CFA 3.txt

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CFA 3.txt
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CFA 3
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  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

    bad

    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
  11. Economic Value added
    alternative RI measure

    EVA = NOPAT - (WACC% - total cap)

    recall, NOPAT = EBIT (1-t)

    positive EVA - management is adding value
  12. Market value added
    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)

    2) requires many adjustments

    -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

    7) strategic vs. nonstrategic buyers
  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
    size premiums

    available and cost of debt

    acquirer vs target

    projection risk

    lifecycle stage
  37. Discount rate models
    CAPM

    expanded CAPM

    build-up approach

    Possible risk premiums for:

    -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

    pool of buyers

    asset risk
  43. estimating DLOM
    restrictred vs. publicly traded shares

    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

    obtain lower cost debt financing via access to cheap credit

    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
  61. 3 advantages to DDM
    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
  62. 3 disadvantages to DDM
    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
  100. Leading P/E
    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
  106. justified leading P/E
    start with GGM

    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

    BAD

    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

    bad

    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

    bad

    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)

    3) adjusted CFO: adj CFO = CFO + [interest x (1-t)]

    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

    7) valuing private business

    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

    Bad: inability to execute large trades, lack of market depth

    long time lag
  152. Price Driven markets: (def, 3 advantages, 2 bad)
    aka dealer market

    market maker maintains inventory and quotes bid and ask prices

    no centralized book of order limits

    example: US Nasdaq

    Advantages:

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

    -more efficient for large block trades

    -competition between dealers leads to tighter bid-ask spreads

    Disadvantages

    -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
  159. intangible trading costs (2)
    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
    trade basket of securities rather than individual securities

    adv: reduces with diversification

    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

    adv: minimizes execution costs

    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

    adv: low costs and anonymous trade

    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
    brokers find buyers and negotiates the trade for the client

    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
    survey of dealers, "upstairs" trades

    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

    lower administrative costs

    increases international diversification

    does not eliminate currency risk or economic risk
  168. Types of Sponsored ADR Issues
    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

    raise additional capital

    increases international visibility/advertising

    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
  173. advantages of ETFs
    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
  181. Equity Risk Premium (ERP)-def
    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:

    -requires frequent updates

    -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

    emerging market premium - use a developed market benchmark and add an emerging market premium
  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

    competitive advantage
  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?

    3) bargaining power of buyers: Will buyers capture the value-added component of price?

    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
  222. Business Cycle Reaction
    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

    Method 2) adjust WACC upward by adding country risk premium; discount unadjusted cash flows a higher 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

    -illiquid due to infrequent trading

    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

    interlinked boards

    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

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