AFM 273 Final Flashcards

What’s the main idea of comparable

• Look at what the market pays for similar companies & use that price to project yours

What’s the problem with comparable

• Companies are different sizes, so you can’t compare raw prices

Solutions to comparables

• Multiples

Define Multiples

• The price you pay per dollar of some operating number from the company

• What you pay/ A measure of what you get

Define Numerator

• What you’re paying (A value)

Define a denominator

• What you’re getting in return (Earnings, Cashflow, Revenue)

How to calculate Multiples

1. Average of weighted average of comparable companies

2. Multiply by your company’s denominator to get the value

What are some equity multiples (price based)

• P/E: Price-to-Earnings

• PEG Ratio:

• P/B: Price-to-Book

• P/CF: Price-to-Cashflows

• P/FFO: Price-to-Fund From Operations

• P/NAV: Price-to-Net Asset Value

Explain P/E (Price-to-Earnings)

• How many dollars you pay for each $1 of yearly profit

• Formula: Share Price/EPS

• Ex. $50 share price/$5 EPS = 10

• Used: Mature & stable companies

Define Trailing P/E

• Price/EPS from the last 12 months

• Uses real numbers

Define Forward P/E

• Price/EPS for the nest 12 months

• Uses analyst forecasts

• Usually lower because earnings are expected to grow

Explain the PEG ratio

• P/E adjusted for growth, high P/E is ok if growth is high too

• Formula: P/E / expected earnings growth rate (gr is a whole number)

• Used: profitable, fast growing firms

Explain the P/B (Price-to-Book)

• How much you pay compared to the accounting value of the company

• Formula: Share price/Book Value of equity per share

• Ex. Price = $30, book value per share = $20 → P/B = 1.5

• Used: Firms with lots of tangible assets (banks) because their b/s are closer to the real market value

Define Book Value

• What the b/s says the company is worth

Explain P/FFO (Price-to-Fund From Operations)

• Real estate deprecation is just an accounting charge so FFO adds it back to show earnings

• Used: REITS

How to calculate FFO

• Net Income + deprecation

• Adjusted for gains or losses on selling property

Explain P/CF (Price-to-Cash Flows)

• Like P/E but uses CF which is harder to manipulate than earnings

• Formula: Share price/Cash flow per share

• Used: Mining & resource firms

Explain P/NAV (Price-to-Net Asset Value)

• Used: Mining & resource firms

• If P/NAV = 1, you pay exactly what the underlying assets are worth

What are some Enterprise Multiples (whole company based)

• EV/EBITDA

• EV/Revenue

• EV/Resources

Explain EV/EBITDA

• How many dollars you pay form the whole business per $1 of its operating earnings

• Formula: EV/EBITDA

• Used: Capital heavy firms (infrastructure) & young firms with heavy deprecation

• Weak point: proxy (Assumes spending on equipment equals depreciation, ignoring taxes and working capital)

Explain EV/Revenue

• How much you think you pay for $1 sales

• Formula: EV/Revenue

• Used: Young companies with losses, have no earnings or cash flow yet

Explain EV/Resources

• EV per unit of resource like barrel of oil or ounce of gold

• Used: Mining & Resources firm

What are some pros of multiples

• Fewer assumptions

• uses real market price, doesn’t rely on forecasting

• Simpler than a DCF

• Quick & easy to explain

What are some cons of multiples

• Hard to find companies that are truly similar

• Values relative to companies & whole industry

• Over simplified (don’t use for investing)

What are four examples of use cases for relative valuations

1. Private companies: Don’t have inputs for DCF (like beta and market value)

2. Short term or momentum trading: If you plan to sell soon (IPO) & what matters s the price the market will pay today

3. Volatile Market: A DCF won’t capture panic selling or irrational behaviour & relative pricing reflects the market as it is

4. Stock broker: Justify stock prices by comparing them to others & making recommendations feel safer

What makes companies comparable

• Same product or service

• Similar size

• Same customer

• Same business model

• Similar growth & risk (return is a multiple of risk)

• Similar capital structure

Define Outliers

• Companies with numbers far from the rest

Should we remove outliers right away

• No, first find out why they’re an outlier

When do we keep outliers

• If it reflects something real in the industry

What to use instead that limits the effect of outliers

• The median

What are the 2 general rules for choosing multiples

• Rule 1 Must be consistently defined: top & bottom must belong to the same group

• Rule 2 Must be calculated the same way: All the comparable must measure the denominator in the same way

What are the choices of EPS

• Primary EPS: Actual shares only

• Fully diluted EPS: Actual shares + All options

• Partially diluted EPS: Only in-the-money option

• Others: Counts everything that could turn into shares options, warrants, convertible debt

Define stock option

• The right to buy a share in the future at today’s price

Define fully diluted shares

• Every share could exist if all options, warrants, convertible were used

Define Warrants

• Like options but issued from the company

Define convertible debt

• Debt that can be turned into shares

What does regression help do

• Check which multiple has the highest R2 with that industry or region

• R2: Best fit

What are the two ways that can be used to choose which multiple is used

1. Use the multiple with the highest R2 in that sector or region

2. Use th multiple that makes the most sense of that sector

What are the 5 steps of a comparable analysis

1. Identify comparable

2. Collect financial information

3. Choose & Calculate multiples

4. Benchmark the comparable

5. Determine the valuation

True or false: if you do both intrinsic & relative valuation both correctly you should get the same value

• True

What does it signal if the intrinsic & relative valuation is different

• Recheck assumptions

True or false: Which valuation model you use depends on your goal

• True

• Long term investing: intrinsic

• Short term investing, IPO: relative

What does a company you use when competition removes all positive NPV trading opportunities

• Effective Market Hypothesis (EMH)

Define EMH

• Prices are fair given all the information provided

What are the 3 forms of EMH

• Weak form: Price isn’t based on information received, or information takes time to come in

• Semi-Strong form: All public information is already in the price

• Strong form: Price reflects everything insiders can’t profit because the law prevents it

Define Public, easy-to-read information

• The price reacts almost instantly

Define Private, hard-to-find information

• The price takes time to react

What are implications of market efficiency

• Only beat the market with competitive advantage

• Average investors don’t need to worry about being taken advantage of

What are implications of market efficiency for corporate managers

• Focus on NPV & FCF: thats what raises stock prices

• Avoid Accounting illusions: Accounting changes that don’t change cash flows don’t change value

• Use Financial transactions to support investment: Sell shares fairly to fund good projects

Define capital budgeting

• Deciding which project os a company should spend its money on

Define capital budget

• The list of projects the company prams to do in the coming years

what question that forecasting asks

• What does the project earn?

What questions does FCF & NPV ask

• What cash does it produce & is it worth it?

What are the 3 key decisions finance makes

1. Capital structure: how much debt vs equity to use

2. Capital Budgeting

3. Operating decisions: managing day-to-day (working capital)

Where do projects come from

• Other departments within a company

What are the 4 steps of capital budgeting

1. Forecast the project’s incremental earnings

2. Adjust earnings into FCF & earnings aren’t cash so we fix that

3. Discount the FCF at the cost of capital to get NPV

4. Accept NPV if its positive

Define incremental

• Only changes because of the project

Define unlevered net income

• Net income without interest

• Assumes: the project is all equity financed so no interest expense

What are the 2 important rules that must be followed when forecasting FCF associated with a project

1. Only incremental cash flow count: Only include CF that changes because of the project

2. Ignore sunk costs: Money that has already been spent & can’t be recovered so doesn’t affect the decision

What are common incremental costs

• Incremental revenue & costs: Extra sales & cost caused by the project

• Incremental taxes: Extra tax due to the project

• Incremental capital expenditures: Money spent buying equipment or buildings

• Incremental NWC
  Incremental CCA tax shield: tax savings from deducting CCA

• Opportunity cost: The value you give up by choosing one option over the other

• Externalities: Side effects on other products (cannibilzation, complementary products)

• Salvage value: Cash from selling an asset when the project ends

Define NWC

• The money the project ties up in day-to-day operations

• Formula: Current Assets - Current Liabilities

What happens when there’s an increase in NWC

• Decrease in FCF

• Increase in NWV means more cash in unpaid bills & inventory

What happens when there’s a decrease in NWC

• Increase in FCF

How do we calculate the change in Net Working Capital

• NWC this year - NWC last year

Explain CCA (Capital Cost Allowance)

• Used: to calculate taxes in capital budgeting

• Need it: because it determines how much deprecation we can deduct for tac purposes

• CCA reduced taxable income which lowers taxes paid

• CCA is not a CF but the tax saving from CCA affect CF

Explain the CRA (Canada Revenue Agency) rules

• Assets are grouped into classes each with a set CCA rate (d)

• When you buy an asset its cost goes into the UCC

Define UCC (Undepreciated Capital Cost)

• The part of the cost you haven’t claimed yet

Explain the half year rule

• Government doesn’t know when you bought the asset, it assumes the middle of the year

What’s the formulas for UCC

• Year 1(Half rule): 0.5 x CapEx

• Year t (General formula: CapEx x (1-d/2) x (1-d) ^(t-2)

What are the 2 approaches to calculating the impact of capital cost allowance on the NPV at a project

• Approach 1:l Deduct CCA each year

• Approach 2: Calculate the PV of all the CCA tax shields separately

Explain Approach 1:l Deduct CCA each year

• Compute CCA for each year then subtract it from earnings before tax then add it back when moving to FCF (bc its not cash)

• Problem: A 5 year forecast might miss tax savings that continue after the project ends

How to calculate unlevered net income

• EBIT x (1 - tc)

• OR (Revenue - Cost - CCA) x (1-tc)

How to calculate FCF

• (Revenue - Cost) x (1 - tc) - CapEx - Change in NWC + tc x CCA

How to calculate CCA tax Shield

• tc x CCA

When can you use this Approach 2: Calculate the PV of all the CCA tax shields separately

• When CCA shield is left out of the FCF

What’s the formula for PV cca tax shield

• (CapEx x d x tc/ r+d) x (1 + r/2/1+r)

• (CapEx x d x tc/ r+d): growing perpetuity accounting for -d

• (1 + r/2/1+r): Half year rule

Formula for selling the asset

• -(min ( sale price, CapEx) x d tc/ r+ d) x (1/(1+r)^t)

What does it means if proceeds > original costs

• Capital gain

Formula for capital gain tax

• ½ (proceeds - CapEx) x tc

What does it mean if proceeds < original cost

• Capital loss

Define depreciable asset

• You can’t deduct the capital loss for tax purposes

What is removed from UCC

• the lower of the original cost or sale price

Only what can be used to claim CCA

• Remaining UCC after deducting the sale price original price

What’s an exception to UCC

• Terminal loss

• If the asset sold was the las asset in the class

• The firm can claim whatever remains in UCC as terminal loss

• Which reduces taxable income

Define opportunity cost

• The value you give up by using a resource for a project instead of the next best

Define externalities

• Indirect effects of the project on other parts of the business

• Cannibalization: when the project takes away sales from an existing product; loss profit is negative cash flow

• Complementary products: customer but more of something else because of the project; increase profit is positive cash flow

Define sunk costs

• A cost already incurred that must be paid whether we take the project or not

• Ex. Past R&D, Fixed overheard, unavoidable competitive effects

Define fixed overhead

• Costs that don’t change because of the project

• Ex. rent, CEO salary

Define cannibilization caution (unavoidable competitive effects)

• Ignore sales lost to competitors anyway

What do we do when firms forecast the FCF of the project less than what its supposed to be

• Add an extra one-time cash flow at the end of the forecast period (terminal value)

Formula of PV terminal value & step by step how to solve

• (FCFn+1/rwacc - gFCF)/(1+rwacc)^n

1. Take the first FCF after the forecast period

2. Divide by (r-g) because its growing

3. Discount back n years to today

What do we leave out when evaluating a project & why

• Interest expense

• Because: Interest depends on how the firm chooses to finance the project which is a separate decision

Define marginal corporate tax rate

• The tax rate on the next dollar of pre-tax income the project earns

What’s the formula for NPV

• NPV = Sum of all PV

• PV (FCFt) = FCFt /(1+r)^t