Corporate Finance - Damodaran

weights of debt and equity components

weights should be based on mkt value not book value, b/c CoC measures cost of issuing securities to finance projects, which are issued at mkt value what is debt?: can't just use BS of firm some liabilities on BS - accounts payable, supplier credit - are non interest bearing; can't apply after-tax CoD to them off balance sheet items also are sources of liabilities to firm (operating leases) - these need to be capitalized and treated as debt

Growth in OP income for negative RoC firms

when firm is losing $$, reinvestment rate also likely to be (-). we have to first project growth in revenues, then use firm's exp operating margin in future years to estimate operating income in those years. Forecasting growth in revenues: 1. rate of growth in revenues will decrease as firm's revenues increase. 2. compounded growth rates in revenues over time can seem low.. but not necessarily 3. must also keep track of $ revenue 4. assumptions abt revenue growth + op margins must be consistent: higher rev growth must have lower margins and v.v. --- op margins: for a firm to survive, higher revnues have to eventually deliver + earnings -> + op margins in future sale-to-capital ratio: revenue generated by each $ of capital invested. lower S/C ratio reduce CFs + increase reinvestment needs, and vice versa firms should have a 2-track strategy, focusing on both generating higher revenue and building competitive strength Imputed RoC

estimate a tax rate

which to use? effective tax rate: taxes due / taxable income marginal tax rate: rate at which the last dollar of income is taxed --> the correct one interest only creates a benefit if the firm has enough income to cover interest expenses - firms w/ operating losses will not get tax benefit from interest expenses in the year of loss.

Analyst estimates of growth

why some firms are more heavily followed: 1. larger market cap 2. institutional holding 3. trading volume (analysts more likely to follow liquid stock) why analyst forecast > historical growth rates- they use additional info: 1. firm-specific info that's been made public since last earnings report 2. macro-economic info that may impact future growth, eg GNP growth, inflation 3. Info revealed by competitors on future prospects 4. Private info about the firm. 5. Public info other than earnings, like earning retention, profit margin, asset turnover However, analysts do not provide better forecasts of earnings over LT Analsts usually forcast earnings per share. When valuing a firm, need forecasts of operating income which generally has a lower growth rate. So adjustments would be needed. Incorporating analyst forecasts: what factors to consider in determining weights 1. amount of recent firm specific info. 2. # analysts following stock 3. extent of disagreement bt analysts 4. quality of analysts following stock.

Measuring lambda (Country Risk Exposure)

- revenue breakdown - regression vs country bond

Estimating TV

1. Going concern approach: assume firm continues to deliver CFs in perpetuity - as the firm grows, it cannot maintain as high a growth and eventually stabilizes at <= growth rate of the economy it operates in ("stable growth"). this can be sustained perpetually,, letting us estimate CFs beyond that point as a terminal value for a going concern. (When will this occur? look at firm size, growth rate, competitive adv) 2. Liquidation approach: assume business is shut down and assets are sold at some point.

Types of expenses

1. Operating expenses benefit firm only in current period, for example fuel used by airline, labor cost for an auto company * Operating income = revenue - operating expense 2. Capital expenses benefit firm in multiple periods, for example building a new factory 3. Financial expenses are associated with NONequity capital raised by firm, eg interest paid on a bank loan Net Income = Revenues - op exp - fin exp

Growth in OP income

1. Stable RoC = reinvestment rate * RoC reinvestment rate: how much firm is plowing back to generate future growth RoC: based on firm's RoC on existing investments, using current accounting RoC 2. +, changing RoC 3. - RoC

Caveats in using 3stage FCFE model

1. in high growth, capital spending > depreciation; as growth stabilizes, the difference will decrease 2. risk: beta moves toward one

Key assumptions about stable growth

1. length of high growth period *size of firm? (smaller -> more room to grow) *existing growth rate & excess returns (momentum) *magnitude & sustainability of competitive advantages 2. characteristics of stable growth firm a. Equity Risk: high growth firms have higher betas than stable growth firms (bc high operating leverage) 0.8 <= stable period betas =< 1.2 b. Project returns: high growth firms have high RoC and earn ecess returns. c. Debt ratios and CoD: High growth firms use less debt; as they mature their debt capacity increases. d. Reinvestment and Retention ratios: High growth firms reinvest more. 3. Transition to Stable Growth a. high growth rate -> stable growth rate abruptly (2 stage model) b. high growth rate (period) -> transition ~> stable (3 stage model) c. characteristics change each year (n stage model)

Calculating CoD

1. riskless rate: increases -> CoD increases 2. default risk: increases -> CoD increases 3. since interest is tax-deductible after-tax CoD is a function of the tax rate after-tax CoD = pretax CoD * (1 - tax rate)

Why Use Bottom-up Betas?

1. the standard error is lower: Std error for bottom-up beta = (Average std error for comparable firms) / (sqrt(n)) 2. the bottom-up can be adapted to reflect changes in firm's biz mix 3. firms change debt ratios over time; bottom-up uses the current D/E ratio 4. they are less dependent on historical stock prices

Reasons for divergence in historical risk premiums used

1. time period used 2. choice of rf security (T-bills; T-bonds;) -> usually use bonds 3. use of arithmetic vs geometric averages (usually use arithmetic; however good arguments for geometrics - existence of neg correlation between returns on stocks)

Beta

3 approches to estimating 1. use historical data 2. use fundamental characteristics 3. use accounting data

Estimating growth rate for a firm

3 basic ways to estimate growth for a firm: 1. look at historical growth rate. 2. use analysts' growth estimate 3. estimate growth rate from fundamentals; determined by how much is reinvested into new assets, the quality of these investments

Risk Free Asset (requirements)

A risk free asset is one where we know the expected returns on it with certainty. (Actual return always = expected return.) 1) No default risk. (no private) 2) No reinvestment risk.

CoC vs APV valuation

APV: levered firm value = unlevered firm value + net effect of debt CoC: leverage effects show up in cost of capital; tax benefit is incorporated in after-tax cost of debt and the bankcruptcy costs in both levered beta & pre-tax cost of debt values are different bc: 1. APV approach allows more flexibility in considering bankruptcy costs - indirect bankruptcy costs. APV will give a more conservative estimate since these BC's don't show up in pretax CoD 2. APV considers tax benefit from a dollar debt value, based on existing debt, whereas CoC approach estimates tax benefit from debt ratio CoC is more practical when valuing ongoing firms whose leverage is not changing a lot, since it is easier to work with debt ratio than dollar-debt APV is more practical for high-debt transactions and where debt repayment schedules are negotiated or known (thus popular in leveraged-buyout circles) Also, conventional APV uses pretax CoD as discount rate, but there are variations on APV that discount the tax savings back at CoC or unlevered CoE

Compare Risk and Return models

CAPM (beta measured against mkt ptfolio); APM (beta measured against multiple unspecified mkt risk factors); Multifactor (beta measured against specified macroeconomic factors); proxy (eg mkt capitalization, P-V book ratios)

Default spread + RSD (CRP)

CRP = CDS * (vol_equity / vol_countrybond) -> assumes investors are choosing between country bond and country equity

comparing dividends to FCFE

Cash to stockholders to FCFE ratio = (divs + equity repurchases)/FCFE ratio of cash to stockholders to FCFE shows how much of cash available to pay to stockholders is actually returned to them in form of dividends and stock buybacks if close to 1, firm is paying out what it can to stockholders < 1, using difference to increase cash balance/invest in mktable secs > 1, paying out too much, drawing on existing cash balance / issuing new secs

Effect of leverage on firm value

Cost of capital and optimal leverage: the value of a firm is a function of cash flows to firm and the cost of capital. Keeping CFs constant, to maximize firm value we minimize cost of capital ;

Why firms pay less than what's available

Desire stability: firms are unwilling to change dividends b/c variability is lower for dividends than earnings/CFs. Future investment needs: expects more capex needs in future tax factors: if dividends are taxed higher than capital gains, firms may choose to retain excess cash signaling perogatives: increase in div's =+ managerial self interest

Growth in equity earnings

Growth in earnings per share: based on retention ratio (% of earnings retained in firm) + RoE on projects HIgher RR and RoE = higher growth rate in RoE

Growth in Net Income

Growth in net income != growth in EPS if there are other sources of equity besides retained earnings e.g. a firm can grow net income by issuing new equity to fund new projects even while EPS stagnates estimate how much equity firm reinvests back into businesses, in form of net cap exp's and investments in WC.

H model

H model is also a 2 stage model for growth but the growth rate in initial phase is not constant, but declines linearly over time to reach stable growth rate in steady state. limitations: the assumption that payout ratio is constant in both phases leads to inconsistency the drop is linear not for firms with low or no dividends due to constant payout ratio assumption

Adjusting Earnings

Income statement provides info on: Operating income (EBIT) Equity income (net income) earnings must be updated; quarterly reports will have more updated info however, trade-off is that not all items are updated in quarter report; eg info about options outstanding are not revealed in quarterly reports (inconsistent inputs or estimation error)

Survival issue

Life cycle and firm survival: Cash burn ratio = cash balance/EBITDA: measures potential for CF problem for firms w/ negative earnings. Likelihood of failure + valuation: Do DCF valuations already account for possibility of failure?

Estimate the MV's of equity and debt

MVeq = # shares outstanding * current stock price MVdebt = more complicated. Convert BV of debts like bank debt into MV

Sins of testing Mkt Efficiency

1. Anecdata 2. Test strategy on same data + time period from which it was extracted 3. Biased sample 4. Failure to control for mkt performance 5. Failure to control for risk 6. Correlation != causation

Finding terminal value

1. Assuming assets are liquidated in terminal yr, estimate what others would pay for assets the firm's accumulated at that point 2. Firm is going concern @ time of TV approx: a) apply multiple to earnings, revenues, BV b) assume CF of firm will grow @ constant rate forever - stable growth rate

Estimating asset exposure to CRP (3 views)

1. all companies in country equally exposed to country risk) exp CoE_usd = rf_US + beta(RP_us) + CRP_cntry exp CoE_cntry = (exp CoE_usd)*(inflationrate_cntry/inflationrate_usd) - 1 2. a company's exposure to country risk is proportional to its exposure to all other mkt risk (measured by beta) exp CoE_usd = rf_US + beta(RP_us + CRP_cntry) 3. each country has an exposure to country risk that is unique exp return = rf_US + beta(mature ERP) + sigma(CRP)

when should we estimate lambdas?

1. emerging mkt companies w/ large developed mkt exposures 2. developed mkt companies w/ large revenues from risky emerging markets.

Estimating CF's: 3 basic steps

1. estimate earnings generated on existing assets+investments 2. estimate portion of this income that goes toward paying taxes 3. measure how much firm is investing back for future growth

Adjustments to Income (Managed Earnings) - types of cross holdings

1. minority passive holding - only dividends received from holding are recorded in income 2. portion of net income/loss from subsidiary shown in IS as adjustment to net income but NOT operating income 3. majority active interest, where IS are consolidated, entire OP income of subsidiary/holding are shown as part of OP income of firm. In such cases, the net income is adjusted for the portion of subsidiary owned by others (minority interests) Ignore income from 1, 2 when valuing firm, value holding separately and add it to value obtained for the other assets

Default risk spreads (CRP)

1. ratings agency +: simple, easy to access, can use to estimate default spread over riskless (using average of spreads within a particular rating) -: lag 2. CDS mkt: add default spread onto cost of both equity and debt of every company traded in a country +: more updated

2 Stage DDM

2 stages of growth - initial phase where growth rate is not stable, and steady state w/ stable LT growth usually used in cases where growth rate in initial phase is higher than the stable growth rate (can be adapted tho) The payout ratio has to be consistent w/ the estimated growth rate. If the growth rate is expected to drop a lot after initial growth, the payout ratio should be higher in the stable phase than growth phase. the limitations of the model: 1. defining length of extraordinary growth 2. assumption that growth rate is high in initial period, suddenly transforms into lower stable rate at the end of period - too drastic ^endemic to all 2 stage models 3. focus on dividends in this model can lead to skewed estimates of value for firms that are not paying out all the dividends that they could afford. firms that accumulate cash will be undervalued.

Cost of preferred stock

Preferred stock has debt characteristics (preferred dividend is prespecified before issue of stock and paid out b4 common dividend) and equity characteristics (not tax deductible) * if viewed as perpetual, no special characteristics, k_pref st = preferred dividend per share / market price per preferred share special features must be valued separately preferred stock is less risky than common equity bcause preferred dividends are paid before dividends on common equity, but riskier than debt since interest payments are paid before preferred dividend payments cost of debt < cost of pref stock < cost of eq

Build-up approach

Build-up risk free rate = expected inflation + expected LT real growth rate

Liquidation Value

The estimate from selling assets that a firm has accumulated to highest bidders 2 ways to estimate: BV of assets, adjusted for inflation - limitation: based on accounting BV earning power of assets

Similarities/Diffs in DDM and FCFE

When firms pay out less in dividends than they have available in FCFE the exp growth rate + terminal value will be HIGHER in DDM but yr-to-yr CF's will be higher in FCFE. Less often, DDM > FCFE; in this case better to go w/ FCFE because high dividends not sustainable Usually FCFE > DDM; the difference between FCFE and DDM measures the value of controlling dividend policy. Which to use? depends on how open the market for corporate control is, more open use FCFE, otherwise DDM.

Negative working capital

When non-cash WC decreases, it increases the CF of the firm. If a firm has bloated inventory/gives out credit too easy managing the components more efficiently can reduce WC + create positive CFs for immediate future. But will that persist? For firms w/ + WC, decreases in WC are feasible only for short periods Once WC has been managed efficiently, WC changes from yr to yr should be estimated using WC as % of revenues If a firm has a (-) WC it is using supplier credit as a source of capital.. a source of default risk, extra supplier bills.. WC will have to remain zero or increase over time

Fundamentals

Estimating cash flows to equity: estimate net income, or earnings per share

Implications of existence of default-free entity

In developed mkts govt = default free entity LT valuation: rf rate = LT govt bond rate ST valuation: rf rate = ST govt security rate If using historical risk premiums: govt security chosen has to be same as that used for RF rate

Investing in Risky secs

Why companies invest in risky securities: 1) higher return (does not make firm more valuable) 2) undervalued secs () 3) strategic investment () 4) biz investment ()

Acquisitions - capital expenditures

acquisitions are external investments, that need to be included in capital expenditures of a firm

Implied equity premium

assumes that market is overall correctly priced extract the equity premium from the equation for valuation +: market driven and current, does not require historical data -: needs model used for valuation to be the correct one; needs that inputs to model be reliable and available there is a tendency towards mean reversion in financial markets.

Historical growth

average or geometric? linear or log-linear regression models? negative earnings -> measures become meaningless: 2 methods to get meaningful #s usefulness of historical growth: 1. too much noise 2. revenue vs earnings growth - revenue growth tends to be more persistent and predictable, since accounting choices have smaller affect on revenues than earnings so historical growth in revenues is more useful in forecasting 3. small firms usually have higher growth rates - hard to analyze

Estimating reinvestment: Net Capital Expenditures

capital expenditures - depreciation difficulties in forecasting: 1. capital spending often incurred in chunks 2. R&D 3. acquisitions are not classified as capital expenditures by accountants capital expenditures should be normalized/smoothed: 1. average capital exp over years 2. use industry average for capital expenditures

3 stage DDM

combines elements of 2-stage and H limitations: much more inputs needed if there is a lot of noise in estimation, the errors may overwhelm benefits of model useful for firm whose earnings are growing at high rates, are expected to continue growing at those rates for some time but then decline gradually toward stable rate

Bottom Up Beta

construct beta (5 steps) 1. identify businesses the firm is in 2. look for other publicly traded firms in those businesses, find their regression betas and compute an average beta for the firms 3. estimate the average UNlevered beta by unlevering the average beta for the firms with their average D/E ratio 4. estimate an unlevered beta for the firm by calculating a weighted avg of the average unlevered betas across businesses, weighted by the proportion of value the firm derives from the biz (failing that, use op. income or revenue) 5. estimate current mkt values of debt + equity at the firm and use it to estimate a levered beta

Fundamental beta

derived from a firm's fundamentals determinants: 1. type of business for example, cyclical firms will have higher betas, as well as firms specializing in luxury goods 2. degree of operating leverage a firm with high fixed costs relative to total costs has a high operating leverage. degree of operating leverage: %change in operating profit / %change in sales 3. degree of financial leverage increase in fin lev = increase in beta since higher fin lev increases variance in income and increases risk

Capitalizing Operating Leases

discount operating lease commitments in future years back at the rate of firm's current pretax cost of borrowing in some countries, use PV of an annuity = to current yr's payment for a period that reflects a typical lease period for firms w/ little conventional debt and high operating leases, need to calculate a modified interest coverage ratio: Modified ICR = (EBIT + current y's op lease expense) / (interest exp + current yr's op lease exp)

Effective vs marginal tax rate

effective tax rate = taxes due/taxable income marginal tax rate = tax rate faced on last $ of income, depends on tax code... Why are there diffs b/t marginal + effective tax rates? 1. firms in the US follow diff accting stnds for tax and reporting; straight-line depr for reporting and accelerated depr for tax 2. tax credits reduce taxes paid -> reduce effective tax rate below marginal 3. firms can defer taxes on income to future periods 4. firms that generate lots of income for foreign domiciles w/ lower tax rates don't have to pay domestic taxes until that income is repatriated back to the domestic country

ERP

equity risk premium: expected return on an investment = risk free rate + extra return to compensate for risk *how to measure this risk? *how to convert risk measure into an expected return?

Accounting betas

estimate parameters from accounting earnings, not traded prices regress changes in earnings at a division/firm on changes in earnings for the market problems: accounting earnings spread expenses and income over several periods so they're smoothed out (biased down betas for risky firms biased up betas for safe firms) influences from non-operating factors eg changes in depreciation/inventory methods accounting earnings measured infrequently, so regressions have few obvs and low explanatory power

Historical Risk Premium

estimate the actual returns on stocks over LT; compare to actual returns earned by default free security -> for well established mkts; not good for mkts where equity mkts are not reflective of overall economy, only shortperiod historical returns available

Cost of convertible bond

bond that can be converted into equity at option of the bondholder straight bond (debt) + conversion option (equity)

FCFE

definition of CF to equity = CFs left over after meeting all obligations including debt payments, and after covering capexp and WC needs.

estimating default risk / default spread

easiest when firm has LT bonds outstanding that are widely traded can also use ratings when firms have bonds outstanding that don't trade so much unrated firms: 1. recent borrowing history 2. synthetic ratings based on financial ratios

Default spreads on bonds

estimating default spreads: 1. find sampling of bonds within a ratings class 2. estimate the interest rate on these bonds 2a. yield on bond = coupon rate / market price 2b. yield to maturity on bond = interest rate that makes PV of coupons + face value of bond equal to the market price 3a. compute simple average or weighted average (weights based on trading volume) of interest rates 3b. index treasury rate: the average interest rate for a ratings class is compared to this rate to arrive at a default spread; the maturity of this should match the avg maturity of the bonds chosen to estimate the avg interest rate determinants of default spreads: default spread of a bond in a given ratings class increases with maturity

Modified historical risk premium

for markets outside US ERP = base premium for mature equity mkt + country premium should there be a country risk premium?: depends if the marginal investor is globally diversified; if country risk is country specific (low correlation across mkts)

Effects of changing RoE (growth in net income)

if overall RoE changes over time... additional growth can be written as a fn of the change in the RoE.

service beta

obtained from estimation service, like Moodys etc (bloomberg also calculates an adjusted, weighted beta)

FCFF

sum of all CFs to all claim holders in firm: stockholders, bondholders, preferred stock holders. 1. FCFF = FCFE + int*(1 - taxrate) + principal repayments - new debt issue + preferred dividend 2. measure FCFF prior to lcaims FCFF = EBIT(1 - tax rate) + depr - change in WC - capital expenditure this is also referred to as unlevered CF since it's prior to debt repayment. tax benefits due to interest payments are not included, ince using after-tax cost of debt in cost of capital already includes it

Effect of tax rate on value

when valuing firm: if the same tax rate has to be applied to earnings every period: marginal when valuing equity: we start w/ net income or earnings per share, which are after tax: however after-tax earnings of a firm reflect the taxes paid that year

Effect of Net Operating Losses

firms w/ large net operating losses carried fwd / continuing operating losses: can have tax savings in first few years that they generate positive earnings to capture effect: 1. change tax rates over time. In the early years, firms will have zero tax rate (losses carried fwd offset income). As net operating losses decrease, tax rates will increase twd marginal tax rate. For a firm w/ net OP losses carried fwd, tax rate used for computing after-tax operating income + cost of capital will = 0 during years when losses shelter income. 2. for firms that already have + earnings but have large net OP loss carried fwd: analysts will value firm ignoring the tax savings generated by net OP losses, and then add the expected tax savings from net OP losses. (The exp tax savings are usually estimated by tax rate * net OP loss)

Gordon Growth Model (DDM)

for "steady state" firm w/ dividends growing at an eternally sustainable rate note about GGM: since growth rate in firm's dividends is expected to last forever, the firm's other measures of performance (ie earnings) are expected to grow at same rate - since otherwise payout ratio converges to zero not steady state - so should be able to substitute exp growth rate in earnings beta should be close to 1 for mature firms Model limitations: GGM is very sensitive to assumptions about the growth rate This model will underestimate value of stock in firms that consistently pay out less than they can afford to, and accumulate cash in the process

marginal tax rates for multinationals

for a firm w/ global operations, its income is taxed @ diff rates in diff locales 1. weighted average of marginal tax rates (weights based on income from each country) 2. use marginal tax rate of country in which company is incorporated 3. keep income from each country separate, apply diff marginal tax to each income stream

FCFF vs FCFE

for firms at their desired debt level, FCFF > FCFE. EBITDA: rough measure of CFs from operations. FCFF is related but more complete since it accounts for potential tax liability from earnings as well as capex and WC. growth in operating income (firm) < growth in net income (equity); financial leverage can augment the latter but in stable growth, growth rates in operating income and equity income must converge. for firms w/ either v high or v low leverage, better to use FCFF. calculating FCFE would be difficult bc volatility induced by debt payments, and value of equity more sensitive to assumptions Probs w/ FCFF: 1. FCFE more intuitive measure of CFs. 2. focus on predebt CFs can blind us to problems 3. Using a debt ratio in CoC to incorporate effect of leverage requires us to make assumptions +s of FCFF to value equity: 1. CFs related to debt don't need to be considered since FCFF is pre debt

ISSUES WITH DDM

how to use it for low/no-dividend paying stocks? adjust dividend payout ratio to reflect changes in expected growth rate (p 344) does it undervalue? caveats: DDM does not beat market every year just proxying for using PE ratios? strategy using low PE ratios to pick stocks adds more to quarterly returns than DDM DDM picks high dividend yield portfolios, but those can create tax disadvantagr if dividends are taxed at rate > capital gains or if there is tax timing liability w/ dividends

Capital expenses that are treated as operating expenses - effect on NCE

if we wish to capitalize R&D exp: adjust capital exp, and depreciation/amortization

underlying principles of fcfe valuation

implicitly assuming all FCFE will be paid out to stockholders 1. no future cash buildup in firm 2. exp growth in FCFE will include growth in income from operating assets, not grwoth in income from increases in mktable secs

Reinvestment: working capital

increase working capital -> generates negative cash flows, ties up cash Working Capital: Current Assets - Current Liabilities however for valuation: 1. back out cash and investments in mktable securities from current assets. Because cash is usually invested in bonds and earns a fair return. 2. back out all interest-bearing debt (short term, LT debt due in current period) from current liabilities, since this debt is considered in cost of capital, and no need to count it twice

Adjustments to Income (Managed Earnings) - income from investments + cross holdings

investments in marketable securities generate 2 types of income: 1) investment/dividends 2) capital gains (losses) associated w/ selling securities neither type should be considered as earnings in valuation unless it's a firm whose business is buying/selling securities (e.g. hedge fund) easier to add market value of securities on at the end

Value of non-operating assets - Cash and near cash

near cash = investmt in ST gov't secs or commercial paper if the cash does not earn a fair return, and if the firm requires a lot of cash for its operations, include the cash as part of working capital requirements instead of added value then the cash/near cash > OP cash requirements are non-operating assets DEALING with non-operating cash holdings (cash + marketable securities) in valuation: 1. lump them in with operating assets and valuing firm as a whole 2. value operating assets, and cash+marketable securities separately Consolidated valuation: can we value firm considering cash as part of assets? yes, but difficult to do when financial investments are small percent of total assets 1. CoE/CoC used to discount CFs have to be adjusted on ongoing basis for cash we would need an unlevered beta that includes beta for cash 2. as firm grows, the propn of income from OP assets will likely change, then we would have to adjust inputs to model -> better to value cash and mktable secs separate from operating asets; bc we use operating income to estimate FCFF which does not usually include income from financial assets. When can we discount cash? 1. cash being held is invested at a rate lower than mkt rate: holding too much cash would then lower the value 2. management is bad [problems in making adjustment: tax rates may change, and companies are not transparent]

CoD for emerging market firm

problems: 1. no ratings available 2. synthetic ratings may be skewed by diffs in interest rates b/t the market and the US. interest coverage ratios decrease as interest rates increase *soln: modify developed tables using US films, restate interest expenses in $ terms 3. country default risk! * CoD_emerging mkt company = rf + CountryDS_emerging mkt + CompanyDS_syntheticrating

Historical mkt betas

regress returns on investment against returns on stock index use Jensen's alpha (a - rf(1-beta)) to see how well investment did; R^2 provides estimate of proportion of risk of firm that can be attributed to market risk; standard error estimation choices: 1. length of estimation period (longer = more data, perhaps not asaccurate though) 2. return interval (daily returns = more obvs, but exposes estimate to bias) 3. choice of market index does not work for private firms!

Measuring Earnings

required to estimate Cash Flows FCFF use operating earnings post-tax FCFE use net income Accounting measures have to be adjusted for use in valuation operating lease -> financial expenses R&D -> capital expenses A firm includes assets [assets in place + growth assets] and liabilities [debt + equity]

Consistency principle

rf rate used to come up with exp returns should be consistent with how CFs are measured (eg if CFs are estimated in nominal US dollar terms, rf rate should = US treasury bond rate) so the rf rate should be in currency in which CFs on the firm are estimated

Real vs Nominal RF rates

stable, low inflation -> valuation in nominal terms unstable, high inflation -> valuation in real terms (not allowing for growth from price inflation); need to use real discount rates TIP (inflation indexed treasuries) are default free securities that can be used to estimate real risk free rates. Real = nominal - inflation

APV approach

start w/: value of firm w/o debt as debt is added to firm, net effect on value is examined by considering both benefits and costs of borowing assume that: + of borrowing: tax benefit - of borrowing: risk of bankruptcy Steps: 1. estimate value of firm w/o leverage 2. consider PV of interest tax savings generated by borrowing given amt of $ 3. evaluate effect of borowing on probability the firm will go bankrupt, and expected cost of bankruptcy how to estimate probability of bankcruptcy? a. estimate a bond rating, use empirical estimates of default probs b. probit, other stat model bankcruptcy cost can be estimated from studies advantage of APV: separates effects of debt into diff components, and allows analyst to use diff disct rates for each component we do not assume debt ratio stays unchanged forever disadvantage: difficult to estimate PD and CoB

Tax books vs reporting books

taxes payable / reported income will usually yield a tax rate lower than the true one. This would over-value the company, which is another argument for using marginal tax rates iif we base projections on reported income, we will overstate exp future income

Cost of Equity (CoE)

the rate of return investors require on an equity investment in a firm Expected return = rf + beta(risk premium)

computing cost of capital

we need a) CoE b) after-tax CoD c) weights on debt and equity 1. Cost of equity: should change as D/E changes beta_lev = beta_unlev(1 + (1 - t)(D/E)) CoE = rf + beta_lev(risk prem) 2. After tax CoD: first, estimate $ debt and interest expenses across all debt ratios then compute financial ratios that estimate default risk, use them to get a rating for firm add a default spread based on rating to rf rate => pretax CoD apply marginal tax rate -> after tax CoD *preferred stock: can count it in, but has to remain fixed while changing weights on debt and equity here we are keeping the operating income fixed and only varying CoC this requires 2 assumptions: 1) debt ratio is decreased by raising new equity and retiring debt; increased by borrowing money and buying back stock (recapitalization) 2) pretax OP income is unaffected by financing mix, and bond rating if OP income changes w/ default risk, minimizing CoC may not be optimal course of action

Multiple approach

Value of firm in future year estimated by applying multiple to firm's earnings or revenues in that year

Tax effect

After-tax operating income = EBIT * tax rate issues: 1. marginal vs effective tax rate 2. firms w/ large losses -> net op losses carried fwd 3. capitalization of r&d -> tax benefit

Adjustments to Income (Managed Earnings) - acquisitions, divestitures

Amortization of goodwill reduces reported income in subsequent periods: look at earnings prior to amortization (same consideration for write-offs of "in process R&D") Divestiture of assets: generates income in form of capital gains. Ignore income associated w/ divestiture

Adjustments to Income (Managed Earnings) - extraordinary items

Extraordinary/recurring/unusual items: 1. 1-time expense 2. expenses and income that do not occur yearly, but at regularr intervals (are actually ordinary) 3. expenses and income that occur yearly but will high volatility (normalize them by averaging expenses across time, reduce income by this amount) 4. items that recur yearly but change signs (ignore for CF purposes) Operating income that is used as a base for projects should reflect CONTINUING operations, should not include 1-time/extraordinary items.

adjusting for financing expenses

Financing expenses that are mistreated as operating expenses Operating lease expenses are treated as operating expenses (vs capital leases which are presented as debt) Adjusted debt = Debt + PV of lease commitments Adjusted op income

Tax benefits from R&D expense

Firms can deduct entire R&D expense for tax purposes, although they can deduct only depr for capital expenses

Stable growth Model

Firms reinvest some CF's back into new assets and extend their lives If assuming CFs will grow at constant rate forever after terminal yr Constraints on stable growth: 3 questions: 1. is company domestic/multinational operating? 2. real/nominal valuation? 3. currency being used? the stable growth rate <= riskless rate used in valuation what if stable growth rate is (-)? allows firm to partially liquidate itself each year until it disappears.

Quantitative vs Qualitative Aspects of Growth

For profitable firms: RoC and reinvestment rates For unprofitable firms: sales-capital ratio, operating margin, and revenue growth

Common misclassifications of expenses

R&D (capital expenses) misclassified as operating expenses -> skews operating and net income financial expenses (operating lease expenses) misclassified as operating expenses -> skews operating income and FCFF effect of "managed earnings" - using accounting techniques

Capital expenses treated as operating expenses

R&D often considered too uncertain/difficult to quantify -> thus often classified as operating -> research assets do NOT show up on BS as part of total assets of firm!!! affects capital and profitability ratios To capitalize: 1. Need to make assumption about amortizable life [how long it will take for R&D to convert to commercial products] 2. Collect data on R&D expenses over past yrs ranging over amortizable life of research asset 3. Adjust BV of equity 4. Adjust OP income 5. Adjust net income -> usually would only consider after-tax portion, but R&D is entirely tax deductible

Relative standard deviation (CRP)

RSD_A = SD_A / SD_B ERP_A = riskprem_B * RSD_A CRP = ERP_A - riskprem_B -: risky emerging mkts often have low stnd devs for their equity mkts because the mkts are illiquid; then this approach would understate the ERPs in those markets -> assumes investors are choosing between equity markets

Accounting earnings (Managed earnings)

Techniques for managing earnings: Planning ahead Revenue recognition (eg, choose not to report some revenue so can report it in a weaker quarter) Booking revenues early Capitalizing operating expenses (to boost operating cash flow) Write-offs Use of reserves (use excess reserves from good, conservative years to smooth out bad years) Income from investments

Event Study

Testing market efficiency: examine exces returns around specific info events 1. Identify Event. 2. Collect returns around these dates for firms in a sample. 3. Adjust returns by period for market performance and risk to get excess returns 4. Average excess returns across all events in the sample, BY PERIOD, and computer stnd error 5. T-stat for excess return on day t = avg excess return / standard error

Portfolio Study

Testing market efficiency: firms with specific characteristics may be more likely undervalued Create portfolio of firms w/ these characteristics and examine returns over a certain period; repeat for # of periods 1. define variable on which firms will be classified. 2. Data on variable is collected for each firm at the start of testing period; firm classified into portfolios based on magnitude of variable 3. Returns collected for each firm in each portfolio for testing period, compute returns for each portfolio 4. Beta for each portfolio are estimated 5. Excess returns earned by each ptfolio are computed, as well as standard error 6. Statistical tests 7. Match extreme portfolios against each other

Dividend Discount Models

The only CF you receive when you buy shares in a publicly traded firm is DIVIDEND DDM: value of stock = PV of expected dividends on it General model: investor expects 2 types of CF's from buying stocks - dividends during the period the stock is held, and an expected price at the end of the holding period.

rf rate for NO default free entity

Use either Moody's or CDS Moody's: assumptions that Moody estimate is accurate CDS: more updated but also more volatile