CFA 3

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)

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)

D0/P0 = (r-g) / (1+g)

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 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

UE_t = EPS_t - E(EPS_t)

SUE_t = (EPS_t - E(EPS_t)) / [EPS_t - E(EPS_t)]σ

unexpected earning / usual expected earnings

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: effect of outliers dependson market value weight

major advantage: corresponds to portfolio value

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

Equivalent to economic profit

RI = net income less opportunity cost of equity capital

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

alternatively, using a pre-levered figure:

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

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

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

alternative RI measure

EVA = NOPAT - (WACC% - total cap)

recall, NOPAT = EBIT (1-t)

positive EVA - management is adding value

alternative RI measure

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

MVA = market value of firm - invested capital

evaluate the change in MVA over time

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

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 assumes:

-constant ROE

-Constant earnings growth

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

higher ω:

low dividend payout

high RI industry persistence

lower ω:

High ROE

Large special items

large accounting accruals

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) = RI_T / [1 + r - ω]

calc in perpituity

PV (cont RI in year T-1) = RI_T / r

market value = value + PV (cont RI in yr. _T)

PV (cont RI in yr. T) = P_T - B_T

PV (cont RI in yr. T-1) = [(P_T - B_T) + RI_t ]/ (1+r)

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

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:

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

Stage of lifecycle

size

quality/depth of management

management/shareholder overlap

short-term investors

quality of information

taxes

liquidity

restrictions of liquity

concentration of control

transactions - venture cap, IPO, sale, bankruptcy, stock-based comp

Compliance - financial reporting, taxes

litigation - shareholder suits, damage claims, lost profits, divorces

income: PV of future income (DCF)

market: price multiples of comps

asset-based: assets - liabilities

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

1) controlling vs. noncontrolling interests

2) scenario analysis

3) life cycle stage

4) management biases

5) capital structure changes

Free cash flow

capitalized cash flow

excess earnings

PV (discrete CFs plus a terminal value)

terminal value

-constant growth model

- price multiple approach

potential double counting of high growth

Gordan growth model variation

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

value of equity = FCFE1 / (r-g)

working capital + fixed assets + value of residual income going forward

size premiums

available and cost of debt

acquirer vs target

projection risk

lifecycle stage

CAPM

expanded CAPM

build-up approach

Possible risk premiums for:

-size

-company-specific risk

-industry risk

Current vs. optimal capital structure (probably optimal)

public vs. private firm debt capacity and cost

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.

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

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%

likelihood of IPO, firm sale, dividends

asset duration

contractual restrictions

pool of buyers

asset risk

restrictred vs. publicly traded shares

pre-IPO vs post-IPO prices

put prices

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

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

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

MV0=NOI1/R0 where R0=market cap rate or (r-g)

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

multiplier (M) from comp properties

M = sales price / gross income

MV = gross income x income multiplier

infrequent sales data

lack of info

use of gross rent

reengineer firm for more efficient operations

obtain lower cost debt financing via access to cheap credit

parallel goal alignment between management and PE owners

comp tied closely to performance and promote goal achievement

tag-along clause-mgmt has exit rights if firm sells its stake

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

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

V0 = sum of CFt/(1+r)^r

cash available to pay shareholders

economic profit, earnings in excess of the investors' required return on the beginning-of-period investments

less volatile than other cash flow measures

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

accounts for reinvested earnings to provide a basis for increased future dividends

non-dividend paying firms

dividends artifically small for tax reasons

dividends may not reflect th control perspective desired by the investor

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

cash available to shareholders and bondholders after taxes, capital investment, and WC investment

cash available to equity holders after payments to and inflows from bondholders

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)

1. constant growth (gordan model)

2. two stage growth

3. h-model

4. other assumptions

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

P0/E1 = (1-b)/(r-g)

CF/r

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 = 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

first: fixed period of supernormal growth

then: indefinite growth at normal level

patent expiration, etc.

assumes drop-off in growth

high-growth phase + h-model pattern

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

CAPM

APT

GGM (half)

build up

g = rr x roe

retention rate (rr) x NI/SE

Net profit margin x asset turnover x equity multiplier

net income/sales x sales/assets x assets/equity

Firm value = FCFF discounted at WACC

equity value = FCFE discounted at required return on equity - r

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

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

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

Beginning net PP&E

-depreciation

+ Assets purchased (solve)

-Book value of assets sold

Ending net PP&E

*gross ignores depreciation

FCFF = NI + NCC + Int(1-t) - WCInv - FCInv

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

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

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

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

useful for stable firms in mature industries

analogous to gordan growth model

Firm value0=FCFF1/(WACC-g)

similar to FCFF/GGM

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

equity value = FCFE1/(r-g)

1) FCFF or FCFE?

2) 2 stages or 3

3) total FCF or components of FCF?

4) Terminal value via GGM or P/E

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

Uses EPS from last year

p0/e0 = market price per share / EPS last 12 months

uses forecasted earnings for coming year

P0/E1=Market price per share / forecast EPS next 12 months

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

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

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

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 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

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

[(1-b)*(1+g)] / (r-g)

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

only useful if large data set

changing relationships

multicollinearity

unknown predictive power

calcs a stock's P/E per unit of expected growth

lower PEG - more attractive valuation

PEG = (P/E)/G

differences in firm risk attributes

differences in the duration of growth

non-linear relationship between growth and the P/E ratio

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

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

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 = market value of equity / book value of equity

=market price per share / book value per share

P0/B0 = (ROE - g) / (r-g)

spread between ROE and r really drives this

(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

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

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

increases:

current profit margin improves

sustainable growth increases

risk falls

decreases:

profit margin decreases

risk increases

inflation increases

growth decreases

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

Market value of equity / total cash flow

market price per share / cash flow per share

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

1) Calculate stock value using DCF

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

2) divide result by cash flow

justified P/CF = V0/CF

increase

cash flow up

growth rate up

required return down

(same as others)

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

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

acquirer assumes the risk and receives the potential reward

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

synergies < expected: acquier loses

some of risks and potential rewards shifts to the target firm

target shareholders will own part of acquiring firm

target average gain ~30%

acquirer loses between 1% and 3%

acquirers tend to under perform

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

creates a new, independent company

sell shares to outside stockholders

create a new, independent company

distribute shares to parent company shareholders - no cash for parent

existing shareholders must exchange shares for shares of new division

break up the firm and sell its assets piece by piece

value of any asset is related to earning power

instrinsic value = PV of cash flows at an opportunity cost of capital

true underlying value of the security given complete understanding

investor estimate of instrinsic value

VE-P=(IV-P) + (VE - IV)

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

the value if the firm ceases to operate, all assets are sold, and the firm is dissolved

assumes adequate time to realize liquidation value

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

cost leadership - lowest cost producer

differentiation - unique products or services

Focus - target segment (s) of industry using either of the above strategies

instinsic value based on fundamental characteristics - EPS, asset turns and leverage, ROE, growth

value derived from the relative comparison to similar assets, based on law of one price

P/E, P/B, P/CF. P/S models

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

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

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

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

tax assessed by: investor's country and local country (corp country)

transaction

capital gain

income

'(P1-P0+Div1)/P0

P1-P0+Div1-CG Tax - Inc Tax - other taxes / p0

capital gains

income tax

taxed in the country where the stockholder resides

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)

commissions, fees, taxes

market impact: impact of purchasing liquidty, cost of rushing orders

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

note: trade-off exists between market impact and opportunity costs

trade basket of securities rather than individual securities

adv: reduces with diversification

dis: time consuming to find counterparty

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

use electronic crossing network, ECNS

adv: low costs and anonymous trade

dis: opportunity cost if order grows stale

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

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

buying and selling contracts on market index while selling and buying securities

adv: low opportunity cost, highly liquid

dis: basis and rollover risk

survey of dealers, "upstairs" trades

av: lower execution costs

dis: less anonymity

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

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

pros

international diversification of capital base

minimizes domestic takeover threats

raise additional capital

increases international visibility/advertising

cons: can lead to higher price volatility

easy investment in foreign firms, limited availability

listed shares: cheaper than ADRs for institutional investors

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

charateristics: special open-ended funds whose holdings mirror and index

point: trade on an exchange like a stock

etfs are shares of a portfolio not individual securities

main point: international diversification with high liquidity and minimal cost

-tax-efficient (low portfolio turnover)

-low cost structure

may be shorted or margined

suited for asset allocation strategies

negative: stale pricing: NAV unchanged when local market is closed

Capital gains plus any cash flow stated as percent of the initial investment

HPR = (P1-P0+CF1)/P0

HPR = price appreciation + dividend yield

historical return based on observed prices and cash flows

can be calculated as an HPR

return based on forecasts of a future price and cash flows

think: forecasted return

minimum return an investor requires given the asset's risk

freq calculated with the CAPM

return expected/realized as a market price converges to instrinsic value

rate used to determine the PV of an investment

the rate that equates the discounted cash flows to the current market determined price

additional return above the risk-free rate investors require for holding (risky) equity securities

excess return

ERP can be used to determin the required return given systemic risk

Ri = Rf + Beta (Rm-Rf)

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?

utilizes current market conditions and expectations concerning economic and financial variables

strength - does not require stationarity

weaknesses:

-requires frequent updates

-makes assumptions

use macro and financial variables such as inflation, earnings, growth

strength: robust results

weakness: used only with developed countries

consensus of experts

strength-easy to obtain

weakness - wide disparity between opinions

Ri = Rf + Beta (Rm - Rf)

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)

Ad hoc model- build up models

Arbitrage Models - all others

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

Pure play method - 4 steps

1) identify a public firm

2) estimate the beta using regression

3) unlever the beta

4) relever beta

B_unlevered = [1/(1+(D/E _{comp. firm}))]B_E

B_nonpublic = [1+(D/E _nonpublic)]B_unlevered

simple, easy, single factor

potential loss of explanatory power

higher explanatory power

more complex and expensive

simple

ad hoc and uses historical values

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

WACC = (We x re) + [wd x rd x (1-t)]

re: required return on equity, found by CAPM, but tough for international

FCFF, discount at WACC

FCFE, discount at R_E

-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

1. country analysis

2. industry analysis (further in study session)

3. company analysis

-financial ratios

-future competitive framework (Porter)

Anticipated GDP growth

monetary/fiscal policy environment

productivity

political stability

investment climate

where the firm competes (not where headquarters is)

point: valuation should be based on global industry competition

global demand

industry cycle stages

value chain

competition structure

industry cooperation

competitive advantage

pioneer

rapid growth

matur growth

stabilization

deceleration

H = (0.125)^2 x 8 = .125

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

appropriate multiple for a no growth firm

-tangible P/E = 1/r

value derived from reinvesting profits at a rate greater than ROE

instrinsic P/E = tangible P/E + franchise P/E

1/r

Franchise P/E = FF x G

franchise factor = (1/r - 1/ROE)

r= require ROE

g=sustainable growth = ROE x retention

G = Growth factor = g/(r-g)

Key point: use multiple explanatory factors to model risk or return

-country factors

-industry factors

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

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?

government policies

complement products

innovation and tech

industry growth

eliminate ineffiencies

improve supply chain or distribution

redistributing pricing power away from customers

creater barriers to entry by increasing fixed costs

industrial life cycle approach: classify industries by stage in industry life cycle

business cycle reaction approach: classify industries by reactions to business cycle phases

Pioneer

Growth

Mature

Decline

Expansion to recession to recover and repeat

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

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

cyclical industry: product follows demand cycle, beta >1, autos

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

Top-down approach

macro forecast to derive industry forecast

inputs: industry customers, submarkets, raw materials, and costs

long-term: supply = demand

short-term: imbalances create opportunity

inputes: capacity utilization analysis, lead time, natural disasters

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 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

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: 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

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

forecast capital expenditures, depreciation and EBITDA on a REAL basis

V0 = Real FCF1 / (Real r - real g)

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

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

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

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

try to maintain a debt rating

lower debt rating = higher credit risk => higher costs for debt

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 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

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)

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

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

Change in P = D(1-T_d) / (1 - T_cg)

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

Between shareholders and managers: dividends reduces free cash flow

Between shareholders and bondholders: dividends transfer wealth from bondholders to shareholders

dividend increase = positive signal

decrease/omission = negative signal

initiation = Positive signal

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

double taxation

effective tax rate = tax corporate + (1- tax corporate)(tax individual)

effective tax rate = shareholder's tax rate

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

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: forcast capital budget 5-10 years

payout in relatively equal amounts

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)]

subsitutes, either buy back stock or give out extra cash

No difference in effect on shareholder wealth

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

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

dividends / net income

= net income / dividend

higher coverage ratios means higher dividend sustainability

=FCFE / (Dividends + share repurchases)

higher coverage ration means higher dividend sustainability

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

agent unwisely expands size of firm (mergers)

excessive compensation

taking too much risk

not taking enough risk

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

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

higher profitability

higher returns

weak:

increased risk to investors

reduced value

bankruptcy