CFA II: Equity

Industry and Company Analysis: describe approaches to balance sheet modeling;

- Most items flow directly from the income statement (or are very closely linked) - Use efficiency ratios to model working capital accounts - Depreciation based on historical depreciation and disclosures about schedules - Capital expenditures, maintenance (small growth overtime) growth capital expenditures

Valuation: describe questions that should be addressed in conducting an industry and competitive analysis;

1) How attractive are the industries in which the company operates? Porters 5 Forces:Intra-industry rivalry, Threat of New Entrants, Substitutes, Supplier Power, & Buyer Power 2) What is the company's relative competitive position within its industry, and what is its strategy? Cost Leadership- Being the lowest cost producer while offering comparable products Differentiation- offering unique products that can command premium prices Focus- Seeking a competitive advantage within a target segment or industry, based on either cost leadership or differentiation. 3) How has the company executed on its strategy and what are its prospects for future execution? Financial and Operational Strategic Execution Analyze companies historic financial performance and forecast expected future performance. Two main caveats: I. Qualitative factors such as structure, intellectual and physical properties, and potential consequences of legal disputes or other contingent liabilities. II. Avoid simply extrapolating past operating results when forecasting future performance- in general, there is "regression towards the mean". If profitable, then more companies will come in, if not, companies will leave and allow more market share. Beyond 10yr forecast, assume industry growth.

Industry and Company Analysis: forecast the following costs: cost of goods sold, selling general and administrative costs, financing costs, and income taxes;

1)Operating Costs COGS: - Forecasted as a percentage of sales - Try to separate out by segment/category/ volume & price components - Should consider hedging strategies - compare against competitors SG&A: Selling and distribution: % of sales General & Admin expenses: Less variable, more fixed and slowly rises - look at history and competitors as a benchmark - look at additional metrics 2)Non-Operating Costs Financing Costs: - Need to look at capital structure - Main drivers are debt level and interest rate Income Taxes: - Statutory Tax Rate: company's domestic tax rate - Effective Tax Rate: reported tax amount on the income stated divided by pretax income - Cash Tax Rate: tax actually paid divided by pretax income

FCF: compare the FCFE model and dividend discount models;

A lot of analysts prefer the because many companies do not pay dividends or dividends not consistently correlated to profitability. Additionally, dividends are cash flow to shareholders whereas FCFE is cash flow available to equity holders without impairing the value.

Valuation: contrast absolute and relative valuation models, and describe examples of each type of model;

Absolute Valuation Models- model that specifies an asset's intrinsic value, which is then compared to the asset's market price. Models Types include: DCF models, dividend models, FCF models, residual income models, & Asset-based valuation models. Relative Valuation Models- estimate an asset's value relative to that of another asset; the underlying idea is that similar assets should sell at similar prices. Major investing strategies are pairs trading: utilizing pairs of closely related stocks, selling the relatively overvalued and buying the relatively undervalued. Model types are usually multiple based.

Multiple: explain the use of the arithmetic mean, the harmonic mean, the weighted harmonic mean, and the median to describe the central tendency of a group of multiples

Arithmetic mean: of the individual P/Es or to calculate a weighted mean of individual P/Es where the weights are the relative market capitalizations. However, both these measures will overestimate the aggregate index value. Harmonic mean: is closer to the aggregate index P/E value. In this calculation, the individual P/Es are inverted, equally weighted, summed, and then inverted again. However, the harmonic mean can be influenced by small outliers. Weighted harmonic mean: precisely corresponds to the aggregate index P/E value. It is similar to the harmonic mean except that the inverted P/Es are not equally weighted but instead weighted by their market capitalization.

Valuation: explain broad criteria for choosing an appropriate approach for valuing a given company.

Broad Criteria for Model Selection are that the valuations model be: I. Consistent with the characteristics of the company being valued (ie. pays dividends) II. Appropriate given the availability and quality of Data III. Consistent with the purpose of valuation, including the analysts perspective.

Return Concepts: explain beta estimation for public companies, thinly traded public companies, and nonpublic companies;

Bu=[1/ (1 +(D/E))]*BE BE'=[1+(D'/E')]*Bu

Private: compare models used to estimate the required rate of return to private company equity (for example, the CAPM, the expanded CAPM, and the build-up approach);

CAPM - Easy, but beta may be inappropriate if the prive company has no intention of going public or being acquired. CAPM = RF+Bi*(Equity Risk Premium) or Adjusted Beta = (2/3)*(Unadjusted Beta) + (1/3) Expanded CAPM - Better because it takes into account more factors. Exp CAPM = RF+Bi*(Equity Risk Premium) + PremSize+ PremCompany Build Up Method - Mainly used when you can't find a Beta or company for comparison. Beta is assumed to be 1, so all are just added to the risk-free rate. However, it can be hard to find the industry premium. Exp CAPM = RF+ Equity Risk Premium + PremSize+ PremCompany+Premindustry

Return Concepts: describe strengths and weaknesses of methods used to estimate the required return on an equity investment;

CAPM- Strengths: Easy, widely accepted, easily obtainable, works well in a portfolio context Weakness: Doesn't work well in individual securities due to idiosyncratic risks (incomplete) Multifactor Models & Build up- Strengths: More complete view of risk, as it applies multiple factors & incorporates Weakness: More factors means more complex

FCF: describe approaches for forecasting FCFF and FCFE

Can be taken as the historical or normalized historical rate. or Forecasting the incremental differences: - Sales and EBIT generally given - Must calculate Incremental FC % in FC= (Cap Ex - Dep Ex)/Increase in Sales % in WC= Increase in Working Capital/ Increase in Sales - Net borrowing given

Porter: describe how an industry's predictability and malleability are expected to affect the choice of an appropriate corporate strategy (classical, adaptive, visionary, or shaping);

Classical (High Predictability, Low Malleability): Adaptive (Low Predictability, Low Malleability): Visionary (High Predictability, High Malleability): Shaping (Low Predictability, High Malleability):

Private: compare public and private company valuation

Company Factors: -Stage in Life Cycle -Size -Overlap of Shareholders and management -Quality/Depth of Management -Quality of Financial Information -Pressure from Short term investors -Tax Concerns Stock Factors: -Liquidity -Concentration of Control -Potential Agreements Restricting Liquidity

Industry and Company Analysis: describe the relationship between return on invested capital and competitive advantage;

Competitive advantage is usually seen through persistent and superior return on invested capital, due to the fact that it can leverage its market position, distribution channels (IE its competitive advantage) to get better margins, which improve its ROIC (net operating profit less adjusted taxes divided by the difference between operating assets and operating liabilities).

RI: explain continuing residual income, and justify an estimate of continuing residual income at the forecast horizon, given company and industry prospects;

Continuing Residual Income- is the residual income after the forecast. Reasons For a Lower Residual Income Persistence - Extreme accounting rates of return (ROE) - Extreme levels of special (non-recurring items) - Extreme levels of accounting accruals Reasons for High Residual Income Persistence - Low dividend payout rate - High historical persistence in the industry

Return Concepts: evaluate the appropriateness of using a particular rate of return as a discount rate, given a description of the cash flow to be discounted and other relevant facts.

Depends on where the cash flow is going (think FCFF vs. FCFE models and their discount rates). When the cash flow is to the equity, the required return on equity makes sense. When the cash flow is to the firm/claims of all of a company's capital providers, you use the WACC.

DDM: compare dividends, free cash flow, and residual income as inputs to discounted cash flow models, and identify investment situations for which each measure is suitable

Dividends Models are suitable when: - Company is dividend paying - Board of directors has established a div policy that bears consistent relationship to profitability - Investor takes non-control perspective FCF Models: - Company is non-dividend paying - Company is dividend paying but significantly exceeds or fall short of free cash flow to equity - FCF aligns with company profitability within a comfortable forecast horizon - the investor takes a control perspective Residual Income: - the company is not paying dividends - the company's expected free cash flows are negative within the analyst's comfortable horizon

FCF: explain how dividends, share repurchases, share issues, and changes in leverage may affect future FCFF and FCFE

Dividends and Share repurchases/issues: Absent because they are included in the definition, they are available cash flow to holders of equity. Increases in Leverage: (debt) does increase FCFE by the debt issue in the year issued. Future FCFE increases by the tax savings from the interest tax shield but is decreased by future interest payments to debtholders. FCFF only changes by the tax savings from the interest tax shield.

Multiple: explain alternative definitions of cash flow used in price and enterprise value (EV) multiples, and describe limitations of each definition

EBITDA - Used when both A&D are relevant expenses EBITA- used when amortization (but not dep) is a major expense EBIT- when neither Amort or Dep is not a major expense FCFF- Can be negative These are generally industry specific, as they pertain more to certain cost structures relevant to the particular business.

Multiple: calculate and interpret EV multiples, and evaluate the use of EV/EBITDA

EV=MV(equity) +MV(debt)-cash -Investments Positively related to growth rate in FCFF Positively related to expected profitability as measured by ROIC Negatively related to the firms WACC

Multiple: describe momentum indicators and their use in valuation

Earnings Surprises- The unexpected earnings is typically scaled by a measure that expresses the variability of analysts' EPS forecasts. Less disagreement there is among analysts, the more meaningful the EPS forecast error of a given size. Standardized Earnings Surprises- Standardized to show that the smaller the historical forecast errors size is, the more meaningful the forecast error. Relative Strength Index- compares a stock's performance during a given time period with its own historical performance or that of a group of stocks, exploiting patterns. However, once the pattern is discovered, the benefit goes away.

Multiple: explain and justify the use of earnings yield (E/P);

Earnings Yield is the inverse of the P/E ratio. The idea is finding companies where the earnings are high and the price is relatively low- hoping to find some stocks on the cheap where the growth expectations are not inflating the price

Return Concepts: explain international considerations in required return estimation;

Exchange Rates - adds more volatility, means more risk Data and Model issues in Emerging market- Bad data adds more risk to the analysis Specific country issues- Geopolitical factors, etc

Private: calculate the value of a private company using free cash flow, capitalized cash flow, and/or excess earnings methods;

FCF is simply a discounted cash flow method wherein forecasts and terminal value assessments are made (as well as adjustments should the cash flow need to be normalized). Capitalized Cash Flow Method estimates value based on the expression for the value of a growing perpetuity and is essentially a single stage FCFF method. Can also estimate the value of equity in the same idea through FCFE. Denominator can be called capitalization rate. Only used for small private companies. Excess Earning Method is essentially the residual income method, but is only used for very small business, and even then very rarely. It is working cap + fixed cap + residual income (Normalized earnings - Capital Discount Rates*(Capital))*(1+g) / (r - g)

FCF: evaluate the use of net income and EBITDA as proxies for cash flow in valuation

FCFE/FCFF vs. EBITDA and net income: Although commonly used in valuation, EBITDA is a poor substitute for FCFF and FCFE because it does not account for depreciation, FCInv, and WCInv. Likewise, net income is a poor substitute for FCFE because it does not account for depreciation, FCInv, WCInv, and net borrowings

FCF: compare the free cash flow to the firm (FCFF) and free cash flow to equity (FCFE) approaches to valuation;

FCFF: is the cash flow available to the company's suppliers of capital after all operating expenses and tax have been paid and necessary investments in working and fixed capital have been made. FCFF is used when: - A levered company with negative FCFE - A levered company with a changing capital structure FCFE: Is the cash flow available to the company's holders of common equity after all operating expenses, interest, and debt have been paid and the necessary investments in working and fixed capital have been made. FCFE is used when: - there is positive FCFE - Stable capital structure - Ownership perspective is taken

Industry and Company Analysis: evaluate whether economies of scale are present in an industry by analyzing operating margins and sales levels;

Factors that can lead to economies of scale include: - greater bargaining power with suppliers - lower cost of capital - lower per unit advertising expenses Gross and operating margins tend to be positively correlated with sales levels in an industry that enjoys economies of scale.

Private: explain various definitions of value, and demonstrate how different definitions can lead to different estimates of value

Fair Market Value - Price asset trades at regularly Market Value - the estimated amount for which an asset or liability should exchange on the valuation date between a willing buyer and a willing seller in an arm's-length transaction, after proper marketing and where the parties had each acted knowledgeably, prudently, and without compulsion Fair Value (reporting) - the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between marketplace participant at the measurement date Investment Value - the value to a particular investor based on the investor's investment requirements and expectations. Investment value is important in the sale of a private company Intrinsic Value- Intrinsic value can be defined as the value that an investor considers, on the basis of an evaluation or available facts, to be the "true" or "real" value that will become the market value when other investors reach the same conclusion.

Valuation: describe definitions of value, and justify which definition of value is most relevant to public company valuation;

Fair Market Value- is the price at which an asset would change hands between a willing buyer and seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell. Fair Value- Financial reporting context, is valuing an asset for the purpose. Investment Value- An asset is worth more to a particular. buyer (because of potential operating synergies. Most relevant to public company valuation is Fair market value, because, assuming the marketplace has confidence that the company's management is acting on the owners best interest, market prices should tend, in the long run, to reflect Fair market value.

Return Concepts: estimate the required return on an equity investment using the capital asset pricing model, the Fama-French model, the Pastor-Stambaugh model, macroeconomic multifactor models, and the build-up method (e.g., bond yield plus risk premium);

Fama-French :re=rf+imrktRMFR +iSizeSMB +iValueHML Pastor-Stambaugh: re=rf+imrktRMFR +iSizeSMB +iValueHML +iLiquidityLiquid

Private: explain and evaluate the effects on private company valuations of discounts and premiums based on control and marketability;

Finding DLOC: DLOC= 1- [1 / (1 + Control Prem)] Valuation Discounts: Total Discount = 1-[(1-DLOC)(1-DLOM)]

Private: calculate the value of a private company based on market approach methods, and describe advantages and disadvantages of each method;

GPCM (Guideline Public Company Method) - Establishes a value estimate based on the observed multiples from trading activity in the shares of public companies viewed as reasonably comparable to the subject private company. Figure out value of company/equity, then adjust for control. Factors to consider for Control prem: type of transaction (strategic or financial), Industry Factors (Same industry), Forms of consideration (stock/cash/mixed). + Advantage: Large number of guideline companies and significant amount of data about them - Disadvantage: Issues regarding comparability and subject in the risk and growth adjustments GTM (Guide Transaction Method) - Uses pricing multiples derived from acquisitions of public/private companies. Compare directly to transactions where control is already factored in. Factors to consider for multiple: Synergies, contingent consideration, noncash consideration, availability of transactions, changes between transaction and valuation dates. + Advantage: Directly for acquisitions, and transaction multiples are the most relevant even for the valuation of a controlling interest in a private company. - Disadvantages: Data may be unreliable because information not always disclosed/confirmed. Prior Transaction Method - Based on the actual transaction history of the subject company. + Advantage: Based on subject company - Disadvantages: may be from a long time ago or infrequent

Industry and Company Analysis: evaluate the effects of technological developments on demand, selling prices, costs, and margins;

Generally, you make quantitative assumptions based on qualitative circumstances and produce a scenario/sensitivity analysis to give a range of options and show the specific impact of each change. The biggest idea behind how technological developments is through cannibalization. Demand- Will generally go down, in the event that the development creates a substitute. Should it create a complement, it can increase the demand- though this is less likely. Selling Price- When technology leads to a lower manufacturing costs, the supply curve will shift to the right as suppliers produce more of the product, eventually driving the price down. Costs- Generally have to look at the cost structure- the break out between variable and fixed costs and because most don't explicitly say it, you have to approximate: Variable= %(Cost of revenue +Operating expenses) / %revenue Fixed Cost= 1 - % Variable cost Variable costs growth are generally assumed to be = to revenue growth, with fixed cost generally about half of that (if not given). Margins- As fixed costs grow at a lower rate and variable costs are assumed to grow at a higher rate, operating margins generally increase over time.

Valuation: explain the going concern assumption, and contrast a going concern value to a liquidation value;

Going Concern- assuming that the company will continue its business activities into the foreseeable future; the going concern value is based on this assumption and is generally used. Liquidation Value- Is the valuation assuming the company is dissolved and its assets sold individually, generally used for companies under financial distress. Must also consider the horizon over which the liquidation occurs, the longer the time period, the better pricing they should get (Orderly Liquidation Value)

DDM: explain the growth phase, transitional phase, and maturity phase of a business

Growth Phase - rapidly expanding markets, high profit margins, and abnormally high growth rates. Often have negative FCFE because the company is heavily invested in expanding operations. Transition Phase- Transition to maturity, earnings growth slows as competition put pressure on prices and profit margins or as sales growth slows because of market saturation. Capital requirements typically decline, so FCFE becomes positive. Mature Phase- reaches an equilibrium in which investment opportunities on average just to earn their cost of capital. ROE approaches required, stabilize to long-term growth.

Return Concepts: calculate and interpret an equity risk premium using historical and forward-looking estimation approaches;

Historical Equity Index to represent equity market returns: Generally use broad-based, market value weighted indices Time period Generally involves a tradeoff, want a bigger sample but need similar market conditions Type of Mean Geometric (multi period - always smaller) vs. Arithmetic (single period) Proxy for Risk Free Rate Long-term gov bond** or short term gov bill Adjustments Survivorship bias Forward Looking GGM= Index Div Yield + Consensus LT earnings Growth - LT Gov bond yield

Return Concepts: distinguish among realized holding period return, expected holding period return, required return, return from convergence of price to intrinsic value, discount rate, and internal rate of return;

Holding Period Return- Return earned from investing in an asset over a specified time period. r= DHP0+ PH-P0P0 Required Return- minimum level of expected return that an investor requires in order to invest in the asset over a specified period of time, given the asset's riskiness. (Think cost of debt/equity) Return from Convergence- Essentially the return expected from the asset covering the difference from the market price to the intrinsic value (the alpha), PLUS as well as the periodic required return. Discount Rate- Discount rate reflects the compensation required by investors for delaying compensation, and their required compensation for the risk of the cash flow. Internal Rate of Return- is the discount rate that sets present value of outflows equal to present value of inflows.

Private: explain the income, market, and asset-based approaches to private company valuation and factors relevant to the selection of each approach;

Income Approach - values an asset as the present discounted value of the income expected from it. The income approach has several variations depending on the assumptions the valuator makes Market Approach - values an asset based on pricing multiples from sales of assets viewed as similar to the subject asset. ("Pricing multiples" may refer to multiples based on share price or multiples based on a measure of total company value.) Asset- Based Approach - values a private company based on the values of the underlying assets of the entity less the value of any related liabilities Need to Consider: Nature of Operations Stage in Life cycle Size

Porter: describe why industry growth rate, technology and innovation, government, and complementary products and services are fleeting factors rather than forces shaping industry structure;

Industry Growth Rate Growth tends to mute rivalry, but fast growth can put suppliers in a powerful position and will likely draw new entrants. Additionally, high growth rate does not guarantee profitability if customers are powerful or substitutes are attractive. Technology and Innovation Not by themselves enough to make an industry structurally attractive. Mundane is usually more profitable than sexy ones. Government Neither inherently good nor bad for industry profitability. Best way to understand the influence is to look at exactly how the policies affect the five competitive forces. Complementary Products and Services Can be a factor into industry rivalry either positively (as when they raise switching costs) or negatively (as they neutralize product differentiation). Need to analyze effect on buyer/supplier power.

Industry and Company Analysis: explain how to forecast industry and company sales and costs when they are subject to price inflation or deflation;

Industry Sales (*Industry Structure) Inflation - In most cases, cost of inputs will eventually result in higher prices for end products. The more power the industry has, the lower the price increase because they can pass it on. In less concentrated industries, it is more likely to increase with the CPI. Depending on elasticity of demand, availability of substitutes, and the reaction of customers the volume may be negatively impacted. Raising prices too late will result in a profit margin squeeze, but acting too soon could result in volume losses. Deflation - First one to lower the end product price usual reaps the benefits. Lowering prices too soon will result in a lower gross margin, waiting too long will result in volume losses. Company Sales (*Price Elasticity of Demand & Geo mix) Inflation - Must take into account the geographical mix of its operations to reflect different rates of the cost of inflation among countries.

Multiple: calculate and interpret a predicted P/E, given a cross-sectional regression on fundamentals, and explain limitations to the cross-sectional regression methodology;

Issues are mainly that the relationship is not stable over time- earnings is generally just one of the explanatory variables. Size and book-to-market absorbed the roles of the other to predict price. Issues with multicollinearity.

Multiple: distinguish between the method of comparables and the method based on forecasted fundamentals as approaches to using price multiples in valuation, and explain economic rationales for each approach;

Method of comparables refers to the valuation of an asset based of comparable assets- ie bench marked. (Similar assets should sell for similar prices) The difference between this idea and forecasted fundamentals, is that the forecasted fundamentals deals with comparing past values to future values. (Doesn't involve making comparisons to other companies)

Private: explain factors that require adjustment when estimating the discount rate for private companies;

Need to Consider: Size - smaller size typically means higher risk, which typically means higher discount rate Cost of Debt - Higher in small companies because they have less access to debt financing, which means more equity financing, which is expensive, and their debt usual comes at a higher operating risk, so they have a higher interest rate Acquisition- Should be consistent with cash flows, not buyer's cost of capital Projection Risk- uncertainty associated with future cash flows Life Cycle Stage- Classification, early stage difficulties, company-specific risk

Private: explain cash flow estimation issues related to private companies and adjustments required to estimate normalized earnings

Normalized Earnings- Economic benefit adjusted for nonrecurring, non-economic, or other unusual items to eliminate anomalies and/or facilitate comparison. Because of control, there can be large issues- such as the owner may decide to pay himself $1.5M instead of a going rate of $500k, non-core operating activities, and capital structure (because its mainly debt).

Multiple: describe rationales for and possible drawbacks to using P/B Multiple

P/B Multiple Rationals: + Book value is generally positive, cumulative balance sheet amount + More stable than EPS + Best for valuing companies composed chiefly of liquid assets + works well for non-going concerning + Differences in stocks P/B may be related to differences in long run avg. returns Drawbacks: - Doesn't account for things like human capital - Different companies use the same asset differently - Accounting choices/requirements impact book value - Share repurchases or issuances may distort comparisons

Multiple: calculate and interpret the P/E-to-growth ratio (PEG), and explain its use in relative valuation;

PEG Ratio=(P/E) / Annual EPS Growth PEG is a non-linear relationship, doesn't account for growth duration, and doesn't factor in risk. One method of adjusting for differences in expected earnings growth between the firm and the benchmark is to calculate the P/E-to-growth ratio (PEG), where the firm's P/E is divided by the expected earnings growth in percent. All else equal, firms with lower PEGs are more attractive than firms with higher PEGs. Firms with PEGs less than 1 are often considered especially attractive

Porter: explain how positioning a company, exploiting industry change, and shaping industry structure may be used to achieve a competitive advantage

Positioning the Company - Dividing up segments, think niche/focus (truck) Exploiting Industry Change - Moving with the change and provide outlet, step into the vacuum Shaping Industry structure Redividing profitability- neutralizing buyer/supplier power Expanding the profit pool- making more efficient Defining the Industry- Different strategies for each industry you compete in.

Porter: Power of Buyers

Power of Buyers: 1) Few buyers, or purchases are large relative to a single vendor 2) Industry products are standardized 3) Buyers can credibly threaten to integrate backwards Buyers are Price sensitive if 4) Purchases represent a significant portion of overall costs 5) Buyers earn low profits 6) Quality of buyers products is little affected by industry's product 7) Industry's product has little effect on buyers other costs

Porter: Power of Suppliers

Power of Suppliers: 1) More concentrated than the industry it sells to 2) Supplier group does not depend heavily on the industry for its revenues 3) Buyers face switching costs 4) Suppliers offer products that are differentiated 5) No good substitute for product 6) Supplier can credibly threaten to integrate forward

Private: Describe uses of private business valuation, and explain applications of greatest concern to financial analysts;

Private Financing - raising capital to build out, VCs invest through rounds at milestones. IPO- IBs need to identify valuation in comparison on the market for easier transition. Acquisition- How much to buy for Bankruptcy- Understanding the value can help with ongoing concern and liquidity assumptions Share-based Comp- Need to know how much to pay execs Financial Reporting- Components of public companies are valued through private company techniques (such as goodwill impairment), stock grants for private Tax Reporting- Lots of tax reporting activities require valuation: corporate activities, restructuring, transfer pricing, and property tax.

RI: explain strengths and weaknesses of residual income models, and justify the selection of a residual income model to value a company's common stock;

RI model is appropriate when: + Company does not pay dividend or divs are not predictable/correlated to profitability + Expected cash flows are negative within comfortable forecast horizon + Great uncertainty in forecasting terminal value RI model is NOT appropriate when: - Significant departures from clean surplus accounting exists - Significant determinants of RI (ex book value and ROE) are not predictable

Multiple: describe rationales for and possible drawbacks to using P/Divs Multiple

Rationals: + Divs are a component of total return + Divs are a less risky component of total return than capital appreciation Drawbacks: - Only one component of return - Investors may trade future earnings growth to receive higher current divs - Argument about relatively safety of divs presupposes that market prices reflect in a biased way

Multiple: describe rationales for and possible drawbacks to using P/E Multiple

Rationals: + Earning power is Chief driver of investment value and EPS (denom) is the chief focus + Widely recognized + Differences in stocks P/E may be related to differences in long run avg. returns Drawbacks: - EPS can be zero, neg, or insignificant - recurring vs. transient components in earnings - application of account standards can be different (ie. different assumptions)

Multiple: describe rationales for and possible drawbacks to using P/S Multiple

Rationals: + Generally less subject to distortion or manipulation + Always positive + Generally very stable, especially because isn't impacted by operating/financial leverage + Appropriate for valuing the stocks of mature, cyclical and zero income companies + Differences in stocks P/B may be related to differences in long run avg. returns Drawbacks: - Can have high sales, but operating profit can be very low - Doesn't encapsulate effect of debt financing on profitability or risk - Does not reflect differences in cost structure - Hard to manipulate, but revenue recognition practices have potential to distort

Multiple: describe rationales for and possible drawbacks to using P/CF Multiple

Rationals: + Generally less subject to distortion or manipulation + More stable than EPS + Addresses issue of accounting conservatism + Differences in stocks P/CF may be related to differences in long run avg. returns Drawbacks: - Items affecting actual cash flow from operations, such as non-cash revenue are ignored - Can be more variable - Starting to get more manipulated - IFRS to GAAP comparisons not great

Porter: Rivalry Among Existing Customers

Rivalry Among Existing Customers 1) Competitors are numerous and roughly equal sized 2) Industry Growth is slow 3) Exit barriers are high 4) Rivals are highly committed to the business 5) Firms cannot read each other's signs well (lack of familiarity, diverse approach, differing goals) Price competition is most liable to occur if: 6) Products are nearly identical and there are few switching costs for buyers 7) Fixed costs are high and margins are low 8) Capacity must be expanded in large increments to be efficient 9) Product is perishable

Valuation: describe applications of equity valuation

Selecting Stocks- Equity analyst to determine mispricings and issue recommendations. Inferring/ Extracting Market Expectations - Reverse engineering fundamentals based on different models. Evaluating Corporate Events- assess impact of M&A, divestitures, LBOs, etc, as these corporate actions affect the company's future cash flow (or if stock used for M&A, then used to find the intrinsic value for transaction). Rendering Fairness Opinions- M&A price setting from 3rd party (investment bank) Evaluating Strategies and Models- Determining best strategy for maximizing shareholder value. Communicating with Analysts/Shareholders- Facilitate communication. Appraising Private Business- Valuation of equity of private businesses for transactional purposes and tax reporting, as well as IPOs. Share-Based Comp- estimation of value depends on equity valuation tools.

RI: calculate the intrinsic value of a common stock using the residual income model, and compare value recognition in residual income and other present value models;

Strengths: + Terminal value does not make up a large portion of total present value (front vs. back loading) + Use readily available accounting data + Readily applied to non-div/ neg (or unpredictable) cash flow companies + Focuses on economic profitability Weaknesses: - The models are based on accounting data that can be subject to manipulation - Accounting data used as inputs may require significant adjustments - Require clean surplus accounting or make lots of adjustments - Assumes cost of debt capital is reflected by interest expense

Valuation: describe sum-of-the-parts valuation and conglomerate discounts;

Sum of Parts Valuation- essentially the break up value, most useful when valuing a company with segments in different industries that have different valuation characteristics; and is frequently used to evaluate the value that might be unlocked through restructuring through a spin-off, split off, tracking stock, or equity (IPO) carve out. Conglomerate Discount- the market applies a discount to the stock of a company operating in multiple, unrelated business compared to the stock of companies with narrower focuses. Explanations for this include: 1. Inefficient internal capital markets: companies allocation of investment capital not maximizing value 2. Endogenous factors: companies try to mask poor performance by making acquisitions in unrelated 3. Doesn't Actually exist: Measurement and process errors

DDM: describe terminal value, and explain alternative approaches to determining the terminal value in a DDM;

Terminal Value is the continuing value of the stock, the point at which one plans to sell it. Estimate the terminal value by applying a multiple to a projected terminal value of a fundamental, or estimate using the gordon growth models.

Industry and Company Analysis: explain considerations in the choice of an explicit forecast horizon;

The forecast horizon is generally based: - Investment strategy for the stock - Cyclicality of the industry (USE NORMALIZED, ie simple average) - company specific factors - employer preferences

Private: describe the role of valuation standards in valuing private companies.

The intent of valuation standards is to protect users of valuations and the community at large. Standards typically cover the development and reporting of a valuation. A number of organizations have released valuation standards. No single set of valuation standards covers the valuation of private companies

FCF: explain the ownership perspective implicit in the FCFE approach;

The ownership is implicit because its the CF to equity, or the owners, rather than to all suppliers of capital- as one can supply capital in the form of bond purchases rather than equity.

Porter: Threat of New Entrants

Threat of Entry: 1) supply side economics of scale 2) Demand side benefits of scale 3) Customer switching costs 4) Capital requirements 5) Incumbancy advantages indepdent of size 6) unequal access to distribution channels 7) Restrictive government policy 8) expected retaliation

Porter: Threat of Substitutes

Threat of Substitutes 1) Substitute offers an attractive price-performance trade off to the industry's product 2) Buyer's switching cost to the substitute is low

Industry and Company Analysis: explain how competitive factors affect prices and costs;

Threats of Substitutes- If numerous subs exist and switching costs are low, companies have limited pricing power (smaller margins) Rivalry among incumbent companies- Pricing power is limited in industries that are fragmented, have limited growth, high exit barriers, high fixed costs and have more or less identical products. Bargaining power of suppliers- companies whose suppliers have greater ability to increase prices and/or limit the quality and quantity of inputs face downward pressure on profitability. Bargaining power of customers- Companies whose customers have greater ability to demand lower prices and/or control the quality and price of end products face downward pressure on profitability. Threat of new Entrants- New entrants means incumbents face downward pressure on profitability.

Industry and Company Analysis: compare "growth relative to GDP growth" and "market growth and market share" approaches to forecasting revenue;

Top Down- Top down approach usually begins at the macroeconomic level, then narrows to sector, industry, and market for product, to arrive at the projection. 1)Growth Relative to GDP (ex: 15% higher than GDP, then do (1.15 x GDP) 2) Market Growth & Share Forecast growth of the market, then % market share Bottom Up: 1) Time Series- Forecast based on historical growth rate 2) Return on Capital - Forecasts based on balance sheet accounts 3) Capacity-Based measure - Forecasts on same-store growth & sales related to new stores Hybrid- combination of both, like using top down to model specific business segments, then aggregate the individual projections. In volume and price approach, the analyst makes separate projections for volumes and average selling price.

Multiple: calculate and interpret underlying earnings, explain methods of normalizing earnings per share (EPS), and calculate normalized EPS;

Two methods to normalize EPS are: 1. the method of historical average EPS (calculated over the most recent full cycle) and 2. the method of average return on equity (EPS = average ROE multiplied by current book value per share).

Multiple: explain sources of differences in cross-border valuation comparisons;

US GAAP vs. IFRS - NI is higher under IFRS - Equity is lower under IFRS - ROE is higher under IFRS Valuation Multiples (Most/Least affected by accounting differences) -P/CFO &P/FCFE MOST comparable - P/B, P/E, & EBITDA multiples LEAST comparable Inflation - Higher inflations -> Lower justified price multiples - Lower inflations -> Higher justified price multiples

Private: describe the asset-based approach to private company valuation;

Underlying principle: The value of ownership is equivalent to the fair value of its assets less the fair value of its liabilities. Almost always results in the lowest valuation because a firm's assets in combination typically result in greater value creation than each of its parts individually. The asset-based approach is most appropriate for Resource firms: Their assets can be valued using comparables sales. Financial services: Their loan and security values can be determined by examining market prices and factors. Investment companies: For example, real estate investment trusts (REITs), where the underlying assets are determined using the market or income approaches. Small companies or early stage companies with few intangible assets.

RI: describe the uses of residual income models;

Valuation Measuring Goodwill impairment Measuring Internal Corporate performance Determining Executive Compensation

Valuation: define valuation and intrinsic value, and explain sources of perceived mispricing;

Valuation- the estimation of an asset's value based on variables perceived to be related to future investment returns, on comparisons with similar assets, or, when relevant, on estimates of immediate liquidation proceeds. Intrinsic Value- the value of the asset given a hypothetically complete understanding of the asset's investment characteristics; the "real" or "True" value. Grossman-Stiglitz Paradox- If market prices are correct and freely obtainable, then no one does the research and therefore the market prices cannot be correct. Investors will not rationally incur the expenses of gathering information unless they expect to be rewarded by higher gross returns compared with the free alternatives of accepting the market price. Sources of Mispricing- The source of mispricing is either 1) the difference between the price and the intrinsic value and 2) the difference between the estimated value and the intrinsic value.

RI: describe accounting issues in applying residual income models;

Violations of Clean Surplus Relationship - Items on OCI (such as marketable securities classified as AFS, or currency translation adjustments resulting from multinational consolidation). - Balance sheet adjustments for Fair Value - Inventory, deferred tax assets/liab, operating leases, reserves and allowances, intangible assets Non-Recurring Items - Unusual items, extraordinary items, restructuring charges, discontinued operations, accounting changes Aggressive Accounting Practices International Considerations - Availability of reliable earnings and forecasts, poor quality accounting rules, violations of previous

Return Concepts: explain and calculate the weighted average cost of capital for a company;

WACC=(dmv/ dmv+Emv)(1-t)(rd)+(Emv/ dmv+Emv)(re)

Industry and Company Analysis: explain an analyst's choices in developing projections beyond the short-term forecast horizon;

When looking at the terminal value of the stock, the following must be considered: - whether/ how future long term growth rate will differ from the historical growth rate - cyclicality: not using boom or trough forecasts in perpetuity - Economic disruption, especially for companies with a high degree of financial leverage - Regulation and technology are also big causes of inflection points - Higher/lower growth than overall economy