CFA II Equity

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  1. Return Concepts:
    1. holding period return
    2. realized return
    3. expected return
    4. required return
    5. return from convergence
    6. discount rate
    7. IRR
    • 1. (Cash flow + any additional gain)/initial investment
    • 2. Historical return (not future expected), can be calculated as realized return
    • 3. future return expected by some analyst
    • 4. minimum return need by investor for given level of risk
    • 5. return earned when buy/sell mispriced stock and then it converges to the "correct" price
    • 6. usually same as required rate, used to determine PV
    • 7. return implied by cash flows
  2. equity risk premium:
    definition, how to estimate
    • Definition
    • equity risk premium = required return - risk free rate

    risk free rate usually t bills (short term) or t bonds (long term)

    • Estimate
    • historic: use past premium
    • problems - stationary, upward bias due to survivorship bias

    future: model using macroeconomic factors or implied by gordon growth model
  3. estimating required return
    single factor: CAPM - required return = rf + beta*(equity premium - rf)

    multifactor: return = rf + sensitivity1*premium1 + sens2*prem2 + ...
  4. multifactor models:
    • fama-french
    • return = (market index - rf)*sensitivity + (small - big)returns*sens + (high B/M - low B/M)*sens

    • pastor-stambaugh
    • return = same as fama-french + liquidity premium*sensitivity

    • BIRR
    • aka arbitrage pricing model. could give any of five premiums*sensitivity
  5. build-up method
    return = rf + equity risk premium + size premium + company specific premium

    does NOT USE BETAS!!
  6. beta estimation for nonpublic or thinly traded firms (pure play)
    • identify similar public firm
    • estimate beta of that firm
    • unlever the beta using public firm's leverage Bu = Bestimate*(Image Upload 1)

    • relever beta using private firm's leverage
    • Bprivate = Bu*(Image Upload 2)
  7. WACC
    WACC = Image Upload 3
  8. How to discount FCFF and FCFE
    • discount FCFF at WACC
    • discount FCFE at return on equity
  9. Market value way to find equity value
    Equity value = firm value - market value of debt
  10. Porter's five forces
    • threat of new entrants
    • threat of substitutes
    • bargaining power of buyers
    • bargaining power of suppliers
    • rivalry among competitors
  11. control vs minority perspective in using dividends or FCF
    • control use FCF
    • minority (just buying 1 share) use dividends
  12. Dividend discount models:
    Gordon growth model
    two stage model
    H model
    • Gordon growth model: Image Upload 4
    • two stage: discount cash flows, then use GGM at the end. can also use trailing P/E*EPS at time t to estimate terminal value
    • H model: Image Upload 5
  13. Present value of growth opportunities
    P0 = E1/r + PVGO

    PVGO/P0 = % of price attributed to future growth

    Divide through by E1 for PVGO for P/E ratio
  14. Calculate sustainable growth rate
    g = b*ROE where b = plowback ratio
  15. What financial statement data is used for DuPont analysis
    Use current IS data and beginning of period BS data (do NOT average BS data)
  16. FCFF, FCFE calculation from:
    FCFE = FCFF + net borrowing - interest*(1-tax)

    NI: FCFF = NI + Non Cash Charges - change in working capital + interest*(1-tax) - FCInv

    CFO: FCFF = CFO + interest*(1-tax) - FCInv

    EBIT: FCFF = EBIT*(1-tax) + NCC - change in working capital - FCInv

    EBITDA: FCFF = EBITDA*(1-tax) + NCC*tax - change in WC - FCInv
  17. Calculate non cash charges for CFO from indirect method
    • NI
    • + Depreciation and amortization
    • - Gain on sale
    • + Loss on sale
    • +/- Restructuring expense/income
    • + increase in deferred tax liability if not expected to reverse
    • + amortization of bonds issued at discount
    • - amortization of bonds issued at premium
  18. Calculate working capital
    (Current assets - cash) - (Current liabilities - current portion of notes payable)
  19. Calculate FCInv using gross and net PPE
    FCInv = change in gross PPE - gain on sale

    FCInv = ending net PPE - beg net PPE + depreciation expense - gain on sale
  20. P/E: 
    rationale for using
    calculation of actual ratio
    calculation of justified ratio
    terminal value
    rationale: key to investment value, most widely used by Wall Street, proxy for risk and growth

    drawbacks: negative or very low earnings make P/E useless, volatile, easily distorted

    • calculation of actual ratio: trailing = Po/Eo
    • leading = Po/E1
    • Back out non-recurring items (gain/loss sale, impairments, accounting estimates) 
    • must normalize earnings for business cycle - either average recent EPS or **average recent ROE and multiply by most recent BVPS**

    • calculation of justified ratio:
    • trailing = (1-b)*(1+g)/(r-g)
    • leading = (1-b)/(r-g)

    PEG: PEG = P/E/g where g is not stated as a decimal

    terminal value = trailing P/E*earnings in time t
  21. P/B: 
    rationale for using
    calculation of actual ratio
    calculation of justified ratio
    rationale: BV usually positive, good for liquid asset firms

    drawbacks: human capital not reflected, size distortion, accounting conventions create distortion, inflation and technology change can create large difference in market value and book value

    calculation of actual: market price/book value of equity

    calculation of justified: Po/Bo = (ROE - g)/(r - g)
  22. P/S: 
    rationale for using
    calculation of actual ratio
    calculation of justified ratio
    rationale: distressed firms bc sales never negative

    drawbacks: does not account for cost structure, some revenue recognition potential distortion

    calculation of actual: price/sales per share

    • calculation of justified: 
    • Po/So = Image Upload 6
  23. P/CF: 
    rationale for using
    calculation of actual ratio
    calculation of justified ratio
    rationale: difficult to manipulate

    drawbacks: FCFE better than CFO, can be negative and difficult to compute

    • calculation of actual: can use different definitions of cash flow - 
    • Traditional CF = NI + NCC
    • CFO
    • Adjusted CFO = CFO + interest*(1-tax)
    • EBITDA - better to use EV/EBITDA, not P/EBITDA
    • FCFE

    • calculation of justified ratio: two steps
    • 1. get value - Vo = FCFEo*(1+g)/(r-g)
    • 2. P/CF = V/CF
  24. P/EBITDA

    justified dividend yield
    • Use EV/EBITDA
    • EV = market value of debt + market value of equity + market value of preferred stock - cash (and cash like securities)

    justified dividend yield: Do/Po = (r-g)/(1+g)
  25. harmonic mean
    weighted harmonic mean
    • ex. one share has E = 1 and P = 10, second has E = 2, P = 16
    • harmonic mean = Image Upload 7

    weighted harmonic mean = Image Upload 8
  26. Calculate residual income
    RI = NI - beginning book value of equity*required return on equity

    RI = (ROE - required return on equity)*BVequity
  27. Private equity terms:
    carried interest
    hurdle rate
    target fund size
    • management fee: GP management fee calculated based on paid-in capital
    • carried interest: GP's share of profits. first payment calculated as carried interest*(NAV - committed capital). note committed capital may be more than paid-in capital. subsequent payments calculated as carried interest*(new NAV - old NAV).
    • ratchet: allocation of portfolio company equity between shareholders and managers
    • hurdle rate: IRR target before GP earns carried interest
    • target fund size: signal's GP's ability to raise funds. GP not being able to reach target size is interpreted as a negative signal 
    • vintage: year fund was started. J curve (VCs) - at 2-3 years bad ideas have cost but good ones havent paid, so expect to see loss of value. 10 years, expect to see gain of value.
  28. Private equity performance terms:
    Paid-in capital (PIC)
    Distributed to PIC (DPI)
    Residual value to PIC (RVPI)
    Total value to PIC (TVPI)
    • PIC: % of capital used by GP. ie how much of the target fund size has been received. = PIC/committed capital
    • DPI: multiple that shows return that has actually been paid to LP. Note no time component. = cumulative distributions/PIC
    • RVPI: multiple that shows return on unrealized gains for LP. = NAV after distributions/PIC
    • TVPI: multiple that shows total value of LP's investment. sum of DPI and RVPI.
  29. calculate NAV for private equity fund before and after distributions
    before: NAV = previous NAV + capital called down - management fee + operating results

    after: NAV before - carried interest - distributions to LP
  30. NPV valuation of VC: calculate pre and post money valuation for VC company, required fractional ownership
    post money: PV of the total terminal value of fund

    pre money: post money - VC investment

    fractional ownership: VC investment/post money value
  31. IRR valuation of VC: calculate investor's future wealth (W), required fractional ownership
    investor's future wealth (W): FV of investment using discount rate

    fractional ownership: investor's future wealth/FV of firm
  32. calculate pre and post money valuations and ownerships for multiple financing rounds
    Image Upload 9
  33. compute discount rate for VC adjusted for risk
    adjusted discount rate = Image Upload 10-1
  34. Calculate value using single stage RI
    Value = Image Upload 11
  35. Calculate Multistage RI using different Continuing RI using:
    earnings persistence
    decline to mature industry level
    Image Upload 12

    earnings persistence:

    Image Upload 13 where Image Upload 14 is persistence of RI

    • decline to mature industry level:
    • Image Upload 15 
    • or
    • Image Upload 16
  36. Define clean surplus relationship
    Image Upload 17

    usually does not hold true due to many comprehensive items (off balance sheet items, currency change from consolidation of foreign subsidiaries, avail-for-sale securities, etc.). This makes RI not applicable in the real world.
Card Set:
CFA II Equity
2013-03-27 23:32:08
CFA II Equity

CFA II Equity
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