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The difference between an analyst's estimate of a security's intrinsic value and its market price has two components
the difference between the security's actual intrinsic value and its market price
the difference between the security's actual intrinsic value and the analyst's estimate of the intrinsic value
the difference between the security's actual intrinsic value and the analyst's estimate of the intrinsic value =
VE - P = (VE - IV) + (IV - P)
Market price is usually not equal to fair market value (T/F)
Porter's Elements of Industry Analysis
The basic building blocks of equity valuation come from...
accounting information contained in the firm's reports and releases
What is Porter's competitive strategy "focus"
target segment(s) of industry using either cost leadership or differentiation
Absolute valuation models measure intrinsic value based on...
fundamental characteristics (future earnings, cash flows, risk, etc)
Relative valuation models measure intrinsic value from relative comparison to similar assets based on...
law of one price
Reasons for conglomerate discounts
internal capital inefficiency
research measurements errors
Liquidation value is the...
cash generated by terminating a business, selling all of its assets, and repaying liabilities
For an analyst valuing public equities, the most relevant definition of value is generally ______ value
__________ value is the most relevant definition of value to use in an agreement between the owners of a private business regarding the price at which the owners can sell their ownership interest
Important considerations when choosing a valuation model include:
Does the model fit the characteristics of the company?
Is the model suitable given the purpose of the analysis?
Is the model appropriate based on the quality and availability of input data?
A wise analyst will examine a valuation to determine:
its sensitivity to changes in expectations
Asset valuation based on the expected future cash flows is utilized to estimate an asset's _______ value
What is Return from convergence
return expected/realized as market price converges to intrinsic value
The four types of estimates for equity risk premium:
macroeconomic model estimates
What type of model is Ibbotson-Chen
What are the two types of multifactor models
ad hoc model (build up)
Fama French model
Which model adds liquidity to Fama French model
Build up method is used with loosely held companies (T/F)
When is the build up method used
when beta estimates are unobtainable
Blume method (adjusted beta)
Multi-factor models have low explanatory power (T/F)
Arbitrage pricing model (BIRR version) uses...
economic variables believed affect cash flows as factors within the model
Equity value =
firm value - MV of debt
For thinly-traded stocks and non-publicly traded companies, an analyst can estimate beta using a four-step process:
(1) identify publicly traded benchmark company;
(2) estimate the beta of the benchmark company;
(3) unlever the benchmark company's beta;
(4) relever the beta using the capital structure of the thinly-traded/non-public company
Required return for build up method =
YTM on long-term debt + risk premium
Unlevered beta of similar quoted company =
beta of similar co. x [1 / (debt of similar co / equity of similar co)]
estimated beta for relevered company =
unlevered beta of similar company x (1 + (debt of company / equity of company)
The market's growth rate is more times than not relevant to cash flows to the firm (T/F)
User of the build-up model is probably not concerned with...
The build-up model typically uses _______ values as estimates
What does ex-ante mean
The country risk rating model determines a risk premium for....
an emerging market
To value equity, use the WACC to calculate the firm's value, then...
subtract the market value of its long-term debt
The country spread model suggests an analyst can approximate the risk premium between a developed market and an emerging market by...
subtracting the bond yields in the developed market from yields in the emerging market
When attempting to build a risk premium into the required returns of stocks in a developing country, an analyst should use the:
country spread model
The more difficult it is to establish the intrinsic value, the greater the potential divergence between the market price and intrinsic value (T/F)
forecast rely on company-specific information (e.g., product introductions)
begins with expectations about a macroeconomic variable (e.g., expected growth rate of nominal GDP)
A market growth and market-share approach begins with...
an estimate of Industry sales (market growth)
The primary determinants of interest expense are... and then...
level of gross debt and interest rate
company revenue is estimated as a percentage of Industry sales (Market sale)
Net debt =
Gross debt - cash - cash equivalents - short term securities
the percentage tax changed in the country where the firm is domiciled
effective tax rate
income tax expense as a percentage of pre-tax income on income statement
cash tax rate
Cash taxes paid as a percentage of pre-tax income
Changes in deferred tax items account for the difference between income tax expense and cash taxes due
Forecasted inventory =
forecasted COGS / inventory turnover
Forecasted AR =
DSO x (forecast sales / 365)
Net PPE =
begin balance + capex - accumulated depreciation
Capex can be based on...
relationship with sales or based on company specific information
Capex can be separated into...
capex for maintenance and capex for growth
Return on Invested Capital (ROIC) =
Firms with higher ROIC (relative to their peers) are likely...
exploiting some competitive advantage in the production and/or sale of their products
When comparing firms with different capital structures, ROE is preferred to ROIC (T/F)
Vertically integrated firms are less affected by input cost price inflation (T/F)
Canalization factor is...
the percentage of the market for the existing product that will be taken by the new substitute
Inflection points for long term growth rate occur due to changes in:
Overall economic environment
Business cycle stage
Gross interest rate =
gross expense / avg gross debt
Net interest rate =
net expense / avg net debt
Yield on average cash balance =
interest income / avg cash and ST securities
Invested capital (IC) =
operating assets - operating liabilities
Return on capital employed (ROCE) =
EBIT / (D+E)
Forecasted depreciation rates are usually based on...
Forecasted capital expenditure is usually based on...
Cyclicality should be considered when developing the timeframe (T//F)
The time horizon should be independent of the average holding period for a stock (T/F)
An average annual turnover of 25% is consistent with a holding period of...
Residual income can be seen as...
To use in a model, dividends or FCF must be...
measureable and related to earnings power
DDM is based on the idea that...
over time, earnings and dividends will converge
Consider using a dividend when:
the firm has as a dividend history
dividend policy is consistent and related to earnings
perspective is that of a minority shareholder
DDM is most appropriate for
mature and profitable firms that are not engaged in a fast-growing segment of the economy
for large, diversified portfolios
Advantages of using dividends
accounts for reinvested earnings to provide a basis for increased future dividends
Disadvantages of using dividends
Non-dividends paying firms
Dividends artificially small for tax reasons
Dividends may not reflect the control perspective desired by the investor
Present Value of Growth Opportunities (PVGO)
the cash flow generated by the firm above that required to be reinvested to maintain current operations
FCFE is FCFF minus...
debt service and preferred dividends
FCF valuation is appropriate when the following characteristics exist:
The firm does not have a stable dividend policy.
The firm has a dividend policy that is not related to earnings.
The firm's FCF is related to profitability.
The perspective is that of a controlling shareholder.
Residual income is earnings in excess of...
the investors' required return on the beginning-of-period investment
Residual income focuses on...
profitability in relation to all opportunity costs faced by the firm
Residual income method is most appropriate under the following conditions
firm does not have a dividend history
FCFE is negative
the firm is transparent and has high quality earnings
GGM is most appropriate for...
mature, stable firms
Strengths of GGM:
sutiable for stable, mature dividend paying firms
easily applied to indices
easily communicated and explained
can be used to determine growth rates, rates of return, and PVGO
supplements other models
Weaknesses of GGM:
very sensitive to inputs
not easily applied to non-dividend paying stocks
unpredictable growth-patterns makes using model difficult
The sustainable growth rate (SGR) is defined as...
the rate that earnings (and dividends) can continue to grow indefinitely, given that a firm's capital structure is unchanged and it doesn't issue any new equity
Sustainable Growth Rate (SGR)
Justified P/E ratio
Strengths of multistage models:
can calculate implied growth rates or required returns
can incorporate the impact of different assumptions into the model
relatively easy to construct using spread-sheet software
Limitations of multistage models
estimates are only has good as the inputs used
model must be fully understood to arrive at accurate estimates
estimates are very sensitive to assumptions regarding growth and the required return
formula and data input can lead to errors that are difficult to identify
Implied growth rate +
r - (D1 / P0)
Value of Perpetual Preferred Shares
Equity risk premium = forecasted dividend yield + ...
long-term earnings growth estimates - US government bond yield
Free cash flow to the firm (FCFF) is...
the cash available to all of the firm's investors, including common stockholders, preferred stockholders, and bondholders after the firm buys and sells products, provides services, pays its cash operating expenses, and makes short- and long-term investments
Free cash flow to equity (FCFE) is...
the cash available to the common stockholders after funding capital requirements, working capital needs, and debt financing requirements
Use the FCF model instead of DDM if the following conditions apply:
The firm does not pay cash dividends.
Dividend policy does not reflect the firm's long-run profitability.
The firm is a take-over target (because FCF models take a control perspective).
Strengths of FCF
used with firms that have no dividends
functional model for assessing alternative financing policies
Limitations of FCF
If FCF < 0
requires detailed understanding of accounting and FSA
information not readily available or published
FCFF from NI =
FCFF from EBIT =
FCFF from EBITDA =
FCFF from CFO =
FCFE from FCFF =
FCFE from NI =
FCFE from CFO =
FCFE with target debt ratio =
Dividends, share repurchases, and share issues have no effect on FCFF and FCFE (T/F)
Leverage changes have only a minor effect on FCFE and FCFF (T/F)
F, no effect on FCFF
Use FCFE when...
capital structure is stable
Use FCFF when...
high or changing debt levels
End net PPE - Beg net PPE + Dep +/- L/(G) on sale
not always a sale
Δ(OCA - OCL)
Debt / asset
Is NI a poor proxy for FCFE
EBITDA is a strong proxy for FCFF (T/F)
FCFE = Earnings per share − ...
(Capital Expenditures − Depreciation) (1 − Debt Ratio) − (Change in working capital)(1 − Debt Ratio)
In using FCFE models, the assumption of growth should be consistent with assumptions of other variables (T/F)
The estimate of value from FCFE models will always be different from the value obtained using DDM, if the FCFE is...
greater than dividends, and the excess cash is not invested in zero NPV projects
Method is comparables is sparsely used by analysts (T/F)
F, most common method used
The economic rationale for the method of comparables is...
the Law of One Price
Actual > justified means...
A justified price multiple is what the multiple...
should be if the stock is fairly valued
A price multiple can be justified based one of two methods:
method of comparables
method of forecasted fundamentals
Method of comparables uses prices scaled by a measure of value such as...
sales, net income, book value, or CF
Method of forecasted fundamentals relates multiples to company fundamentals such as...
growh, risk, and payout
Rationales for P/E
Earnings power (EPS) key to investment value
Focal point for Wall Street
Differences in P/Es may be related empirically to differences and long-run stock returns according to research
Ratio can be used as a proxy for risk and growth
Drawbacks for P/E
Negative and very low earrings make P/E useless
Volatile or transitory earnings make interpretation difficult
Management discretion on accounting choices can distort earnings (FSA link)
Solely using the ratio avoids addressing the fundamentals (growth, risk, and cash flows)
Justified trailing P/E ratio
Justified leading P/E ratio
Methods used to find normalized earnings for cyclical businesses
historical average EPS
PEG ratio does not account for:
Differences in firm risk attributes
Differences in the duration of growth
Nonlinear relationship between growth and the P/E ratio
Terminal value = trailing P/E x ?
Assuming similar risk, the implied valuation rule is that stocks with lower PEG ratios are undervalued relative to high-PEG stocks (T/F)
Justified trailing P/E = justified leading P/E x ?
Rationale for P/B ratio
Usually positive (even when EPS < 0)
Less volatile, more stable than EPS
Good for firms with mostly liquid assets (e.g., financial firms)
Useful for distressed firms, liquidation
Differences in P/B ratios explain differences in long-run average returns
Drawbacks for P/B ratio
Does not reflect value of intangible assets, off-B/S assets (e.g., human capital)
Misleading when comparing firms with significant differences in asset size
Different accounting conventions obscure comparability (particularly international)
Inflation and technological change can cause big differences between BV and MV
Justified P/B ratio
Rationale for P/S ratio
P/S useful for distressed firms
Sales revenue is always positive
Sales are generally more stable and less prone to distortion than EPS, over time
P/S useful for mature, cyclical, and zero-income stocks
Differences in P/S rations may be related to difference in long-run average returns
Drawbacks for P/S ratio
High sales growth does not translate to operating profitability
P/S ratio does not capture different cost structures between firms
Revenue recognition methods can distort reported sales and forecasts
Justified P/S ratio
Rationales for P/CF
More difficult to manipulate CF than EPS
Cash flow is more stable than earnings
Addresses quality of earnings problem
Differences in P/CFs may explain differences in long-run average returns
Drawbacks for P/CF
flows, such as net fixed investments, working capital investment and net borrowings
FCFE is preferable to CFO, but FCFE more volatile and more difficult to compute
FCFE can be negative with large capex
market value of equity / total cash flow
market price per share / cash flow per share
NI + dep + amort
adjusted CFO =
CFO + [(net cash interest outflow) x (1 - t)]
CFO - FCInv + Net borrowing
Analysts typically use trailing cash flows when calculating price-to-cash-flow ratios (T/F)
Justified P/CF ratio
If using total company value, _____ is more appropriate than equity market price (P)
market value of CS + Mkt Value of debt + minority interest - cash and short-term investments
Trailing D/P (Dividend Yield) ratio
Leading D/P (dividend yield) ratio
Rationale for D/P
Dividend yield is a component of total return
Dividends are a less risk component of total return than capital appreciation
Justified D/P =
Drawbacks for D/P
focus on D/P is incomplete because it ignores capital appreciation
dividends now would displace future savings, which implies a trade-off between current and future cash flows
Rationale for EV / EBITDA
Comparing firms with different financial leverage since EBITDA is pre-interest
Controls for dep/amort differences
EBITDA usually positive when EPS is negative
Drawbacks for EV / EBITDA
Ignores changes in WC investments
FCFF (which controls for Capex) is more closely tied to value
The goal of normalizing earnings is to adjust for...
Most of the time, the P/E multiple of a cyclical firm will ______ at the depths of recession and __________ at the peak of an economic boom
The problems encountered when using the price-to-earnings (P/E) multiples of cyclical firms can be completely eliminated by using average or normalized earnings (T/F)
F, only minimized
Retention Rate × Profit Margin × Sales/book value of equity =
Leading P/S =
(profit margin × payout ratio) / (r − g)
Book values are not very meaningful for firms in service industries (T/F)
What price multiples is most severely damaged by international accounting differences?
(not sure if it's the most affected but it is very affected)
P/E multiples are often computed using the average of the multiples of comparable firms, because...
it is conceptually very straightforward
______ is most strongly linked to valuation theory
Residual income is equal to...
the net income of a firm less a charge that measures stockholders' opportunity costs in generating that income
Accounting income will overstate returns from Equity investor perspective because it ignores...
cost of equity
RI (calculation) =
net income - (equity capital x cost of equity)
Alternatively, using a pre-leveraged figure, RI =
EBIT*(1-t) - (total capital x WACC)
Economic value added (EVA®) measures...
value added to shareholders by management
the effect on value of management's decisions since the firm's inception
market value of firm - invested capital
Residual income model
Single stage residual income model
Strengths of RI
terminal value does not dominate the valuation equation
uses available accounting data
applicable to non-dividend paying firms
focuses on economic profit
Limitations of RI model
accounting data may be manipulated
accounting data may require significant adjustment
model assumes a clean surplus relationship
What is meant by a clean surplus relationship
end BV = beg BV + earnings - div
Ri is most appropriate for...
non-dividend paying firms
firms with negative FCF for the foreseeable future,
firms with high uncertainty about the terminal value of the equity
Value is recognized later under RI model than under DSCF model (T/F)
look at notes for continuing RI model
Common balance sheet adjustments that you may have to allow for include the following:
Changing inventory value from LIFO to current value.
Capitalization of operating leases.
Pension asset/liability issues.
In a single-stage residual income model with ROE greater than the required rate of return, justified P/B will be greater than one
In a single-stage residual income model with ROE greater than the required rate of return, market value will be _____ than book
In a single-stage residual income model with ROE greater than the required rate of return, free cash flow to equity will be positive (T/F)
F, there is no clear relationship with free cash flow to equity
In a competitive market, ROE has been found to decline over time to the...
cost of equity
As ROE approaches the cost of equity, residual income approaches...
In general, firms making aggressive accounting decisions will report book values that are...
PV(cont. RI in year T-1)
w = 1 + g
Intrinsic value for RI is the sum of three components:
V0 = B0 + (PV high-growth RI) + (PV cont. RI)
Implied Growth Rate of RI =
Approach 1: Drop to zero (w=0)
PV(cont RI in yr. T-1) = RI(t) / (1+r-0) = RI(t) / (1+r)
Approach 2: current level forever (w=1)
PV(cont Ri in yr. T-1) = RI(t) / (1+r-1) = RI(t) / r
Approach 3: Decline slowly to 0 (0 < w < 1)
PV(cont RI in yr. T-1) = RI(t) / (1+r-w)
Approach 4: Mature industry
Market value = book 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)
Private vs Public Companies Company Specific Factors
Stage of life cycle
Quality/depth of management
Quality of information
Private vs Public Companies Stock Specific Factors
Restrictions on liquidity
Concentration of control
Reasons For Valuing Private Companies
Transaction-related valuations are necessary when...
selling or financing a firm.
Types of transaction-related valuations
Venture capital financing
Types of compliance-related transactions
Compliance-related valuations are performed for...
legal or regulatory reasons and primarily focus on financial reporting and tax issues
Litigation-related valuations may be required for...
shareholder suits, damage claims, lost profits claims, or divorce settlements
Types of litigation-related transactions
Approaches to valuation
Issues in Cash Flow Estimation
Controlling versus non-controlling interests
Life cycle stage
Capital structure changes
Income Approach Methods
capitalized cash flow
Discount Rate Estimation Elements
Availability and cost of debt
Acquirer vs target
Types of market approaches
Guideline Public Company Method
Guideline Transactions Method
Prior Transaction Method
The guideline public company method uses...
the market values of similar publicly traded shares adjusted for differences in growth and risk between the two companies
Advantage of guideline public company
plenty of data
Disadvantage of guideline public company
data may not be comparable
The guideline transactions method uses...
the values from actual sales of controlling positions in either public or private companies
The prior transaction method uses...
sales prices from actual transactions in the subject company's shares
Characteristics of asset-based approach
Not used for going concerns
Usually the lowest valuation
Asset-based approach can be used for:
Firms with few intangibles
Natural resource firms
Prior transaction method is best used when using...
recent arm's-length data of the same motivation
1 - [1 / (1 + control premium)]
For DLOC, Estimate using ______ earnings instead of normalized earnings for:
DLOM Varies With...
Likelihood of IPO, or dividends
Pool of buyers
Investment value is the value of a private company that depends on...
the investor's expectations and investment requirements
________ Method uses the price multiples of comparable public companies
Guideline Public Company
________ method typically assumes minority control
Guideline Public Company
_______ Method uses the price multiples of acquisitions of the entire public or private companies, thus reflecting controlling interest
Value of equity =
FCFE(1) / (r-g)
If an interest in a firm cannot be easily sold, a ______ is applied
The primary advantage of using put prices to estimate the DLOM is...
the volatility of the firm can be incorporated into the analysis
A private business is being valued for the purpose of determining the appropriate level of performance-based managerial compensation would be best described as...
The _________ approach values a firm using the price-multiples such as the price-to-book-value ratio and price-earnings ratio of comparable assets
What type of valuation models value a company without peer valuation
DGM and FCF models are examples of what type of valuation models
Will an increase in depreciation increase or decrease ROIC
Price / P/E =
What is 3 step Dupont
profit margin x asset turnover x financial leverage
(Div / Index value) + expected earnings growth - LT government bond yield =
equity risk premium
The primary problem with using returns gathered over a long time period is that equity premiums...
vary over time with the market's perception of risk and relative risk
The build-up method assigns premiums based on...
company size and other company-specific factors
For taking rapid inflation changes into account, a ________ model works the best
The bond-yield method adds a risk premium to the...
yield on the company's publicly traded debt
What is cost leadership
producing at the lowest cost
The method of forecasted fundamentals relates multiples to company fundamentals using a...
The method of forecasted fundamentals relies on benchmarks (T/F)
F, not typically
The method of forecasted fundamentals relies on specifically on the Law of One Price (T/F)
___________ make cross-border comparisons for valuation purposes challenging
Different accounting conventions
Total Discount (for DLOC and DLOM) =
1 - [(1 − DLOC)(1 − DLOM)]
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