Lvl2: Equity

rational efficient markets formulation

investors will not rationally incur the expenses of gathering information unless they expect to be rewarded by higher gross returns compared with the free alternative of accepting the market price

difference between a valuation estimate and the prevailing market price

• true mispricing - true but unobservable intrinsic value V and the observed market price P

• error in the estimate of the intrinsic value - valuation estimate and the true but unobservable intrinsic value

valuation process

• Understanding the business. Industry and competitive analysis, FS analysis

• Forecasting performance

• Selecting appropriate model

• converting forecasts to valuation

• applying conclusions - investment recommendation

sum-of-the-parts valuation

sometimes called the breakup value or private market value

segments in different industries that have different valuation characteristics

DDM is suitable when

• dividend-paying

• board of directors has established a dividend policy that bears an understandable and consistent relationship to the company’s profitability

• investor takes a non-control perspective

FCFE /FCFF model suitable when

• not dividend-paying

• dividends significantly exceed or fall short of free cash flow to equity

• free cash flows align with the company’s profitability

• control perspective

residual model

book value per share plus the present value of expected future residual earnings.

residual model suitable when

• not paying dividends

• expected free cash flows are negative

present value of growth opportunities

justified pe ratio

leading PE

trailing PE

H-model

growth begins at a high rate and declines linearly throughout the supernormal growth period until it reaches a normal rate at the end

• H = half-life in years of the high-growth period (i.e., high-growth period = 2H years)

• g_S = initial short-term dividend growth rate

• g_L = normal long-term dividend growth rate after Year 2H

sustainable growth rate

g = b × ROE

FCFF vs FCFE

FCFF = NI + NCC + Int(1 – Tax rate) – FCInv – WCInv

FCFE = FCFF – Int(1 – Tax rate) + Net borrowing.

FCFF = CFO + Int(1 – Tax rate) – FCInv

FCFE = CFO − FCInv + Net borrowing.

FCFF = EBITDA(1 – Tax rate) + Dep(Tax rate) – FCInv – WCInv.

Interest and dividends (IFRS vs GAAP)

deferred taxes

• should not add back deferred tax changes expected to reverse unless ot can consistently defer until a much later date

Incremental fixed capital expenditures as a proportion of sales increases

Required rate of return (real)

Country return (real)

+/– Industry adjustment

+/– Size adjustment

+/– Leverage adjustment

value of firm (FCFF)

V = Value of operating assets (FCFF) + value of non-operating assets (cash, marketable securities, land held for investment)

when to use FCFF vs FCFE

• target debt/equity ratio is expected to remain consistent - FCFE

P/E ratios

• Earning power is a chief driver of investment value,

• widely recognized and used

• EPS can be zero, negative, or insignificantly small

• difficult to distinguish transient components

• managers may distort EPS

normalizing EPS

estimating the level of EPS that the business could be expected to achieve under mid-cyclical conditions

• historical average EPS

• average return on equity, in which normalized EPS is calculated as the average return on equity (ROE) from the most recent full cycle, multiplied by current book value per share - effect on EPS of growth or shrinkage in the company’s size

inverse price ratio - earnings yield

• reciprocal of the negative PE ratio

Predicted P/E Based on Cross-Sectional Regression

• over a particular time period - predictive power over a different time/stock not known

• relationships between P/Es and such characteristics as earnings growth, dividend payout, and beta are not stable over time

• prone to the problem of multicollinearity

PEG ratio

P/E divided by the expected earnings growth rate (in %)

• assumes a linear relationship between P/E and growth - in reality not linear

• does not factor in differences in risk

• does not account for differences in the duration of growth

justified price - historical eps

P/B

• generally positive even when EPS is zero

• book value per share is more stable than EPS- when EPS is abnormally high or low or is highly variable

• companies composed chiefly of liquid assets, such as finance, investment, insurance, and banking institutions

• not expected to continue as a going concern

• human capital more important than physical capital - service companies not appropriate

• levels of assets differ significantly - diff business models

• Accounting effects on book value

• some historical value some fair value

• share repurchases or issuances can distort historical comparison

(Common shareholders’ equity)/(Number of common stock shares outstanding) = Book value per share

Adjustments to PB ratio

• subtracting reported intangible assets

• goodwill should be excluded

• restate the book value of the company using LIFO to what it would be based on FIFO

• adjusted for significant off-balance-sheet assets and liabilities

justified PB ratio

Price/Sales

• Sales are generally less subject to distortion or manipulation than are other fundamentals

• Sales are positive even when EPS is negative

• appropriate for valuing the stocks of mature, cyclical, and zero-income companies

• business may show high growth in sales even when it is not operating profitably

• Share price reflects the effect of debt financing on profitability and risk but sales are before financing

• does not reflect differences in cost structures

• revenue recognition practices

justified PS ratio

price to CF ratio

• Cash flow is less subject to manipulation

• addresses the issue of differences in accounting conservatism

• Operating cash flow, for example, can be enhanced by securitizing accounts receivable

price/dividend yield

• less risky component of total return than capital appreciation

• but only one component of total return

• may trade off future earnings growth to receive higher current dividends

annualized dividend rate divided by the current market price per share

justified price/dividend yield

Enterprise Value/EBITDA

• for comparing companies with different financial leverage (debt)

• EBITDA controls for differences in depreciation

• EBITDA is frequently positive when EPS is negative

• EBITDA will overestimate cash flow from operations if working capital is growing

• FCFF better

Enterprise Value

• Market value of common equity (Number of shares outstanding × Price per share)

• Plus: Market value of preferred stock (if any) and any minority interest (unless included elsewhere)

• Plus: Market value of debt

• Less: Cash and investments (specifically, cash, cash equivalents, and short-term investments)

• Equals: Enterprise value.

Return on invested capital

operating profit after tax divided by invested capital

Earnings surprise

UE_t = EPS_t – E(EPS_t),

standardized unexpected earnings (SUE)

harmonic mean - for multiples

mitigate the impact of large outliers. It may aggravate the impact of small outliers

look-ahead bias

use of information that was not contemporaneously available in computing a quantity - back testing

capital charge

total cost of capital in money terms

COE* Equity + COD*(1-t)*Debt

Residual income

NOPAT (after tax) - Capital charge or

Net income - Equity charge

ROIC

NOPAT (after tax)

Residual income can also be calculated as (ROIC – Effective capital charge) × Beginning capital.

economic value added

EVA = NOPAT – (C% × TC),

C% is the cost of capital, and TC is total capital

market value added

residual income model

current book value of equity + pv of expected residual income

assumes clean surplus accounting

excess earnings model

justified residual income model

Tobin’s q

ratio of the market value of debt and equity to the replacement cost of total assets

• expected to be higher the greater the productivity of a company’s assets

residual income model where residual income fades over time

persistence factor, ω, which is between zero and one

1: will not fade

residual income model - Strengths & weaknesses

• Terminal values do not make up a large portion of the total present value

• readily available accounting data

• companies that do not pay dividends or to companies that do not have positive expected near-term free cash flows

• when cash flows are unpredictable

• focus on economic profitability

• accounting data that can be subject to manipulation

• require either that the clean surplus relation hold

• assumes that the cost of debt capital is reflected appropriately by interest expense

DLOC & Control premium

DLOC = 1 – [1/(1 + Control premium)]

discount for lack of marketability (DLOM)

reflect the relative absence (compared with publicly traded companies) of a liquid market for a company’s shares.

DLOM + DLOC

Total Discount = [1 – (1 – DLOC)×(1 – DLOM)]