Reading equity valuation: applications and processes

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Reading 24: equity valuation: applications and processes

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Different kinds of value & valuation

Ø intrinsic value (IV)• we are referring to the valuation of an asset or security by someone who has

complete understanding of the characteristics of the asset or issuing firm.

Ø Fair market value• the price at which a hypothetical willing, informed, and able seller would trade

an asset to a willing, informed, and able buyer.Ø Investment value• the value of a stock to a particular buyer. depending on the buyer’s specific

needs and expectations, and perceived synergies with existing buyer assets.Ø Liquidation value• the estimate of what the assets of the firm would bring if sold separately, net

of the company’s liabilities. 2


applications of equity valuation.

Ø Objectives• Stock selection:Check if this security is fairly priced, overpriced, or underpriced

relative to its current estimated intrinsic vaule and relative to the prices ofcomparable securities.

• Inferring(extracting)market expections:Market prices reflect the expectations ofinvestors about the future performance of companies.

• Evaluating corporate events:Investment bankers, corporate analysts, and investmentanalysts use valuation tools to assess the impact of such corporate events as mergers,acquisition, divestitures, spin-offs, and going private transactions.

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Ø Objectives• Fairness opinions:The parties to a merger may be required to seek a fairness

opinion on the terms of the merger from a third party, such as an investment bank.• Evaluating business strategies and models: Companies concerned with maximizing

shareholder value evaluate the effect of alternative strategies on share value.• Communicating with analysts and shareholders:Valuation concepts faciliate

communication and discussion among company management, shareholders, andanalysts on a range of corporate issues affecting company value.

• Appraising private businesses:Valuation of the equity of private businesses isimportant for transactional purposes and tax reporting purposes among others.

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• Porefolio mangementü Planning, execution and feedback 3 steps in the portfolio management

process(valuation is not closely associated with the planning andexecution steps).

ü PlanninguIdentification and specification the investment objectives and constraints

writing detail on the investment strategy of securities selection.uValuation on individual security is not apply to Indexing strategy but active

management.ü ExecutionuPortfolio selection;uPortfolio implementation.ü Feedback

5


Quantitative and qualitative factors in valuation

Ø Quantitative factors• Key source from company's accounting information and financial disclosures.• Including balance sheet, income statement, cash flow statement, as well as the

footnotes.Ø Quantitative factors• Purpose:to measure industry performance, such as legal and regulatory envirnment.• Includingü Quality of the firm's management team;ü The transparency of its performance;ü The analyst's confidence in the firm's;ü Industry's accounting practices.

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quality of input

Ø quality of financial statement information

• investigating the issues associated with the accuracy and detail of a firm’sdisclosures

• The basic building blocks of equity valuation come from accountinginformation contained in the firm’s reports and releases.

7


Alpha

Ø Alpha,an excess risk-adjusted return, also called an abnormal return.Ø Formula• Ex ante alpha=expected holding period return-required return• Ex post alpha=actual holding period return-contemporaneous required

returnØ The difference between intrinsic value(V)and market value(P) perceive

mispricing becomes part of the manger's forecast of expecte returninfluence the total return on the asset namely influence alpha.

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going concern assumption

Ø Going concern assumption

• the assumption that a company will continue to operate as a business, asopposed to going out of business.

• The valuation models we will cover are all based on the going concernassumption.

Ø Non-going-concern assumption

• The assumption that the company will finish operating and all assets will besold out

Ø Going concern value > Liquidation value9


Types of valuation models

Ø Absolute valuation models

• Discounted cash flow model

ü DDM

ü FCF model

ü Residual income model

Ø Relative valuation models (price multiple model)

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sum-of-the-parts valuation

Ø Sum-of-the-parts value

• Rather than valuing a company as a single entity, an analyst can valueindividual parts of the firm and add them up to determine the value for thecompany as a whole. The value obtained is called the sum-of-the-parts value ,or sometimes breakup value or private market value .

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Conglomerate discount

Ø Conglomerate discount

• The market applies a discount to the stock of a company operating in multiple,unrelated businesses compared to the stock of companies with narrower focus

Ø Three explanations for conglomerate discounts are:

• Internal capital inefficiency: The company’s allocation of capital to differentdivisions may not have been based on sound decisions.

• Endogenous (internal) factors: For example, the company may have pursuedunrelated business acquisitions to hide poor operating performance.

• Research measurement errors: Some hypothesize that conglomeratediscounts do not exist, but rather are a result of incorrect measurement. 12


Reading 25: Return concepts

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framework

Ø Return concept

Ø Equity risk premium

Ø Required return on equity

Ø International consideration

Ø WACC

Ø Discount rate selection in relation to cash flow

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Return concept

Ø Holding Period

• Holding period return is the increase in price of an asset plus any cash flowreceived from that asset, divided by the initial price of the asset.

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Return concept

Ø Annualized holding period returns

• For example, if the return for one month is 1% (0.01), then the annualizedholding period return of (1 + 0.01) 12 − 1 = 0.1268 or 12.68%.

Ø Realized & Expected Holding Period Return

• A realized return is a historical return based on past observed prices and cashflows.

• An expected return is based on forecasts of future prices and cash flows.

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Return concept

Ø Required Return (opportunity cost )

• An asset’s required return is the minimum return an investor requires giventhe asset’s risk.

• A more risky asset will have a higher required return.

• If expected return is greater than required return, the asset is undervalued.

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• The discount rate is the rate used to find the present value of an investment.

Ø Internal Rate of Return

• It is the rate that equates the value of the discounted cash flows to the currentprice of the security.

• If markets are efficient, then the IRR represents the required return.

Return concept

Ø Discount Rate

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Equity risk premium

Ø Equity risk premium

• The equity risk premium is the return in excess of the risk-free rate thatinvestors require for holding equity securities.

• equity risk premium = required return on equity index − risk-free rate

Ø CAPM

• required return for stock j= risk-free return + β j× (equity risk premium)

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Equity risk premium

Ø There are two types of estimates of the equity risk premium

•

•

historical estimates

forward-looking estimates

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Equity risk premium——historical estimates

Ø A historical estimate of the equity risk premium consists of the difference between thehistorical mean return for a broad-based equity-market index and a risk-free rate over a giventime period.

• strength ： objectivity and simplicity

• Issues in historical estimates

ü Selected an appropriate index (stationary)

ü Time period. The longer the period used , the more precise the setimate

ü Arithmetic mean or geometric mean in estimating the return; ERP will be lower if geometricmean is used.

ü Long term bond or short term bill is a proxy for risk-free assets; the use of longer-term bondsrather than shorter-term bonds to estimate the risk-free rate will cause the estimated riskpremium to be smaller.

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Equity risk premium

Ø A historical estimate of the equity risk premium consists of the difference between thehistorical mean return for a broad-based equity-market index and a risk-free rate over a giventime period.

• strength ： objectivity and simplicity

• Issues in historical estimates

ü survivorship bias: The historical estimate can also be upward biased if only firms that havesurvived during the period of measurement are included in the sample.

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Equity risk premium

Ø Forward-looking estimates：use current information and expectationsconcerning economic and financial variables.

• The strength of this method ：

ü it does not rely on an assumption of stationarity

ü less subject to problems like survivorship bias

• There are three main categories

ü Gordon growth model

ü Supply-side models

ü Estimates from surveys.

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Equity risk premium

Ø GGM• GGM equity risk premium estimate=Dividend yield on the index based on year-ahead

aggregate forecasted dividends and aggregate market value +Consensus long-termearnings growth rate—Long term government bond yield.

• A simple way to understand the equation

ERP r-RFR g-RFR

• The above equation assumes growth rate is constant.• An analyst may make adjustment to reflect P/E boom or bust.Ø Another method to solve these problems

Equity Index Price PVrapid (r) PVtransition(r) PVmature(r)

0

1

PD

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1YTM of 20-yearT-bonds1

Equity risk premium

Ø Supply-Sied Estimates (Macroeconomic Model)

TIPS：Treasury Inflation Protected Securities• Expected real growth in GDP

Expected growth in real earing per share=real GDP growth=labor productivity growth rate+labor supply growth rate

Ø Survey estimates• Use the consensus of the opinions from a sample of people.

• Exected inflation

1YTM of 20-yearTIPS

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Estimates Strength WeaknessHistoricalEstimates

•Afamiliarandpopularchoice(ifreliable long-termrecordsareavailacle)

•Unbiasedestimate(ifnosystematicerrorshasbeenmade)

•Objectivequality(groundedindata)

•Precisionissues(duetothereduced/dividedlengthofdata)•Difficult-to-maintainstarionaryassumption(iftheseriesstartingpointextededtothedistantpast)•Empiricallycountercylicalexpctedequityriskpremiun•Survivorshipbiasandpositive/negativesuprises

Forward-lookingEstimates

•Available(directbasedoncurrentinfo.Andexceptationsconcerningsuchvariables)•Notsubjecttotheissueofnon-stationarityordatabiases

•Oftensubjecttootherpotentialerrorsrelatedtofinancial/economicmodelsandbehavioralbiasesinforcasting.•Subjective

Equity risk premium

Ø Comparison

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Estimates Strength Weakness

GGM •Popularmethod;•Reasonablewhenappliedtodevelopedeconomiesandmarkets;•Typicallysamplesourxes.

•Changethroughtimeandneedtobeunpdated;•Assumptionofastablegrowthrate.

Supplu-SideEstimates

•Provenmodels;•Currentinformation;

•Onlyappropriatefordevelopedcountries;

SurveyEstimates

•Easytoobtain •Widedisparityfromdifferentgroups

Equity risk premium

Ø Comparison

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Required return equity

Ø To estimate the required return on equity, the analyst can choose followingmodels

• CAPM• Multi-factor Modelsü Fama-French Model(FFM)ü Pattor-Stambaugh model(PSM)ü Marcroeconomic Multifactor models• Build-up methodü Bond Yield Plus Risk Premium Method

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Ø Capital Asset Pricing Model

• required return on stock j = risk-free rate + (equity risk premium × beta of j)

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Ø Beta Estimates for Public Companies

• For a public company, an analyst can compute beta by regressing the returnsof the company’s stock on the returns of the overall market.

Ø Adjusted Beta for Public Companies

• adjusted beta = (2/3 × regression beta) + (1/3 × 1.0)

• Beta drift refers to the observed tendency of an estimated beta to revert to avalue of 1.0 over time.

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companies



Ø Estimating Beta for tiny trraded stock or nonpublic companies

● Step 1:Selecting benchmark company(comparable);

√ Use the public companies' information in the same industry;

● Step 2：Estimate the benchmark's beta(similar with previous section);

● Step 3:Unlevered enchmark's beta

● Step 4:Lever up the unlevered beta for tiny traded stock or nonpublic

E 1D/ Eu

�

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Ø Multifactor Model

• Multifactor models can have greater explanatory power than the CAPM, whichis a single-factor model. The general form of an n-factor multifactor model is:

• Factor sensitivity or factor beta is the asset's sensitivity to a particularfactor(holding all other factors constant),and zero sensitivity to all otherfactors.

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Ø Multifactor Model• Fama-French Model V.S. Pastor-Stambaugh Model(PSM)

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FactorSensitivityRiskPermium(%)

MarketFacor 1.20 4.5

SizeFactor -0.50 2.7

ValueFactor -0.15 4.3


Ø The estimated factor sensitivites of TerraNova Energy to Fama-French factors andthe risk premium associated with those factors are given in the table below.

1. Based on the Fama-french model,calculate the required return for TerraNovaEnergy using theses estimates.Assume that the Treasure bill rate is 4.7 percent.

2. Describe the expected style characteristics of TerraNova based on its factorsensitivites.

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2. TerraNova Energy appears to be a large-cap, growth-oriented, high ,market riskstock as indicated by its negative size beta, negative value beta, and market betaabove 1.0.

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Ø Macroeconomic Multifactor Models（了解）

• The Burmeister, Roll, and Ross model incorporates the following five factors:

1. Confidence risk: unexpected change in the difference between the return ofrisky corporate bonds and government bonds.

2. Time horizon risk: unexpected change in the difference between the returnof long-term government bonds and Treasury bills.

3. Inflation risk: unexpected change in the inflation rate.

4. Business cycle risk: unexpected change in the level of real business activity.

5. Market timing risk: the equity market return that is not explained by theother four factors.

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Ø Build-Up Method

• The build-up method is similar to the risk premium approach. It is usuallyapplied to closely held companies where betas are not readily obtainable.

• required return = RF + equity risk premium + size premium + specific-companypremium

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Estimates Strength WeaknessCAPM •Verysimpleinthatitusesonlyone

fator•Choosingtheappropriatefactor.•Lowexplanatorypowerinsomecases

Multifactor •Higherexplanatorypower(notassued)

•Morecomplexityandexpensive

Build-up •Simple•Canapplytocloselyheldcompanies.

•Historicalvaluesmaynotberelevanttocurrentmarketconditions


Ø Comparison

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International consideration

Ø Country risk

1. CAPM model

2. Country Spread Model

3. Country Risk Rating Model

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WACC

Ø The cost of capital is most commonly estimated using the company's after-taxweighted average cost of capital, or weighted average cost of capital (WACC)forshort.

• A weighted average of required rates of return of the component sources ofcapital

rceMVCE

MVDMVCEMVD

MVDMVCEWACC rd1Taxrate

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Discount rate selection in relation to cash flow

Ø Being used as discount rates in valuation,required returns need to be definedappropriately relative to the cash flows to be discounted.

• Cash flow to equity the required return on equity• Cash flow to the firm the firm's cost of capital(after-tax weighted average

cost of capital)Ø When cash flows are stated in real terms,amounts reflect offsets made for

actual or anticipated changes in the purchasing powers of money.• Nominal cash flows nominal discount rates• Real cash flows real discount rates

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Reading 26: INDUSTRY AND COMPANY ANALYSIS

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approaches for developing inputs to equity valuation models

Ø Bottom-up analysis starts with analysis of an individual company or its reportable

segments. Revenue projections based on historical revenue growth or a

company’s new product introductions over the forecast horizon are considered

bottom-up approaches.

Ø Top-down analysis begins with expectations about a macroeconomic variable,

often the expected growth rate of nominal GDP. Revenue projections that are

derived from an estimate of GDP growth and an expected relationship between

GDP growth and company sales are an example of a top-down approach.

Ø Hybrid analysis incorporates elements of both top-down and bottom-up analysis.

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Long term VS short term forcast

Ø Long term forecasting

• 基于growth rate (g) , 粗略估计

Ø Short term forecasting

• 预测每一年的B/S I/S，对应得到FCF

Ø 先预测利润表，基于利润表结果，预测资产负债表

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Forecasting items

Ø Forecasting items (利润表)

• Revenue

• COGS

• SG&A

• Interest

• Tax

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Forecasting items

Ø Forecasting items (资产负债表)

• A/R

• Inventory

• F.A

• I.A

• A/P

• Note payable

• Long-term debt

• Capital

• R/E• Cash 48


Reading 27: Discounted Dividend Valuation

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framwork

1. The Gordon Growth model

2. Discount cash flow model

3. Multistage dividend discount model

4. Growth phase, transitional phase, and maturity phase

5. Equity analysis

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The Gordon Growth model

Ø Assumption

1. The firm expects to pay a dividend, D 1, in one year.

2. Dividends grow indefinitely at a constant rate, g (which may be less than zero).

3. The growth rate, g, is less than the required return, r.

Ø Formula

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Ø The value of a firm's equity has two components• The present value of a perpetual cash flow of equity;• The present value of its present value of growth opportunities(PVGO).

v0 E1 /r PVGOwhere:E1 earnings at t=1

r=required return on equity

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Ø Justified P/E• Leading P/E P 0 / E1 1b/r g• Trailing P/E P 0 / E0 1b*1 g/r g

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D D

1r 1r 1r

Discounted cash flow models

Ø Valuing perferred stock• The preferred stock holders are promised to receive a stated dividend for an

infinite period;• Preferred stock is perpetuity since it has no maturity;• Valuation model of a preferred stock.

D

rD

N V ...2

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Discounted cash flow models

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V0 n D01 gSt D0 1 gSn 1 gL1r 1rn r gL

Multistage dividend discount model

Ø Two-Stage DDM

• two-stage DDM we assume the company grows at a high rate for a relativelyshort period of time (the first stage) and then reverts to a long-run perpetualgrowth rate (the second stage).

t t1

where:

gs=short-term growth rate

gL=long-term growth rate

r=required retunrn

n=length of high growth period 60



Ø Carl Zeiss Meditec AG(Deutsche BÖrse XETRA:AFX),65 percent pwned bythe Carl Zeiss Group, provides screening,diagnostic, and therapeuticsystems for the treatment of ophtalmologic(vision) problems.Reviewingthe issue as of mid-August 2013,when it is trading for €23.37.

• Hans Mattern, a buy-side analyst covering Meditec, forecasts that thecurrent dividend of €0.40 will grow by 9 percent per year during the next10 years.Thereafter,Mattern believes that growth rate will decline to 5percent and remain at that level indefinitely.

• Mattern estimates Meditec's required return on equity as 7.1 percentbased on a beta of 0.90 against the DAX, a 2.4 percent risk-free rate, andhis equity risk premium estimate of 5.2 percent.

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Time Value Calculation DtorVt PV

1 D1 $0.401.09 $0.4360 $0.4071

2 D2 $0.401.09 $0.4752 $0.4143

3 D3 3

$0.401.09$0.5180 $0.4217

4 D4 4

$0.401.09$0.5646 $0.4291

5 D5 5

$0.401.09$0.6154 $0.4368

6 D6 6

$0.401.09$0.6708 $0.4445

7 D7 7

$0.401.09$0.7312 $0.4524

8 D8 8

$0.401.09$0.7970 $0.4604

9 D9 9

$0.401.09$0.8688 $0.4686

10 D10 10

$0.401.09$0.9469 $0.4769


Ø Correct Answer:

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Ø Three-stage DDM:the growth rate fits the three growth stages.

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Ø IBM(as of early 2013)pays a dividend of $3.30 per year. A current price is$194.98.An analyst makes the following estimates.

• The current required return on equity for IBM is 9 percent, and• Dividends will grow at 14 percent for the next two years,12 pecent for the

following five years,and 6.75 percent thereafter.• Based only on the information given,estimate the value of IBM using a three-

stage DDM approach.

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Time Value Calculation DtorVt PresentValue

1 D1 3.301.14 $3.7620 $3.4514

2 D22

3.301.14$4.2887 $3.6097

3 D32

3.301.141.12$4.8033 $3.7090

4 D422

3.301.141.12$5.3797 $3.8111

5 D523

3.301.141.12$6.0253 $3.9160

6 D624

3.301.141.12$6.7483 $4.0238

7 D725

3.301.141.12$7.5581 $4.1346

7 D725

3.301.141.121.0675/0.090.0675

$358.59 $196.161


Ø Correct Answer

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Ø Correct Answer(cont):Given these assumptions, the three-stage model indicates that a fair priceshould be $222.82, which is above the current market price by over 14percent. Characteristically, the present value of the terminal value of$196.16 constitutes the overwhelming portion(here, about 88 percent)oftotal estimated value.

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Ø H-Model

• The growth rate starts out high, and then declines linearly until it reach thelong-term growth rate

t2

V0

H

D0 1gLD0 Hgs gLr gL

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Ø Vinci SA (NYSE Eouronext:DG).Through 2003, DG paid a single regular cashdividend per fiscal year.Since 2004 it has paid two dividends per (fiscal) year, aninterim dividend in December and a final dividend in May.Although during thepast five years total annual dividends grew at less than 3 percent peryear,Delacour foresees faster future growth. Having decided to compute the H-model value estimate for DG,analyst gathers the following facts and forecasts:

• The share price as of mid-August 2013 was €41.70.• The current divided is €1.77.• The intial divided growth rate is 7 percent, declining linearly during a 10-year

period to a final and perpetual growth rate of 4 percent.• DG's required rate of return on equity will be 9.5 percent.

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Ø Correct Answer:

V0

0.0950.04 0.0950.04

33.474.8338.30

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Ø Spreadsheet modeling(只掌握概念)

l 优点：

1. Flexibility

2. Computational accuracy

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phase Initialgrowth(初创期)

Growthphasetransition

(成长期）

Maturity（成熟期）

model Three-stage Two-stage Gordongrowth

3 phase

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Calculating SGR

Ø The sustainable growth rate (SGR)

• the rate at which earnings (and dividends) can continue to grow indefinitely

• 公式：

SGR = b × ROE

b = earnings retention rate = 1 − dividend payout rate

ROE = return on equity

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Calculating SGR

Ø The sustainable growth rate (SGR)

• Expansion (PRAT model)

• Dupont model

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• 例题

Company A has an equity multiplier of 1.5, ROA of 10 percent, it retains two-thirds ofearnings . What are the sustainable dividend growth rates for Company A

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Reading 28: FREE CASH FLOW VALUATION

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framework

1. 计算FCF的公式

2. 计算公式中的item

3. 根据财务报表计算FCF

4. 用FCF折现（模型与DDM中相同）

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Introduction to FCF

Ø Why we use FCF (FCFF/FCFE)

•

•

•

•

some companies do not pay dividends;

the dividends paid differ significantly from the company’s capacity to paydividends;

Free cash flows align with profitability within a reasonable forecast periodwith which the analyst is comfortable;

FCF valuation takes a "control” perspective; DDM takes a “minority”perspective

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Introduction to FCF

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Introduction to FCF

Ø FCF 选择的问题（FCFF or FCFE）

•

•

•

FCFE is easier and more straightforward

If a company has negative FCFE, we use FCFF, which is usually positive

Equity value = Firm value - Market value of debt

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Introduction to FCF


•

•

The value of the firm is the present value of the expected future FCFFdiscounted at the WACC

firm value = FCFF discounted at the WACC

ü FCFFt= FCFFt-1× （1+g)

ü Firm Value=FCFF1/ (WACC-g) = FCFF0(1+g) /(WACC-g)

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Introduction to FCF


•

•

The value of equity : the present value of the expected future FCFEdiscounted at the required return on equity(r).

The methods to estimate r

1. CAPM

2. Multifactor model

3. Build up method

• Constant Growth Valuation Model

1. Equity Value=FCFE1I (r-g)

2. FCFE （1+g) I (r-g) 81


FCF计算公式

Ø 10 个公式

•

•

•

计算 FCFF 有 4 个公式

计算 FCFE 有6个公式

记住2个核心公式，推导其余8个公式

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FCF计算公式

Ø 计算FCFF

• From EBIT : FCFF=EB1T× (1-T)＋ NCC – FCINV – WCINV（核心公式）

• From NI: FCFF=( Nl+ NCC – Wcinv) ＋ Int×(1-T) – FCINV

•

•

From EBITDA: FCFF=EBITDA× (1-T)＋ NCC×T – FCINV – WCINV

From CFO: FCFF= CFO ＋ lnt× (1-T) – FCINV

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FCFE=NI+NCC-WCINV-FCINV+NBl From NI :

l From DR :

FCF计算公式

Ø 计算FCFE (以计算FCFF公式为基础)

l 核心公式：FCFE = FCFF − Int(1 − tax rate) + net borrowing

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NoncashItem adjustmentDepreciation +Amortization +impairmentofintangibles +Restructuringcharges(expense) +Restructuringcharges(incomeresultingfromreversal)

-

公司处置F.A的Losses +公司处置F.A的Gains -Amortizationoflong-termbonddiscount +Amortizationoflong-termbondpremiums -Deferredtaxes

NCC(Non-cash charges) adjustments

Ø NCC(Non-cash charges) adjustments for FCFF calculation

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Ø 例题

Meyer Henderson, CFA, is analyzing the financials of Roth Department Stores. He intends to use afree cash flow to the firm (FCFF) model to value Roth’s common stock. In the 2016 financialstatements and footnotes he has identified the following items:Item #1: Roth reported depreciation and software amortization of $23 million in 2016.

Item #2: The deferred tax liability increased by $17 million in 2016.

Item #3: Roth reported income of $6 million in 2016 from the reversal of previous restructuringcharges related to store closings in 2015.

Item #4: Net income totaled $173 million in 2016.

Item #5: The net increase in noncash net working capital accounts was $47 million in 2016.

Item #6: Net capital spending totaled $86 million in 2016.

Item #7: Roth reported interest expense of $19 million. 86


Ø 例题

Henderson estimated Roth’s marginal tax rate to be 35%. He also expects Roth tobe profitable for the foreseeable future, so he does not expect the deferred taxliability to reverse. As the base-year projection for his FCFF valuation, Hendersoncalculates FCFF for 2016 as:

FCFF2016= $173 + $23 - $6 + $17 + [$19(1 − 0.35)] − $86 − $47= $86.35 million

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WCINV 计算

Ø WCINV 计算

•

•

•

The investment in net working capital is equal to the change in workingcapital

excluding cash, cash equivalents, notes payable, and the current portion oflong-term debt.

公式：WCINV=WCt -WCt-1

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FCINV 计算

Ø FCINV 计算

•

•

Fixed capital investment is a net amount: it is equal to the difference betweencapital expenditures (investments in long-term fixed assets) and the proceedsfrom the sale of long-term assets:

公式：FCInv = capital expenditures − proceeds from sales of long-term assets

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FCINV 计算

Ø If no long-term assets were sold during the year:

• 公式1：基于GV

FCInv = ending gross PP&E − beginning gross PP&E

• 公式2：基于BV

FCInv = ending net PP&E − beginning net PP&E + depreciation

90


FCINV 计算

Ø If long-term assets were sold during the year

•

•

Calculate FCInv = capital expenditures − proceeds from sale of long-termassets.

公式1：基于GV

FCInv = = ending gross PP&E − beginning gross PP&E + disposal gross PP&E –disposal G/L - disposal net PP&E

• 公式2：基于BV

FCInv = ending net PP&E − beginning net PP&E + depreciation − gain on sale.

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92


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NB 计算

Ø NB计算

• 定义式

ü net borrowing = long- and short-term new debt issues − long- and short-termdebt repayments

• 计算式

ü net borrowing=debt末- debt初

ü 注意debt包含long and short-term(short-term debt : note payable)

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Free Cash Flow With Preferred Stock

Ø 特殊情况： Free Cash Flow With Preferred Stock

•

•

•

•

Remember to treat preferred stock just like debt, except preferred dividendsare not tax deductible.

If the company has preferred stock

FCFF=NI + Int * (1-T) + NCC – WCINV- FCINV

FCFE=NI + NCC – WCINV– FCINV +NB

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Ø The current FCFF for Barlow Energy is closest to

A. $36.

B. $62.

C. $86.

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Target debt ratio

计算FCFE

From NI : FCFE=NI+NCC-WCINV-FCINV+NB

NB = (WCINV + FCINV - Depr) * DR

公式6: FCFE=NI+NCC-WCINV-FCINV +(WCINV + FCINV - Dep) * DR

FCFE = NI − [(1 − DR) × (FCInv − Dep)] − [(1 − DR) × WCInv]

98


Single-Stage FCFF Model

Ø Single-Stage FCFF Model

• it’s the Gordon growth model with FCFF replacing dividends and WACC

replacing required return on equity.

99


Single-Stage FCFE Model

Ø Single-Stage FCFE Model

• The single-stage constant-growth FCFE valuation model is analogous

to the single-stage FCFF model, with FCFE instead of FCFF and

required return on equity instead of WACC:

100


101


Two-Stage Model

Ø Two-Stage FCFF Model

• The company value is the present value of the first stage‘ FCFF plus the

present value of the terminal value of the FCFF.

Ø Two-Stage FCFE Model

• The equity value is the present value of the first stage’ FCFE plus the present

value of the terminal value of the FCFE.

102


Three-Stage Model

Ø Three -Stage FCFF Model

• The company value is the present value of the high-growth and transitional

period’ FCFF plus the present value of the terminal value of the FCFF.

Ø Three -Stage FCFE Model

• The equity value is the present value of the high-growth and transitional

period’ FCFE plus the present value of the terminal value of the FCFE.

103


sensitivity analysis in FCFF and FCFE valuations

• Sensitivity analysis shows how sensitive an analyst’s valuation results are to

changes in each of a model’s inputs.

• Some variables have a greater impact on valuation results than others. The

importance of various forecasting errors can be assessed through

comprehensive sensitivity analysis.

104


Reading 29: MARKET-BASED VALUATION:PRICE AND ENTERPRISE VALUE MULTIPLES

105


framework

Ø Price multiple

• P/E

• P/B

• P/S

• P/CF

• EV/EBITDA

• Dividend yield

Ø Momentum valuation indicators

106


Introduction

Ø The method of comparables values a stock based on the average price multiple of

the stock of similar companies.

• The economic rationale for the method of comparables is the Law of One Price.

Ø The method of forecasted fundamentals values a stock based on the ratio of its

value from a discounted cash flow (DCF) model to some fundamental variable

107


P/E

Ø P/E

• Advantage

• Earnings power, as measured by earnings per share (EPS), is the primary

determinant of investment value .

• The P/E ratio is popular in the investment community.

• Empirical research shows that P/E differences are significantly related to long-run

average stock returns.

108


P/E

Ø P/E

• Disadvantage

ü Earnings can be negative, which produces a meaningless P/E ratio.

ü The volatile, transitory portion of earnings makes the interpretation of P/Es

difficult for analysts .

ü Management discretion within allowed accounting practices can distort reported

earnings, and thereby lessen the comparability of P/Es across firms.

109


P/E

Ø P/E

110


Methods of normalizing EPS

Ø The following two methods are used to normalize earnings:

1. Under the method of historical average EPS,.

ü the normalized EPS is estimated as the average EPS over some recent period,

usually the most recent business cycle.

ü The method of historical average EPS ignores size effects

2. Under the method of average return on equity

ü normalized EPS is estimated as the average return on equity (ROE) multiplied by

the current book value per share (BVPS). average ROE is often measured over the

most recent business cycle.

ü The reliance on BVPS reflects the effect of firm size changes 111


112


P/E-to-growth ratio (PEG)

Ø The relationship between earnings growth and P/E is captured by the P/E-to-

growth (PEG) ratio:

• 公式：

• The implied valuation rule is that stocks with lower PEGs are more attractive than

stocks with higher PEGs, assuming that risk is similar.

113


P/E-to-growth ratio (PEG)

Ø The drawbacks to using the PEG ratio:

• The relationship between P/E and g is not linear, which makes comparisons

difficult .

• The PEG ratio still doesn’t account for risk .

• The PEG ratio doesn’t reflect the duration of the high-growth period for a

multistage valuation model, especially if the analyst uses a short-term high-

growth forecast.

114


P/B

115


P/B

Ø Rationales for using price-to-book (P/B) ratio in valuation:

• Book value is a cumulative amount that is usually positive, even when the firm

reports a loss and EPS is negative. Thus, a P/B can typically be used when P/E

cannot.

• Book value is more stable than EPS

• Book value is an appropriate measure of net asset value for firms that primarily

hold liquid assets. Examples include finance, investment, insurance, and banking

firms.

116


P/B

Ø Disadvantages of using the price-to-book ratio include:

• P/Bs can mislead when there are significant size differences.

• Different accounting conventions can obscure the true investment in the firm

made by shareholders .

• Inflation and technological change can cause the book and market value of assets

to differ significantly.

• P/Bs do not recognize the value of nonphysical assets(无形资产).

117


P/B calculation

Ø Justified P/B（用 RI valuation 计算）

• 公式：P/B0=(ROE-g) I (r-g)

• The P/B increases as ROE increases.

• It also increases as the spread between ROE and r increases.

118


P/S

Ø Rationales for using price-to-sales (P/S) ratio in valuation :

• P/S is meaningful even for distressed firms .

• Sales revenue is not as easy to manipulate or distort as EPS and book value .

• P/S ratios are not as volatile as P/E multiples .

• P/S ratios are particularly appropriate for valuing stocks in mature or cyclical

industries and start-up companies with no record of earnings .

• Empirical research finds that differences in P/S are significantly related to

differences in long-run average stock returns.

119


P/S

Ø Disadvantages of using the price-to-sales ratio include :

• Higher sales do not necessarily indicate higher operating profits .

• P/S ratios do not capture differences in cost structures across companies .

• While less subject to distortion than earnings, revenue recognition practices can

distort sales forecasts.

120


P/S calculation

Ø Justified P/S (结合P/E ratio)

• 公式：

• 变形： IV/Sales=EPS/Sales * IV/EPS

121


P/CF

Ø Advantages of using the price-to-cash flow (P/CF) ratio include :

• Cash flow is harder for managers to manipulate than earnings .

• Price to cash flow is more stable than price to earnings .

• Reliance on cash flow rather than earnings handles the problem of differences in

the quality of reported earnings, which is a problem for P/E .

• Empirical evidence indicates that differences in price to cash flow are significantly

related to differences in long-run average stock returns.

122


P/CF

Ø Disadvantages of using the price to cash flow include:

• Items affecting actual cash flow from operations are ignored when the EPS plus

noncash charges estimate is used. For example, noncash revenue and net changes

in working capital are ignored .

• From a theoretical perspective, free cash flow to equity (FCFE) is preferable to

operating cash flow. However, FCFE is more volatile than operating cash flow, so it

is not necessarily more informative.

123


EV/EBITDA

Ø Enterprise value (EV) is total company value:

• 公式：EV = market value of common stock + market value of preferred equity +

market value of debt + minority interest – cash and investments

• EBITDA = recurring earnings from continuing operations + interest + taxes +

depreciation + amortization

• 公式：

124


EV/EBITDA

Ø EV/EBITDA is useful in a number of situations :

• The ratio may be more useful than P/E when comparing firms with different

degrees of financial leverage.

• EBITDA is useful for valuing capital-intensive businesses with high levels of

depreciation and amortization.

• EBITDA is usually positive even when EPS is not.

125


Dividend Yield

Ø Dividend yield (D/P) is the ratio of trailing or leading dividend divided by current

market price per share:

• 公式：

126


Compare price multiple with benchmark

127


momentum indicators

Ø Momentum indicators

• Unexpected earnings or earnings surprise is the difference between reported

earnings and expected earnings:

• earnings surprise = reported EPS − expected EPS

• 存在问题：只考虑收益（EPS），没有考虑风险（标准差）

128


momentum indicators

Ø Momentum indicators

• the standardized unexpected earnings (SUE) measure is defined as:

• 2

129


Momentum indicators

Ø Relative strength indicator （RSTR）

• Relative strength indicators compare a stock’s price or return performance during

a given time period with benchmark

ü its own historical performance

ü some group of peer stocks.

130


计算 portfolio P/E

Ø the portfolio or index P/E is best calculated as the weighted harmonic mean P/E.

• 公式：

131


Reading 30: RESIDUAL INCOME VALUATION

132


framework

1. Residual income是什么，怎么算

2. Residual income single-stage model

3. Residual income two-stage model

133


Concept of residual income

Ø Residual income (RI), or economic profit, is the net income of a firm less a

charge that measures stockholders’ opportunity cost of capital.

• 公式：RI = NI – Equity capital * cost of equity

Ø Economic value added (EVA ) measures the value added for shareholders by

management during a given year.

• 公式：

134


Concept of residual income

Ø Market value added (MVA) is the difference between the market value of a

firm’s long-term debt and equity and the book value of invested capital

supplied by investors.

• 公式：MVA = market value − total capita

135


136


137


138


Residual income computation

Ø 定义式：RI = NI – Equity0* re

Ø 计算式：RI = Equity0* （ROE - re）

Ø RI 的递推计算公式（基于 clean surplus relation）

139


Residual income valuation model

Ø The residual income valuation model breaks the intrinsic value of a stock into

two elements:

•

•

(1) current book value of equity

(2) present value of expected future residual income:

140



Ø Difference with DDM & FCFE

• with a dividend discount model (DDM) or free cash flow to equity (FCFE)

model, a large portion of the estimated intrinsic value comes from the present

value of the expected terminal value.

141



Ø Single – stage valuation

• 公式：

Ø the relation with justified price-to-book ratio（考点）

• If ROE is greater than the required return on equity, the second term (the

present value of residual income) will be positive, the market value will be

greater than book value, and the justified P/B ratio will be greater than one.

142



143



144



Ø Continuing residual income (Two-stage model)

• In the residual income model, intrinsic value is the sum of three components:

• V 0= B 0+ (PV of interim high-growth RI) + (PV of continuing residual income)

145


• Step 1: Calculate the current book value per share.

• Step 2: Calculate residual income in each year 1 to T − 1 during the interim

high-growth period and discount them back to today at the required return on

equity.

• Step 3: Calculate continuing residual income that begins at the end of the

high-growth period starting in year T, and then calculate the present value of

continuing residual income as of the end of year T − 1146



#4: Residual Income Declines to Long-Run Level in Mature Industry

147



• Assumption #4: Residual Income Declines to Long-Run Level in Mature Industry

ü PVT-1= BT-1* P/BT-1–BT-1

148


Issues in applying residual income models.

Ø Issues in applying residual income models.

• Clean Surplus Violations

ü Foreign currency translation gains and losses that flow directly to retained

earnings under the current rate method.

ü Certain pension adjustments.

ü Gains/losses on certain hedging instruments.

ü Changes in revaluation surplus (IFRS only) for long-lived assets.

ü Changes in the value of certain liabilities due to changes in the liability’s credit risk

(IFRS only).

ü Changes in the market value of debt and equity securities classified as availablefor-sale. 149


Issues in applying residual income models.

Ø Issues in applying residual income models.

• Variations from Fair Value

ü Operating leases

ü Special purpose entities (SPEs)

ü Inventory

ü Deferred tax liabilities

150


Reading 31: PRIVATE COMPANY VALUATION

151


Compare public and private company valuation

Ø Company-Specific Factors

• Stage of lifecycle : Private companies are typically less mature than public firms.

• Size: Private firms typically have less capital, fewer assets, and fewer employees

than public firms and, as such, can be riskier.

• Quality and depth of management: Smaller private firms may not be able to

attract as many qualified applicants as public firms.

• Management/shareholder overlap: In most private firms, management has a

substantial ownership position.

• Short-term investors : management may take a shorter-term view compared to

private firms where managers are long-term holders of significant equity interests.152



Ø Company-Specific Factors

• Quality of financial and other information: Public firms are required to make

timely, indepth financial disclosures. A potential creditor or equity investor in a

private firm will have less information than is available for a public firm. This leads

to greater uncertainty, higher risk, and reduces private firm valuations.

• Taxes: Private firms may be more concerned with taxes than public firms due to

the impact of taxes on private equity owners/managers.

153



Ø Stock-Specific Factors

• Liquidity: Private company equity typically has fewer potential owners and is less

liquid than publicly traded equity.

• Restrictions on marketability: Private companies often have agreements that

prevent shareholders from selling, reducing the marketability of shares.

• Concentration of control: The control of private firms is usually concentrated in

the hands of a few shareholders.

154


Definitions of Value

Ø Definitions of Value

• Fair market value

• Fair value for financial reporting

• Fair value for litigation

• Market value:

• Investment value

• Intrinsic value

• Liquidation value

155


Issues for financial statement adjustments

Ø Issues for financial statement adjustments

• Estimating Normalized Earnings

• Strategic and Nonstrategic Buyers

• Estimating Cash Flow

156


Estimating Normalized Earnings

Ø Estimating Normalized Earnings

• Normalized earnings should exclude nonrecurring and unusual items.

• Artificially low earnings may also be the result of excessively high owner

compensation or of personal expenses charged to the firm.

• Any real estate owned by the firm may merit treatment separate from that of firm

operations.

157


Strategic and Nonstrategic Buyers

Ø Strategic and Nonstrategic Buyers

• A transaction may be either strategic or financial (nonstrategic).

• In a strategic transaction, valuation of the firm is based in part on the perceived

synergies with the acquirer’s other assets.

• A financial transaction assumes no synergies, as when one firm buys another in a

dissimilar industry.

158


Estimating Cash Flow

Ø Estimating Cash Flow

• FCFF is usually more appropriate when the significant changes in the firm’s capital

structure are anticipated.

• The reasoning is that the discount rate used for FCFF valuation, the weighted

average cost of capital (WACC), is less sensitive to leverage changes than the cost

of equity, the discount rate used for FCFE valuation.

• the FCFF valuation is less sensitive to the degree of financial leverage assumed in

the analysis than the FCFE valuation.

159


the Income Approach

Ø The Income Approach

• The Free Cash Flow Method ( a two-stage model )

• The Capitalized Cash Flow Method (single-stage model )

ü Under this method, a single measure of economic benefit is divided by a

capitalization rate to arrive at firm value, where the capitalization rate is the

required rate of return minus a growth rate.

160


the Income Approach

Ø The Excess Earnings Method

• Excess earnings are firm earnings minus the earnings required to provide the

required rate of return on working capital and fixed assets.

• The value of intangible assets can be estimated as the present value of the stream

of excess earnings

• This value for the intangible assets is added to the values of working capital and

fixed assets to arrive at firm value.

161


3 models used to estimate the required rate of return

• CAPM: Typically, beta is estimated from public firm data, and this may not be

appropriate for private firms that have little chance of going public or being

acquired by a public firm.

• Expanded CAPM: This version of the CAPM includes additional premiums for size

and firm-specific (unsystematic) risk.

• Build-up method: When it is not possible to find comparable public firms for beta

estimation, the build-up method can be used.

162


factors that require adjustment

Ø factors that require adjustment when estimating the discount rate for private

companies.

• Size premiums: Size premiums are often added to the discount rates for small

private companies.

• Availability and cost of debt: A private firm may have less access to debt financing

than a public firm.

• Projection risk : Because of the lower availability of information from private firms

and managers who are inexperienced at forecasting, that analyst should increase

the discount rate used.163


factors that require adjustment

Ø factors that require adjustment when estimating the discount rate for private

companies.

• Lifecycle stage: It is particularly difficult to estimate the discount rate for firms in

an early stage of development.

• Acquirer versus target : When acquiring a private firm, some acquirers will

incorrectly use their own (lower) cost of capital, rather than the higher rate

appropriate for the target, and arrive at a value for the target company that is too

high.

164


Market-based valuation

Ø Market multiple

• large private firm valuation is usually based on EBIT or EBITDA multiples.

• For small private companies with limited assets, net income multiples might be

used instead of EBITDA multiples.

165


Market-based valuation

Ø The three methods

• guideline public company method (GPCM) : 要考虑control premium

• the guideline transactions method (GTM) ：不考虑control premium

• the prior transaction method (PTM)

166


Asset-based approach

Ø Asset-based approach

• The asset-based approach estimates the value of firm equity as the fair value of its

assets minus the fair value of its liabilities.

• It is generally not used for going concerns. Of the three approaches, the asset-

based approach generally results in the lowest valuation

167


Asset-based approach

Ø The asset-based approach might be appropriate in the following circumstances:

• Firms with minimal profits and little hope for better prospects.

• Finance firms such as banks, where their asset and liability values (loan and

security values) can be based on market prices and factors.

• Investment companies such as real estate investment trusts (REITs) and closedend

investment companies (CEICs) where the underlying assets values are determined

using the market or income approaches.

• Small companies or early stage companies with few intangible assets.

• Natural resource firms where assets can be valued using comparables sales.168


Valuation discounts

Ø The Discount for Lack of Control

• 公式：

169


Valuation discounts

Ø The Discount for Lack of Marketability（题目中直接给）

• If an interest in a firm cannot be easily sold, discounts for lack of marketability

(DLOM) would be applied (sometimes termed a discount for lack of liquidity).

Ø Total discount

• 公式：

170


THANKS!

171

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Reading equity valuation: applications and processes

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