, all else equal

-assumes no interaction between g, payout, and ROE

- recall g=ROE x (1-div/EPS)

P/E inversely related to required return (real rate, inflation, and equity risk premium), all else equal
109. Using regression comparable P/E problems (4)
only useful if large data set

changing relationships

multicollinearity

unknown predictive power
110. PEG Ratio (def / equ)
calcs a stock's P/E per unit of expected growth

lower PEG - more attractive valuation

PEG = (P/E)/G
111. PEG Ratio does not account for (3)
differences in firm risk attributes

differences in the duration of growth

non-linear relationship between growth and the P/E ratio
112. Terminal value estimation (2 way to find)
terminal value = (trailing P/E) x (earnings forecast)

or through GGM

2 methods to find trailing P/E

1) fundamentals: requires estimates of g, r, and payout

2) comparables: uses market data to calc benchmark
113. price to book ratio (P/B0) (Def+BVPS)
Book value per share attempts to represent the investment that common shareholders have made in the company

BVPS is calculated as common equity divided by number of shares outstanding
114. P/B ratio (5 good 4 bad)
good

• 1) usually positive
• 2) less volatile than EPS
• 3) good for firms with mostly liquid assets
• 4) useful for distressed firms
• 5) differences in P/B ratios explain differences in long-run average returns

1) doesn't reflect intangible asets

2) misleading when comparing firms with significant differences in asset size

3) different accounting conventions obscure comparability

4) inflation and technological change can cause big differences between BV and Market Value
115. P/B ratio (equ)
P/B ratio = market value of equity / book value of equity

=market price per share / book value per share
116. Justified P0/B0 ratio
P0/B0 = (ROE - g) / (r-g)

spread between ROE and r really drives this
117. fundamental factors affecting Justified P/B (3)
(ROE - r)

-larger spread = value creation = higher market value

compare to residual income model

intuition: firms that earn ROE = r will have a P/B of 1
118. price to sales (5 good 3 bad)
good

1) P/S useful for distressed firms

2) Sales revenue is always positive

3) sales are generally more stable and less prone to distortion than EPS over time

4) P/S useful for mature, cyclical, and zero-income stocks

5) related to long-term returns

1) high sales growth not translate to profitability

2) P/S ratio does not capture different cost structures between firms

3) revenue recognition methods distort reported sales and forecasts
119. P/S equ (3)
market value of equity / total sales

market price per share / sales per share

P0/S0 = [(E0/S0) x (1-b) x (1+g)] / (r-g)

e0/s0 = profit margin

payout = 1-b

required return = r

sustainable growht rate = g

aka Net profit margin x trailing PE ratio
120. Fundamental movers of P/S ratio (3 good 4 bad)
increases:

current profit margin improves

sustainable growth increases

risk falls

decreases:

profit margin decreases

risk increases

inflation increases

growth decreases
121. P/CF rationale (4 good, 4 bad)
good

1) more difficult to manipulate CF than EPS

2) cash flow if more stable

3) addresses quality of earnings prob

4)P/CF may explain differences in returns

1) earnings plus non-cash charges approach ignores some cash flows such as net fixed investments, working capital investment, and net borrowings

2) FCFE is preferable to CFO, but FCFE more volatile and more difficult to compute

3) FCFE can be negative with large cap ex
122. P/CF equ (2)
Market value of equity / total cash flow

market price per share / cash flow per share
123. What is cash flow for P/CF? (5)
1) traditional CF: CF = net income + non-cash charges

2) CFO (from statement of cash flows)

4) EBITDA : appropriate for firm value, not equity

5) FCFE: cash flow concept with the closest relationship to theory
124. Justified P/CF (2 steps)
1) Calculate stock value using DCF

v= = FCFE0(1+g) / (r-g)

2) divide result by cash flow

justified P/CF = V0/CF
125. fundamental factors affecting justified P/CF (3)
increase

cash flow up

growth rate up

required return down

(same as others)
126. EV / EBITDA ratio
EV or firm value = MV of common stock + MV of debt + mv preferred - cash and investments

divided by EBITDA

*ratio provides an indication of firm value, not equity value

Firm EV/EBITDA < benchmark means UNDERVALUED
127. Rationale for EV/EBITDA (3+ 2-)
for

1) comparing firms with different financial leverage since EBITDA is pre-interest

2) controls for dep/amort differneces

3) EBITDA usually positive when EPS is negative

against:

1) ignores changes in WC investments

2) FCFF (which controls for capex) is more closely tied to value
128. Effect of Payment: cash offer
acquirer assumes the risk and receives the potential reward

synergies > expected: takeover premium for target is fixed, so acquirer wins

synergies < expected: acquier loses
129. Effect of Payment: Stock offer
some of risks and potential rewards shifts to the target firm

target shareholders will own part of acquiring firm
130. Short-term effect on stock price: (merger)
target average gain ~30%

acquirer loses between 1% and 3%
131. Long-term effect on stock price: Merger
acquirers tend to under perform
132. divestitures: definition + 4 reasons
selling, liquididating, or spinning off a division or subsidiart

reasons: division no longer fits long-term strategy

2) lack of profitability

3) individual parts are worth more than the whole

4) infusion of cash
133. equity carve-outs
creates a new, independent company

sell shares to outside stockholders
134. spin-offs
create a new, independent company

distribute shares to parent company shareholders - no cash for parent
135. split offs
existing shareholders must exchange shares for shares of new division
136. liquidiations
break up the firm and sell its assets piece by piece
137. Graham and Dodd
value of any asset is related to earning power
138. John burr williams
instrinsic value = PV of cash flows at an opportunity cost of capital
139. instrinsic value: (IV)
true underlying value of the security given complete understanding
140. estimated value (VE)
investor estimate of instrinsic value
141. two sources of perceived mispricing
VE-P=(IV-P) + (VE - IV)
142. going concern value
typically the relevant instrinsic value for public firms; assumes assets remain in place and continue to produce cash flow in the future via continuing operatins
143. liquidation value:
the value if the firm ceases to operate, all assets are sold, and the firm is dissolved
144. orderly liquidation value:
assumes adequate time to realize liquidation value
145. 8 uses of equity valuation
1) stock selection

2) inferring inputs from the market vs. history

3) projecting worth of company actions

4) fairness opinions for mergers

5) planning and consulting - max shareholder value

6) communication with investors

8) portfolio management
146. Porter's elements of competitive strategy (3)
cost leadership - lowest cost producer

differentiation - unique products or services

Focus - target segment (s) of industry using either of the above strategies
147. absolute valuation model
instinsic value based on fundamental characteristics - EPS, asset turns and leverage, ROE, growth
148. Relative valuation model
value derived from the relative comparison to similar assets, based on law of one price

P/E, P/B, P/CF. P/S models
149. which valuation model is appropriate (3)
consistent with characteristics of company: undertand firm and how assets create value

based on quality and availability of data: DDM problematic when no dividends, P/E probematic with highly volatile earnings

consistent with purpose of analysis: FCF vs. dividents for controlling interest
150. Modern stock exchanges evolved from (3):
Private bourses: british influence, private ownership, bias toward self regulation

public bourses: french influence, gov. appointed stock brokers

banker's bourses: developed from german banking act, which gave banks a monopoly in equity exchange markets
151. Types of Markets: Order driven (Def, and 2 benefits, and 2 disadvantages
known as auction markets: prices determined by public orders to buy and sell

no active market makers

-all traders publicy post their orders, price determing by directly matching supply and demand

Example: Tokyo

traders view all standing orders, monitor liquidity via supply and demand

automated systems provide high-speed, low-cost trading - efficient for low volume

long time lag
aka dealer market

market maker maintains inventory and quotes bid and ask prices

no centralized book of order limits

example: US Nasdaq

-purchases made at lowest offering price and sale occur at highest bid price

-more efficient for large block trades

-no centralized book of limit orders

-market maker suffers from loss of anonymity
153. Interational investment: tax implications

3 forms of taxes
tax assessed by: investor's country and local country (corp country)

transaction

capital gain

income
154. gross (pre-tax) return:
'(P1-P0+Div1)/P0
155. Net (A-T) return
P1-P0+Div1-CG Tax - Inc Tax - other taxes / p0

capital gains

income tax
156. capital gains
taxed in the country where the stockholder resides
157. dividend income
can be taxed by both governments

conflict in tax jurisdiction/double taxation

investor recieves

1) dividend income net of withholding tax

2) tax credit (applied against home country taxes)
158. tangible or explicit trading costs
commissions, fees, taxes
market impact: impact of purchasing liquidty, cost of rushing orders

opportunity costs: cost of delay, patience or failure to complete trade

note: trade-off exists between market impact and opportunity costs
160. 7 ways to reduce execution costs: program trading

dis: time consuming to find counterparty
161. 7 ways to reduce execution costs: internal crossing
match to buy for one client and a asell for another within firm

dis: relatively rare to have immediate match available within firm, difficult to ensure fair price
162. 7 ways to reduce execution costs: external crossing
use electronic crossing network, ECNS

dis: opportunity cost if order grows stale
163. 7 ways to reduce execution costs: principal trades
principal acts as dealer

adv: liquidity asured lowering opportunity costs

dis: not anonymous, total execution costs can be higher because of price exposure resulting from inventory position
164. 7 ways to reduce execution costs: agency trades

adv: hope to achieve best execution with low opportunity cost

dis: large commission, anonymity not assured
165. 7 ways to reduce execution costs: futures contracts
buying and selling contracts on market index while selling and buying securities

adv: low opportunity cost, highly liquid

dis: basis and rollover risk
166. 7 ways to reduce execution costs: indications of interest

av: lower execution costs

dis: less anonymity
167. American depository receipts (ADRs) def and benefits
Dollar-denomiated certificate representing ownership in a foreign firm

traded like stocks, indirect ownership of foreign equities

increases international diversification

does not eliminate currency risk or economic risk
Level 1: OTC traded, not required to omply with SEC

Level 2: exchange traded: must meet SEC registration

Level 3: exchange traded: may float a secuirt offering on US exchange to raise capital
169. why firms list abroad? (5)
pros

international diversification of capital base

minimizes domestic takeover threats

cons: can lead to higher price volatility
170. ADRs vs Listed Shares (2)
easy investment in foreign firms, limited availability

listed shares: cheaper than ADRs for institutional investors
171. Closed-end funds, definition and where premium/discount determind by
intermediary invests in stocks from a single country and sells IPO

shares do NOT necessarily trade at NAV

Premium/discount determined by: higher foreign investment restrictions, premium. Higher management fees/lack of liquidity-> discount

biggest disadvantage: premium/discount to NAV correlated to US equities, decreasesd diversification benefits
172. ETFs (def)
charateristics: special open-ended funds whose holdings mirror and index

point: trade on an exchange like a stock

etfs are shares of a portfolio not individual securities
main point: international diversification with high liquidity and minimal cost

-tax-efficient (low portfolio turnover)

-low cost structure

may be shorted or margined

suited for asset allocation strategies

negative: stale pricing: NAV unchanged when local market is closed
174. 7 return concepts: Holding period return
Capital gains plus any cash flow stated as percent of the initial investment

HPR = (P1-P0+CF1)/P0

HPR = price appreciation + dividend yield
175. 7 return concepts: Realized return
historical return based on observed prices and cash flows

can be calculated as an HPR
176. 7 return concepts: expected return
return based on forecasts of a future price and cash flows

think: forecasted return
177. 7 return concepts: required return
minimum return an investor requires given the asset's risk

freq calculated with the CAPM
178. 7 return concepts: return from convergence
return expected/realized as a market price converges to instrinsic value
179. 7 return concepts: discount rate
rate used to determine the PV of an investment
180. 7 return concepts: IRR
the rate that equates the discounted cash flows to the current market determined price
additional return above the risk-free rate investors require for holding (risky) equity securities

excess return
182. Required return for a stock
ERP can be used to determin the required return given systemic risk

Ri = Rf + Beta (Rm-Rf)
183. Historical ERP
historical mean difference between broad market equity index and T-bill

stength - objective and simple

weaknesses:

-assumes stationary of mean and variance of returns over time

-upwardly biased due to survivorship bias

-which risk-free rate to use?
184. Forward-looking ERP
utilizes current market conditions and expectations concerning economic and financial variables

strength - does not require stationarity

weaknesses:

-makes assumptions
185. Macroeconomic Model (ERP)
use macro and financial variables such as inflation, earnings, growth

strength: robust results

weakness: used only with developed countries
186. Survey (ERP)
consensus of experts

strength-easy to obtain

weakness - wide disparity between opinions
187. Models to predict return: CAPM
Ri = Rf + Beta (Rm - Rf)
188. Multifactor Models
use multiple factors to explain returns

-required return: Rf+RP1 +RP2+…+RPn

-where RP = risk premium = (sensitivity) x (Factor)

Factor sentitivity - asset's sensitivity to a factor (beta in CAPM)

Factor risk premium - return driver (ERP in CAPM)
189. Types of models (multifactor models)
Ad hoc model- build up models

Arbitrage Models - all others
190. Beta estimation: public firms
estimated with regression model

regress the company's returns on the returns of the overall market index

Rcompany = alpha + beta (Rmarket)

Beta drift: computed beta migrates toward 1.0
191. Beta Estimation: thinly traded and nonpublic firms
Pure play method - 4 steps

1) identify a public firm

2) estimate the beta using regression

3) unlever the beta

4) relever beta
192. Unlever beta (equ)
Bunlevered = [1/(1+(D/E comp. firm))]BE
193. Relever beta (equ)
Bnonpublic = [1+(D/E nonpublic)]Bunlevered
194. Strength/Weakness: CAPM
simple, easy, single factor

potential loss of explanatory power
195. Strength/Weakness: Multifactor models:
higher explanatory power

more complex and expensive
196. Strength/Weakness: builid up
simple

ad hoc and uses historical values
197. Required Return calculation abroad (2)
exchange rates: compute the required return in the home currency and adjust it

198. weighted average or rates of return required by capital suppliers (WACC)
WACC = (We x re) + [wd x rd x (1-t)]

re: required return on equity, found by CAPM, but tough for international
199. Firm value
FCFF, discount at WACC
200. Equity Value
FCFE, discount at RE

-use FCFE when capital structure not volatile

-use FCFF with high debt levels, negative FCFE

Equity value = firm value - MV of debt

big point: must align the discount rate with the cash flows
201. Top down process of global industry analysis (3)
1. country analysis

2. industry analysis (further in study session)

3. company analysis

-financial ratios

-future competitive framework (Porter)
202. Country Analysis - Top down (5)
Anticipated GDP growth

monetary/fiscal policy environment

productivity

political stability

investment climate
203. Country vs. Industry analysis (location)
where the firm competes (not where headquarters is)

point: valuation should be based on global industry competition
204. global industry analysis (6)
global demand

industry cycle stages

value chain

competition structure

industry cooperation

205. Industry life cycle analysis (5)
pioneer

rapid growth

matur growth

stabilization

deceleration
206. Herfindahl Index - example: 8 firms with each having 12.5% market share
H = (0.125)^2 x 8 = .125
207. Franchise value (def long)
another approach to equity analyis (vs. ratio analysis - 5-point DuPont ROE

franchise value: divides the firm's intrinsic P/E into two parts

1) tangible or static P/E value, plus

2) franchise or growth P/E value

Key concept:

-If ROE > cost of capital

- then: instrinsic P/E > tangible P/E
208. Tangible P/E (static P/E)
appropriate multiple for a no growth firm

-tangible P/E = 1/r
209. Franchise P/E (growth P/E)
value derived from reinvesting profits at a rate greater than ROE
210. Instrinsic P/E (equ)
instrinsic P/E = tangible P/E + franchise P/E
211. Tangible P/E (equ)
1/r
212. Franchise P/E (equ)
Franchise P/E = FF x G
213. Franchise Factor (equ)
franchise factor = (1/r - 1/ROE)

r= require ROE

g=sustainable growth = ROE x retention

G = Growth factor = g/(r-g)
214. Inflation effects on valuation (def and equ)
215. Multi-factor Models in Global Analysis (def)
Key point: use multiple explanatory factors to model risk or return

-country factors

-industry factors
216. Porter: 2 fundamental questions
1) industry level analysis

industry attractiveness: is the industry attractive in terms of longer-term profitability potential?

2) firm-level analysis

competitive advantage: How does the firm earn sustainable superior margins relative to other industry players
217. Porter's Five Forces
1) threat of entry: will new entrants add capacity and compete away the value-added component of price?

2) threat of substitutes: Do alt products put a ceiling on the price buyers are willing to pay?

4) bargaining power of suppliers: will suppliers capture the value-added component of price?

5) rivalry among existing competitors: will existing firms compete away the value-added component?
218. Non-Porter Forcers (fleeting factors) 4
government policies

complement products

innovation and tech

industry growth
219. 4 ways to improve long-term attractiveness
eliminate ineffiencies

improve supply chain or distribution

redistributing pricing power away from customers

creater barriers to entry by increasing fixed costs
220. 2 primary approaches to industry life cycle classification
industrial life cycle approach: classify industries by stage in industry life cycle

business cycle reaction approach: classify industries by reactions to business cycle phases
221. Industry life Cycle
Pioneer

Growth

Mature

Decline
Expansion to recession to recover and repeat

growth industry: growing sales and high margins throughout cycle (biotech)

defensive industry: demand for products relatively independent of cycle: usually mature industry, beta <1, food and utilities

cyclical industry: product follows demand cycle, beta >1, autos
223. external factors (5)
technology: will technology innovate or be obsoleete in mature phase, fedex vs. e-mail

government: regulations, taxes, subsidies - sugar industry

social changes: lifestyle (long-term) or fashion (short-term and less predictable)

demography: very long term, easy to predict, hard to predict implications

foreign influences: impact of foreign competitors, OPEC and the oil industry, textiles, and media
224. Demand Analysis (industry analysis)
Top-down approach

macro forecast to derive industry forecast

inputs: industry customers, submarkets, raw materials, and costs
225. supply analysis
long-term: supply = demand

short-term: imbalances create opportunity

inputes: capacity utilization analysis, lead time, natural disasters
226. Four factors that affect pricing
1) product segmentation: differentiation

2) industry concentration: high concentration may lead to coordinated pricing

3) ease of entry: ease of entry will keep prices low

4) supply input price: volatility of input cost will impact pricing strategy/profitability
227. Inflation and Cash Flow Issue
Inflation overstates growth in emerging markets

1) inflation distorts the value of non-monetary assets such as PP&E

2) cash flow projections distorted since revenue and expenses are affected differently by inflation

example: revenue vs. depreciation
228. 3-Part process for EM overview
Part 1: calculate FCF (real and nominal)

NOPLAT = EBITDA - Dep - taxes

FCF = NOPLAT + Dep - FCInv - WCInv

Part 2: calc disconut rate (real and nominal)

Part 3: calc firm value

Gordan growth model (GGM)

Real FCF discount at real rate

Nominal FCF discount at nominal rate
229. Issue # 1: income taxes (real vs nominal values)
Issue #1) income taxes: paid on inflation-distorted nominal earnings

process

1) estimate nominal EBITDA

2) estimate nominal tax expense

3) calc real tax expense using the inflation index

real tax=nominal tax / inflation index
230. Issue #2: net working capital (real vs nominal values)
distorted by inflation

process

1) estimate nominal NWC outflows

2) calc real NWC outflows using the inflation index

-does NOT equal change in real NWC because ignores holding loss
231. Issue #3: Capital expenditures(real vs nominal values)
forecast capital expenditures, depreciation and EBITDA on a REAL basis
232. Gordan Growth Model
V0 = Real FCF1 / (Real r - real g)
233. Adjusting for Country Risk: 2 methods
Method 1) adjust expected cash flows downward to reflect probability they will occur, discount using unadjusted WACC

CFA recommends adjust cash flows, not discount rate
234. Why adjust cash flows, not discount rate for EM? (4)
1) country risks are diversifiable: not reflected in WACC under MPT assumptions

2) different sensitivities to country risk

3) country risk is one sided (downside): modelled better by adjusting cash flows

4) identifying cash flow effects helps the analyst understand risks in the firm's fundamentals
235. Issues with WACC in EM (6)
RFR: more difficult to estimate

-local gov't bonds not risk free

beta: use industry beta from int'l comparables, relative to global market

Market risk premium: for global portfolio

Pre-tax cost of debt: local risk-free rate + us credit spread on comparable debt

marginal tax rate: use statutory tax rate NOT effective tax rate

capital structure weights: NOT company weights: use global industry average
236. Country risk premiums - 2 scenarios
1) dollar-denominated local gov't bond exists

-country risk premium = local gov't dollar-denominated bond yield minus comparable maturity US t-bond yield minus comparable credit quality US credit spread

2) doesn't exist: CRP = local gov't local currency bond yield minus inflation differntial (local - US) minus comparable credit quality US credit spread
237. Role of debt rating in capital structure
try to maintain a debt rating

lower debt rating = higher credit risk => higher costs for debt
238. Factors to consider when evaluating capital structure policy
changes in capital structure over time

capital structure of competitors with similar business risk

agency costs: higher quality of coporate governance -> lower agency costs and less debt
239. Dividend Irrelevance Theory
Dividend policy is irrelevant

assumes perfect markets, no corporate taxes, bankruptcy costs, transaction costs

Homemade dividends: investors wanting more dividends can seel shares, investors wanting less dividends can use dividends to buy new shares
240. dividend preference theory
suggests that investors prefer the certainty of a cash dividend over the uncertainty of a stock price increase

higher dividends lead to higher stock prices (lower cost of equity)
241. Tax preference theory
investors prefer small dividend payments to large payments

capital gains are taxed at lower rate

not tax until realized

Result: smaller dividends result in higher stock price and lower cost of equity
242. Clientele effect
dip in stock price when a firm switches from no dividends to dividend paying

non-dividend demanding shareholders leave, those that want it buy. Price returns to equilibrium
243. Clientele Effect due to taxes (equ)
Change in P = D(1-Td) / (1 - Tcg)

for a given amount of dividend, investor would be indifferent if the price of the stock would drop by P, when it goes ex-dividend
244. Clientele Effect (Agency Issues)
Between shareholders and managers: dividends reduces free cash flow

Between shareholders and bondholders: dividends transfer wealth from bondholders to shareholders
245. Signaling Content of Dividends (3 scenarios)
dividend increase = positive signal

decrease/omission = negative signal

initiation = Positive signal
246. Factors affecting/decreasing dividend payout policy
lots of investment opportunities

high volatility of future earnings

need financial flexibility

tax considerations: lower capital gains taxes

high flotation costs, avoid paying banker

contractual and legal restrictions
247. Effective tax rate on dividends for split rate systems (equ)
double taxation

effective tax rate = tax corporate + (1- tax corporate)(tax individual)
248. Imputation system effective tax rate (equ)
effective tax rate = shareholder's tax rate
249. Stable and constant divident policy (2 def)
stable dividend policy: dividends are based on long-term earnings forecast. Dividends are smoothed so as to not fluctuate with earnings

Constant dividend payout policy: dividend payout is constant and hence dividends fluctuate directly with earnings seldom used
250. Residual dividend model (def and 4 steps)
dividends = earnings - funds retained

funds retained to finance equity portion of capital budget

1. identify optimal capital budge

2. determine amount of equity needed given target capital structure

3. meet equity requirements to extent possible with retained earnings

4. pay dividends with the residual earnings
251. Longer-term residual dividend
longer-term residual dividend: forcast capital budget 5-10 years

payout in relatively equal amounts
252. Target payout adjustments model (equ and def)
Target payout adjustment model: dividends paid out as a % of total earnings

set target dividend payout based on long-term sustainable earnings

move slowly toward that target

avoid cutting or eliminnating dividend except in extreme circumstances

expected dividend = previous dividend + [(expected increase in EPS) x (target payout ratio) x (adjustment factor)]
253. share repurchase vs. cash dividend
subsitutes, either buy back stock or give out extra cash

No difference in effect on shareholder wealth
254. rationales for share repurchase over dividend
1. tax advantages to shareholders: if tax rate on cap gains < tax rate on dividends

2. signal to shareholders that management believes shares are undervalued

3. added flexibility: repurchase not sticky

4. offseting dilution: prevents EPS dilution from exercise of employee stock options

5. increase leverage: repurchase shares to increase financial leverage
255. Global trends in dividend policy (3)
lower proportion of US companies pay cash dividends

proportion of companies paying cash dividends is declining over time in developed markets

proportion of companies making stock repurchases is increasing over time in developed markets
256. Dividend payout ratio
dividends / net income
257. dividends coverage ratio
= net income / dividend

higher coverage ratios means higher dividend sustainability
258. FCFE coverage ratio
=FCFE / (Dividends + share repurchases)

higher coverage ration means higher dividend sustainability
259. Corporate governance (2 objectives and 4 core attributes)
elminate / reduce conflicts of interest

insure company assets used in best interests of investors

core attributes: define shareholder rights

define oversight responsibilities

provide fair and equitable treatment

provide transparency/accuracy in disclosures
260. Manager vs. shareholder conflicts (4)
agent unwisely expands size of firm (mergers)

excessive compensation

taking too much risk

not taking enough risk
261. Director vs Shareholders (5 conflicts)
Lack of independence (managers on BoD)

board members have personal relationship with management

board members with consulting agreements

directors are overcompensated

point: BOD aligned with management, not shareholdres
262. Board of Directors responsiblities (6)
institute corporate values

create long-term strategic objectives

determine management's responsibilities

ensure complete and accurate information

meet regularly

ensure board members are adequetly trained
263. Firms with strong vs weak governance (5)
higher profitability

higher returns

weak:

increased risk to investors

reduced value

bankruptcy

What would you like to do?

Home > Flashcards > Print Preview