AEM 3520
Equity Only
(ROE- re) * shareholders equity
Residual Income
-Main input into the valuation model is earnings -Combines "current value" of the balance sheet with the present value of future "residual income" -Useful for valuing equity directly -Rearrangement of dividend or free cash flow valuation models
Important multiple
EV/EBITDA
Bloomin Brands Comps
Exclude based on size and growth: - McDonalds too big - Shake Shake expecting too large of growth - Zoe's large growth - Dine Equity growth too low
Funds
• Equity Mutual Funds - Income, Growth, Value, Short, Index, Size, Industry, Regional • Bond/Debt Funds - Corporate bonds, junk bonds, municipal bonds, mortgages • Hedge Funds - Long/Short Equity, Market Neutral, Short Bias, Event Driven, Quantitative, Global Macro, Merger Arbitrage, Convertible Arbitrage, etc. • Others (e.g., commodities, currencies)
• Intergalactic's price is $20 per share, book value is $12 per share. - If cost of equity is 15% and expected growth is 5%, what is inferred ROE? - If price increases to $35 and growth expectation remains constant, what is new inferred ROE? - If price increases to $35 and ROE expectation remains constant, what is new inferred growth?
• Rearrange residual income model: P = BV + ([ROE-r]*BV)/(r-g) - 20 = 12 + ([ROE-0.15]*12)/(0.15-0.05) => ROE = 0.22 - 35 = 12 + ([ROE-0.15]*12)/(0.15-0.05) => ROE = 0.34 - 35 = 12 + ([0.22-0.15]*12)/(0.15-g) => g = 0.11
Comparable Selection
• Risk and growth are key value drivers • Systematic risk similar to comparables • Growth prospects similar to comparables • Match on size or age • Compare historical growth to comparables • Compare future growth estimates to comparables (e.g., analyst EPS forecasts)
2 Types of Credit Risk
• Short-term liquidity risk: the near-term ability to generate cash to service working capital needs and debt service requirements, i.e., will the firm be able to fund operations and pay off suppliers and providers of short-term debt? - Current ratio = current assets ÷ current liabilities - Quick ratio = (cash + securities + A/R) ÷ current liabilities - Net trade cycle = Inventory Holding Period + Days in A/R - Days in A/P • Long-term solvency risk: the longer-term ability to generate cash internally or from external sources to satisfy plant capacity (capital expenditures) and debt repayment needs - Debt to equity ratio = total debt ÷ total equity - Interest Coverage = EBIT ÷ Interest Expense - Debt to EBITDA = total debt ÷ EBITDA
Some say sell side analysts are too optimistic in their expectations to buy, and to slow in their recommendations to sell. What might cause this?
• They get paid to generate trading, and buyers initiate most trading • They get paid to generate security issuance • Analysts value and protect personal connections with managers
Forecasting COGS, SG&A, R&D
• Use historical percentage of expenses to sales • Adjust historical expense ratios for current conditions • Increasing demand along with economies of scale result in lower expense ratios • Lumpiness in adding new capacity increases expense ratios in short-term • Declining demand tends to increase expense ratios in short-term due to stickiness of expenses • Estimate relationship between expenses and sales using regression analysis • Build "functional form" model of expenses
Common Accounting Steps for employee comp
When the award is granted to employees, the company estimates the fair value of the award. The fair value of the award is recorded as an expense in the income statement, ratably over the vesting period. When the shares are issued, common stock and additional paid-in capital increase in the same manner as for cash-based stock issuances.
Z-Score
(1.2*Working Capital/Total Assets)+(1.4*Retained Earnings/Total Assets)+ (3.3*EBIT/Total Assets)+(0.6*Market Value of Equity/Total Liabilities)+(0.99*Sales/Total Assets)
Residual Income Debt and Equity
(ROA-WACC)*Assets
DCF Valuation (Debt and Equity)
- Free Cash Flows to firm represent net cash flows generated by company before any financing cash inflows or outflows -Forecast Cash Flows over 5-10 period -Terminal value cash flow based on forecasted low growth rate when company is expected to have no competitive advantage -Cash flows discounted using weighted average cost of equity debt capital WACC
Benefits of Debt
- Interest tax shields: Corporations can deduct interest paid on debt from taxes - Incentive alignment: Managers need to generate cash to pay interest and principal => less cash available to mishandle
Costs
- Legal costs: When in distress, firms have to hire lawyers, bankers, and accountants to help with restructurings - Foregone investment: Difficult for highly levered/distressed firms to attract additional capital to finance investment opportunities - Agency costs: Shareholders and debt holders objectives conflict in distress situations, and managers usually serve the interests of shareholders
PEG Ratios
- PEG ratios are still influenced by growth! • Works best for firms with moderate growth rate - PEG ratios continue to be influenced by differential risk! • Low PEG can mean (1) under-valued stock or (2) more risky!
What do mangers do when they know they will miss expectations?
- Walk analysts down. - Pre-announce to get a smoother negative return path.
What the EBIT FCFF Formula assumes
-D&A is only non-cash items in earnings - Ignores other non-cash gains and loses such as gain on sale in PP&E and asset impairments - Not adding back stock compensation makes it seem as stock comp is paid in cash
Advantages Residual Income vs DCF
-Intrinsic Value Easily Applied and implemented: Current book value of equity, earnings forecast, dividend payout ratio (cash and stock dividends + stock repurchases) -Earnings easily accessible - Relies on income: which is predictable than cash -A terminal value less important than in DCF
Types of Stock Based Compensation
-Restricted stock. Shares are issued to the employee but the employee is not free to sell the shares during a restriction period. -Restricted stock units (RSUs). Employee is awarded the right to receive a specified number of shares (or cash equivalent) after a vesting period.
Key Points Bloomin
-Unlevered valuations show greater undervaluation further you move up the income statement -Because Bloomin Brands is less profitable per sales than peers, it also has more D&A than peers
Multiples Valuation Steps (numbered)
1) Identify potential comparable companies 2) Collect financial and market information for comparables and company being valued 3) Assess comparability of financial statements for comparable companies and company being valued and make adjustments as needed 4) Compute relevant multiples for comparables 5) Assess reasonable range and measures of central tendency (mean, median) for relevant multiples 6) Multiply selected value(s) for relevant multiples by corresponding denominator for company being valued
Multiples Valuation Steps
1) Identify potential comparable companies 2) Collect financial and market information for comparables and company being valued 3) Assess comparability of financial statements for comparables and company being valued and make adjustments as needed
Revenue Recognition
1. Identify customer contract 2. Identify performance obligations in the contract 3. Determine transaction price 4. Allocate the transaction price to the performance obligations in the contract obligation 5. Recognize revenue when the reporting organization satisfies a performance obligation
Sponsor's plan/goal
1. Use the target's cash flows to service and repay the debt 2. Improve the financial performance of the target 3. Grow the business 4. Exit within 5 years 5. Shooting for an 20%+ annualized return
Ratios used is Altman Z-Score
1. Working capital / Total assets • Liquidity 2. Retained Earnings / Total assets • Age, accumulated profitability, internal (vs. external) financing 3. Earnings before interest and taxes / Total assets • Profitability - ROA variant 4. Market value equity / Book value of total debt • LT solvency 5. Sales / Total Assets • Asset utilization - Asset Turnover
Number of Days' Purchases in Accounts Payable
365/(Purchases/Average Accounts Payable)
Days' Sales in Accounts Receivable
365/(Sales/Average Accounts Receivable)
Number of Days' Sales in Inventory
365/Inventory Turnover
Z-score scoring brackets
>3.00: Company is healthy, low bankruptcy potential in short term Between 2.99 and 1.80: Gray area company is exposed to some risk of bankruptcy; caution is advised Z-Score less than 1.80: Company is in financial distress and there is high bankruptcy potential in the short term
What is an LBO
Acquisition of a "target" (e.g., company, division, assets) using debt to finance a large portion of the purchase price, and an equity contribution by a "financial sponsor" (or "equity sponsor" or "LBO sponsor"). Assets of the target are used as collateral
Momentum
Buy recent (12 months) winners and short-sell recent losers
Quality
Buys stocks that are profitable, growing, stable, and well-managed
How can multiples be used to value equity?
By taking equity by subtracting debt from market value of firm or net debt from enterprise value
What are hidden leases?
Capital Leases, Operating Leases
Cohen, Malloy, and Nguyen (2016) study Findings
Company's rarely change summaries of financial performance, risk and business description, however, when they do, it's bad news
Days Inventory Held
Days in Period/(COGS/Inventory)
Days Sales Outstanding (similar to DS Accounts Receivable)
Days in Period/(Sales/Accounts Receivable)
Discretionary trading
Decision to buy or sell is at the trader's discretion, based on experience, various kinds of information, intuition, etc.
Quantitative or "quant" trading
Define trading rules explicitly and build systems that implement them systematically
Residual Income formula
Earnings- (r*Capital Invested) Actual Performance - Expected performance
Permanent Differences Example
Municipal Bond Revenue US GAAP: recognized as revenue IRS: exempt from tax Premiums Paid on Proceeds From Life Insurance: US GAAP: Recognized when Incurred IRS: Not recognized Government Fines US GAAP: Recognized when incurred IRS: Not Deductible
Can Rf create a difference in multiples between two firms?
NOT USUALLY
Can Risk Premium create a difference in multiples between two firms?
NOT USUALLY
Is there a definitive number of comparables that are useful for a firm?
No
Sell Side vs Buyside
Sell-side: usually covers an industry or sector •Buy-side: coverage decision is more complicated; might choose stocks based on value/growth, risk profile, momentum, quality
Valuation approach short or long term?
Short Term: multiples Long Term: Direct valuation
What makes for a good LBO candidate?
Stable, predictable cash flows. - Critical to service the debt and make principal payments. - Steams from strong, loyal customer base, strong brand, long-term sales contracts, • Large tangible asset base - Used as collateral which increases the amount of cheaper bank debt that can be used. • Low CAPEX requirements - Increase free cash flow • Growth opportunities - Increases the speed to exit • Strong management - If not, the sponsor will need to make changes in key leadership. • Barriers to entry in the industry - Reduces competition • Viable exit strategy
Private Debt Process
Step 1: Consider nature and purpose of loan Step 2: Consider type of loan and any collateral Step 3: Conduct financial analysis of the potential borrower Step 4: Work out details
Public Debt Process
Step 1: Pay debt analysts to provide/publicize a debt rating Step 2: Sell debt to public (with investment banker's help)
Value trading
Stocks vary excessively, creating situations in which price is temporarily below value
Stock Option Backdating
The practice of altering the date a stock option was granted.
Key concept in residual Income that determines value?
The value determiner is whether earnings exceed required return on equity capital
Should levered or unlevered multiples be used to value equity?
Use levered after interest multiples Example: • Market value of equity (or stock price) in numerator • Net income (or EPS), cash flow from operations, or equity free cash flow in denominator
Should levered or unlevered multiples be used to value a firm?
Use unlevered before interest multiples Example: • Market value of firm or enterprise value in numerator • Market value of firm equals market value of equity and debt • Enterprise value equals market value of equity and debt less cash and marketable securities (i.e., net debt) => assumes no cash and marketable securities needed for operations • EBIT, EBITDA, revenue, or unlevered free cash flow in denominator
Value vs fundemental
Value: market value of equity, enterprise value Fundamental: - Revenue and revenue driver: Revenue growth - Earnings to equity holders: net income/EPS - Cash Flow to Equity Holders: FCF to equity, - Cash flow to enterprise: EBITDA, Free cash to all claimants - Book value of equity - Book value of enterprise: BV Debt+BV Equit- Cash
Are Discount Dividend FCF and Residual Income theoretically equivalent?
YES
Can Beta create a difference in multiples between two firms?
YES
In equilibrium, is there enough mispricing to compensate a skilled fundamental analysis?
YES
If FSA wasn't done would mispricing be abundant?
Yes, if FSA wasn't done mispricing would be abundant
Simplified Decision Rule
Z-Score less than or equal to 2.675 is bankrupt Z-Score greater than 2.675 is not bankrupt
Revenue vs Expense Grwoth
if income is growing slower than revenue, than expenses have to be growing faster than revenue,
Special Items Bloomin Brands Earnings
restructuring, loss on sale, loss on extinguishment of debt. overall undervalued company
How to avoid the saw tooth problem
using ending balances in turnover ratios
Basic equation of multiple
value/ Fundamental= what you are paying/what you are getting
Investing Approaches
• Active vs. Passive - 70% (~$10 trillion) of funds are active vs. only 30% passive, but hundreds of billions flowing into passive for the past few years • Traditional vs. Quantitative - We've been doing traditional all semester, but will do a bit of quantitative next week. Quantitative becoming more popular as trading technology advances. • Formal vs. Informal - Our forecasts and valuations were full-scale or formal. But also can, e.g., (1) compare earnings projection to consensus or (2) adopt "marginalist" approach
Pros and Cons Direct Valuation
• Advantages: - Looks at fundamentals of the firm - Ignores the current mood of the market • Disadvantages: - Several assumptions needed, and error can occur in any of these forecasts. • Incorrect forecasts for cyclical businesses, etc.
What can the turnover technique be used for
• Assets or Net operating assets (NOA) • Cash necessary for operations • Accounts receivable • Inventories • Prepaid expenses • PP&E • Accounts payable • Deferred revenue
Disadvantages to quant trading
• Can't be tailored to each specific situation. In other words, focused on "systematic" variation, not "idiosyncratic" shocks. • Can't be based on soft information, e.g., phone calls, gut feelings NOTE: These weaknesses may diminish in computing power. For example, the textual analysis of thousands of documents we discussed last time
Forecasting Tax Expense
• Different rules for financial reporting and tax • Permanent differences cause effective tax rate to differ from statutory tax rate • Revenue or expense under accrual accounting but no tax revenue or expense or vice versa • Different statutory tax rates across countries • 2017 Tax Cuts and Jobs Act lowered U.S. statutory tax rate for corporations from 35% to 21%
Cash Flow Forecasting Tips
• Do not attempt to forecast future cash flow statements directly from historical cash flow statements • Derive forecasts of cash flow statement using forecasts of balance sheet and income statement • Only way you can guarantee your financial statements will tie out • Increases in assets imply uses of cash; decreases in assets imply cash being conserved/generated • Increases in liabilities and stockholders' equity imply sources of cash or cash being conserved; decreases in liabilities and stockholders' equity imply uses of cash • Classify increases/decreases into operating, investing, and financing
Examples of Flexible Accounts on a Balance Sheet
• Excess cash • Marketable securities (short-term or long-term) • Debt • Equity (dividends and stock issuances/buybacks)
Efficient Market Hypothesis
• For - Markets quickly react to information - Few funds/analysts outperform the market - Stock returns are highly correlated with fundamentals • Against - Prices drift in direction of some news, reverse after other news - Several variables, including financial statement numbers, predict stock returns
Factors Influencing P/E
• Growth • Cost of Capital: - Risk free rate - Risk premium - Beta • Payout
Income, Growth, Value and Short, which fund would be best for given an investment strategy?
• Income: Conservative, shorter-horizon • Growth: Optimists, long-horizon, mutual/pension funds, retail, indexers • Value: Bargain hunters, medium-horizon, fundamental analysts, hedge funds • Short: Pessimists, activists, hedge funds
How Balance Sheet Multiples can be used to value equity or a firm
• Market value of equity in numerator => book value of equity in denominator • Market value of firm in numerator => book value of equity and debt in denominator • Enterprise value in numerator => book value of equity and net debt in denominator • Useful for companies currently generating losses
How to make companies cost structure look comparable
• Moving further up income statement assumes more of cost structure is comparable across companies
Enterprise Value to Sales
• Multiple of last resort. - If you can't use any other multiple, then use EV/Sales. Sales is the furthest away from earnings/cash flows. • Primary drivers: - growth, capital structure, risk, and margin • Why is margin a driver here? - Two firms with the same sales can have very different margins! And margin feeds into earnings. • Care must taken in using P/Sales. Why? - Capital Structure differences influence how much of the sales converts to the equity holders profits. Equity is a residual claimant relative to debt. - Once we go above the interest line in the income statement, then we need to switch to Enterprise Value
Takeaways From Multiples Valuation
• Multiples valuation allows ballpark estimate to be computed relatively quickly and easily • Refinement of ballpark estimate requires careful consideration of comparables selection and multiples computation • There is no perfect comparable
Issues with P/E
• Negative EPS • Cyclical industries • Volatility
Is stock based compensation a firm expense?
• No cash payment to employees for labor. • Providing options/stocks is costless to the firm
PEG Formula
• PEG = PE / (g * 100) where • g is typically analysts' consensus 3-to-5 year earnings growth rate forecast in percentage terms • Example: PEG = 15 / (0.12 * 100) = 1.25 for company with PE of 15 and forecasted earnings growth of 12%
Microsoft IPO Example
Microsoft IPO: $1.10 EPS Average P/E of Peers: 15 Estimated IPO= $1.10*15= $16.50
Class example: Under Armour
For example when comparing a P/E ratio: Take the P/E of the company the current firm is being compared to multiply by the current firm's EPS
Net trade cycle
Inventory Holding Period + Days in A/R - Days in A/P
Relationship between Revenue and SG&A to Revenue
Inversely related.
Three types of quant
Fundamental Quant., Statistical Arbitrage, High frequency trading
Why stock based compensation?
Incentivize employees to think and act like shareholders - Motivate employees to work hard and make decisions that improve company performance and value as stock performance is tied to corporate performance targets. Encourage employee retention and longevity: -With most plans, employees earn the right to own or purchase shares over time. The period of time over which ownership rights are earned is called the vesting period. -During this vesting period, employees have greater incentive to stay with the company
Which Financial Statement does stock based compensation appear on?
Income Statement, but rarely reported as a separate line item: Cost of goods sold (for employees in R&D and manufacturing) or Selling general and administrative expense (for employees in selling and administration and executive roles).
Highest and Lowest Debt financed Industries
Lowest: 1. Newspapers 2. Clothing 3. Trucking Highest: 1. Restaurants 2. Agricultural Implements 3. Commercial Printing
Total Enterprise Value and it's impacts
MVE + MVD - Cash - Insulated from unanticipated changes in leverage - Makes firms with different capital structure more comparable.
Enterprise Value
Market Value of Equity+ Market Value of Deb+ Non controlling interest- Cash
What else can manipulate the market's view?
Media can give a more objective view of a company and within a few days, the market will react to the changes in the company.
Is stock based compensation a cash expense?
No, so companies add it back in the cash flow statement
PE Formula
P = EPS / (r - g) where • r is expected return, g is expected earnings growth rate (in perpetuity) • Rearranging terms, P / EPS = 1 / (r - g) • higher r => lower PE; higher g => higher PE
What is the goal of the Altman Z-Score
Predict bankruptcy using ratios
Relative Valuation: Getting the Price Per Share
Price Per Share (i)=(Price Per Share (j)/Driver Per Share (j))* Driver Per Share (i)
Market Value of Equity
Price* Shares Outstanding
Enterprise Value to EBITDA
Primary drivers: - growth, capex, capital structure and risk • Widely used in the market, why EBITDA? - Supposed to proxy for FCFF • FCFF = CFO + interest *(1-t) + CFI • EBITDA = NI + D&A + interest *(1-t) + Taxes - Missing ΔWC and Capex - Why not just use FCFF? • Cash flow is volatile (depreciation smooth earnings) - Only explanation for using EBITDA over EBIT: • Believe that depreciation is never going to be replaced with....
