-
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)
-
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)
-
Justified Dividend Yield equ
D0/P0 = (r-g) / (1+g)
-
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
-
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)
-
Standardized Unexpected Earnings equ
SUEt = (EPSt - E(EPSt)) / [EPSt - E(EPSt)]σ
unexpected earning / usual expected earnings
-
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
-
Weighted harmonic mean def + advantage
weighted harmonic mean: effect of outliers dependson market value weight
major advantage: corresponds to portfolio value
-
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
-
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
-
Economic Value added
alternative RI measure
EVA = NOPAT - (WACC% - total cap)
recall, NOPAT = EBIT (1-t)
positive EVA - management is adding value
-
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
-
-
-
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
-
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
-
Single-Stage RI valuation (2 assumptions and equ)
 - single-stage RI assumes:
-constant ROE
-Constant earnings growth
-
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
-
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
-
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]
-
Continuing RI if ω = 1
calc in perpituity
PV (cont RI in year T-1) = RIT / r
-
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)
-
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
-
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:
-
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
-
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
-
Private vs. Public companies - firm specific factors -3
liquidity
restrictions of liquity
concentration of control
-
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
-
3 approaches to valuation
income: PV of future income (DCF)
market: price multiples of comps
asset-based: assets - liabilities
-
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
-
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
-
3 income approach methods
Free cash flow
capitalized cash flow
excess earnings
-
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
-
capitalized cash flow method - 2 equ
Gordan growth model variation
value of the firm = FCFF1 / (WACC - g)
value of equity = FCFE1 / (r-g)
-
excess earnings method
working capital + fixed assets + value of residual income going forward
-
discount rate estimation elements 5
size premiums
available and cost of debt
acquirer vs target
projection risk
lifecycle stage
-
Discount rate models
CAPM
expanded CAPM
build-up approach
Possible risk premiums for:
-size
-company-specific risk
-industry risk
-
estimating WACC (2)
Current vs. optimal capital structure (probably optimal)
public vs. private firm debt capacity and cost
-
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.
-
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
-
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%
-
-
DLOM (marketing) varies with 5 things
likelihood of IPO, firm sale, dividends
asset duration
contractual restrictions
pool of buyers
asset risk
-
estimating DLOM
restrictred vs. publicly traded shares
pre-IPO vs post-IPO prices
put prices
-
Total discount of DLOM and DLOC (equ)
total discount = 1- [(1-DLOC)(1-DLOM)]
-
valuing real estate investments (equ)
-
1) main value determinants
2) investment characteristics
3) principal risks
4) most likely investor
Raw land
apartments
office buildings
warehouses
shopping centers
hotel/motel
-
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
-
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
-
Income Property - Market Value equ
MV0=NOI1/R0 where R0=market cap rate or (r-g)
-
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
-
-
Gross income multiplier technique
multiplier (M) from comp properties
M = sales price / gross income
MV = gross income x income multiplier
-
Limitations of Gross income multiplier technique
infrequent sales data
lack of info
use of gross rent
-
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
-
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
-
-
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
-
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
-
DCF (equ)
V0 = sum of CFt/(1+r)^r
-
free cash flow (def)
cash available to pay shareholders
-
residual income (def)
economic profit, earnings in excess of the investors' required return on the beginning-of-period investments
-
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
-
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
-
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
-
FCFF (def)
cash available to shareholders and bondholders after taxes, capital investment, and WC investment
-
FCFE (def)
cash available to equity holders after payments to and inflows from bondholders
-
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)
-
-
-
DDM assumptions for future growth (4)
1. constant growth (gordan model)
2. two stage growth
3. h-model
4. other assumptions
-
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
-
Gordan growth for P/E (equ)
P0/E1 = (1-b)/(r-g)
-
PV of preferred stock (equ)
CF/r
-
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
-
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
-
2 stage DDM (assumptions)
first: fixed period of supernormal growth
then: indefinite growth at normal level
patent expiration, etc.
assumes drop-off in growth
-
-
3-stage with h-model (def)
high-growth phase + h-model pattern
-
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
-
3.5 ways to find require return ®
CAPM
APT
GGM (half)
build up
-
growth rate ®
g = rr x roe
retention rate (rr) x NI/SE
-
3-part ROE equ
Net profit margin x asset turnover x equity multiplier
net income/sales x sales/assets x assets/equity
-
Firm value (equ)
Firm value = FCFF discounted at WACC
-
equity value (equ)
equity value = FCFE discounted at required return on equity - r
-
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
-
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
-
-
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
-
-
Increase in WCInv -> decrease FCF
assets
liabilities
Inventory
A/R
A/P
Accrued taxes & expenses
-
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
-
FCFF equ
FCFF = NI + NCC + Int(1-t) - WCInv - FCInv
-
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
-
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
-
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
-
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
-
Single Stage FCFF model
useful for stable firms in mature industries
analogous to gordan growth model
Firm value0=FCFF1/(WACC-g)
-
Single stage FCFE model
similar to FCFF/GGM
often used with int'l firms, especially in high-inflation
equity value = FCFE1/(r-g)
-
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
-
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
-
Trailing P/E0
Uses EPS from last year
p0/e0 = market price per share / EPS last 12 months
-
Leading P/E
uses forecasted earnings for coming year
P0/E1=Market price per share / forecast EPS next 12 months
-
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
-
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
-
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
-
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
-
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
-
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
-
Justified Trailing P/E0
[(1-b)*(1+g)] / (r-g)
-
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
-
Using regression comparable P/E problems (4)
only useful if large data set
changing relationships
multicollinearity
unknown predictive power
-
PEG Ratio (def / equ)
calcs a stock's P/E per unit of expected growth
lower PEG - more attractive valuation
PEG = (P/E)/G
-
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
-
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
-
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
-
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
-
P/B ratio (equ)
P/B ratio = market value of equity / book value of equity
=market price per share / book value per share
-
Justified P0/B0 ratio
P0/B0 = (ROE - g) / (r-g)
spread between ROE and r really drives this
-
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
-
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
-
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
-
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
-
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
-
P/CF equ (2)
Market value of equity / total cash flow
market price per share / cash flow per share
-
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
-
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
-
fundamental factors affecting justified P/CF (3)
increase
cash flow up
growth rate up
required return down
(same as others)
-
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
-
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
-
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
-
Effect of Payment: Stock offer
some of risks and potential rewards shifts to the target firm
target shareholders will own part of acquiring firm
-
Short-term effect on stock price: (merger)
target average gain ~30%
acquirer loses between 1% and 3%
-
Long-term effect on stock price: Merger
acquirers tend to under perform
-
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
-
equity carve-outs
creates a new, independent company
sell shares to outside stockholders
-
spin-offs
create a new, independent company
distribute shares to parent company shareholders - no cash for parent
-
split offs
existing shareholders must exchange shares for shares of new division
-
liquidiations
break up the firm and sell its assets piece by piece
-
Graham and Dodd
value of any asset is related to earning power
-
John burr williams
instrinsic value = PV of cash flows at an opportunity cost of capital
-
instrinsic value: (IV)
true underlying value of the security given complete understanding
-
estimated value (VE)
investor estimate of instrinsic value
-
two sources of perceived mispricing
VE-P=(IV-P) + (VE - IV)
-
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
-
liquidation value:
the value if the firm ceases to operate, all assets are sold, and the firm is dissolved
-
orderly liquidation value:
assumes adequate time to realize liquidation value
-
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
-
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
-
absolute valuation model
instinsic value based on fundamental characteristics - EPS, asset turns and leverage, ROE, growth
-
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
-
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
-
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
-
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
-
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
-
Interational investment: tax implications
3 forms of taxes
tax assessed by: investor's country and local country (corp country)
transaction
capital gain
income
-
gross (pre-tax) return:
'(P1-P0+Div1)/P0
-
Net (A-T) return
P1-P0+Div1-CG Tax - Inc Tax - other taxes / p0
capital gains
income tax
-
capital gains
taxed in the country where the stockholder resides
-
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)
-
tangible or explicit trading costs
commissions, fees, taxes
-
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
-
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
-
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
-
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
-
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
-
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
-
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
-
7 ways to reduce execution costs: indications of interest
survey of dealers, "upstairs" trades
av: lower execution costs
dis: less anonymity
-
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
-
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
-
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
-
ADRs vs Listed Shares (2)
easy investment in foreign firms, limited availability
listed shares: cheaper than ADRs for institutional investors
-
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
-
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
-
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
-
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
-
7 return concepts: Realized return
historical return based on observed prices and cash flows
can be calculated as an HPR
-
7 return concepts: expected return
return based on forecasts of a future price and cash flows
think: forecasted return
-
7 return concepts: required return
minimum return an investor requires given the asset's risk
freq calculated with the CAPM
-
7 return concepts: return from convergence
return expected/realized as a market price converges to instrinsic value
-
7 return concepts: discount rate
rate used to determine the PV of an investment
-
7 return concepts: IRR
the rate that equates the discounted cash flows to the current market determined price
-
Equity Risk Premium (ERP)-def
additional return above the risk-free rate investors require for holding (risky) equity securities
excess return
-
Required return for a stock
ERP can be used to determin the required return given systemic risk
Ri = Rf + Beta (Rm-Rf)
-
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?
-
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
-
Macroeconomic Model (ERP)
use macro and financial variables such as inflation, earnings, growth
strength: robust results
weakness: used only with developed countries
-
Survey (ERP)
consensus of experts
strength-easy to obtain
weakness - wide disparity between opinions
-
Models to predict return: CAPM
Ri = Rf + Beta (Rm - Rf)
-
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)
-
Types of models (multifactor models)
Ad hoc model- build up models
Arbitrage Models - all others
-
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
-
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
-
Unlever beta (equ)
Bunlevered = [1/(1+(D/E comp. firm))]BE
-
Relever beta (equ)
Bnonpublic = [1+(D/E nonpublic)]Bunlevered
-
Strength/Weakness: CAPM
simple, easy, single factor
potential loss of explanatory power
-
Strength/Weakness: Multifactor models:
higher explanatory power
more complex and expensive
-
Strength/Weakness: builid up
simple
ad hoc and uses historical values
-
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
-
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
-
Firm value
FCFF, discount at WACC
-
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
-
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)
-
Country Analysis - Top down (5)
Anticipated GDP growth
monetary/fiscal policy environment
productivity
political stability
investment climate
-
Country vs. Industry analysis (location)
where the firm competes (not where headquarters is)
point: valuation should be based on global industry competition
-
global industry analysis (6)
global demand
industry cycle stages
value chain
competition structure
industry cooperation
competitive advantage
-
Industry life cycle analysis (5)
pioneer
rapid growth
matur growth
stabilization
deceleration
-
Herfindahl Index - example: 8 firms with each having 12.5% market share
H = (0.125)^2 x 8 = .125
-
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
-
Tangible P/E (static P/E)
appropriate multiple for a no growth firm
-tangible P/E = 1/r
-
Franchise P/E (growth P/E)
value derived from reinvesting profits at a rate greater than ROE
-
Instrinsic P/E (equ)
instrinsic P/E = tangible P/E + franchise P/E
-
-
Franchise P/E (equ)
Franchise P/E = FF x G
-
Franchise Factor (equ)
franchise factor = (1/r - 1/ROE)
r= require ROE
g=sustainable growth = ROE x retention
G = Growth factor = g/(r-g)
-
Inflation effects on valuation (def and equ)
-
Multi-factor Models in Global Analysis (def)
Key point: use multiple explanatory factors to model risk or return
-country factors
-industry factors
-
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
-
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?
-
Non-Porter Forcers (fleeting factors) 4
government policies
complement products
innovation and tech
industry growth
-
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
-
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
-
Industry life Cycle
Pioneer
Growth
Mature
Decline
-
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
-
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
-
Demand Analysis (industry analysis)
Top-down approach
macro forecast to derive industry forecast
inputs: industry customers, submarkets, raw materials, and costs
-
supply analysis
long-term: supply = demand
short-term: imbalances create opportunity
inputes: capacity utilization analysis, lead time, natural disasters
-
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
-
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
-
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
-
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
-
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
-
Issue #3: Capital expenditures(real vs nominal values)
forecast capital expenditures, depreciation and EBITDA on a REAL basis
-
Gordan Growth Model
V0 = Real FCF1 / (Real r - real g)
-
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
-
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
-
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
-
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
-
Role of debt rating in capital structure
try to maintain a debt rating
lower debt rating = higher credit risk => higher costs for debt
-
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
-
-
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
-
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)
-
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
-
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
-
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
-
Clientele Effect (Agency Issues)
Between shareholders and managers: dividends reduces free cash flow
Between shareholders and bondholders: dividends transfer wealth from bondholders to shareholders
-
Signaling Content of Dividends (3 scenarios)
dividend increase = positive signal
decrease/omission = negative signal
initiation = Positive signal
-
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
-
Effective tax rate on dividends for split rate systems (equ)
double taxation
effective tax rate = tax corporate + (1- tax corporate)(tax individual)
-
Imputation system effective tax rate (equ)
effective tax rate = shareholder's tax rate
-
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
-
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
-
Longer-term residual dividend
longer-term residual dividend: forcast capital budget 5-10 years
payout in relatively equal amounts
-
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)]
-
share repurchase vs. cash dividend
subsitutes, either buy back stock or give out extra cash
No difference in effect on shareholder wealth
-
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
-
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
-
Dividend payout ratio
dividends / net income
-
dividends coverage ratio
= net income / dividend
higher coverage ratios means higher dividend sustainability
-
FCFE coverage ratio
=FCFE / (Dividends + share repurchases)
higher coverage ration means higher dividend sustainability
-
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
-
Manager vs. shareholder conflicts (4)
agent unwisely expands size of firm (mergers)
excessive compensation
taking too much risk
not taking enough risk
-
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
-
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
-
Firms with strong vs weak governance (5)
higher profitability
higher returns
weak:
increased risk to investors
reduced value
bankruptcy
|
|