CFA 2 Equity

What are the advantages and disadvantages of dividends as a measure of cash flow, and when is it appropriate to use them as a basis for valuation.

Advantages: justified because the stock price should be the present value of future dividends the investor receives. Dividends are also less volatile than other cash flows. Disadvantages: not all firms pay dividends, it is much more difficult to use this valuation for non-paying firms. Minority investors also have no influence on dividend policy. Dividends are appropriate measure when: - the company has a history of paying dividends - dividend policy is clear and related to the earnings of the firm - perspective is that of a minority shareholder - bears meaningful relationship to firm's underlying value

Describe the conglomerate discount.

Based on the idea that investors apply a markdown in value to a company operating in multiple unrelated industries. Explanations: - internal capital inefficiency - endogenous factors (ie. pursuing unrelated business acquisitions to hide poor performance) - research measurement errors (the thought that these discounts do not actually exist and just a result of analyst incorrect measurement)

Two-Stage Growth Rate Model Valuation

Plug in to the formula, or map out each flow on a timeline. If a firm doesn't pay a dividend, then the value of the firm is just the present value of the terminal value computed at the point in time which dividends are projected to start. Helpful to enter the cash flows into the calculator and compute the NPV there. The same can be done for the three-stage model.

Explain predicted P/E and its limitations.

Predicted P/E can be estimated from linear regression of historical P/Es on its fundamental variables. There are three main limitations: 1. predictive power for a different time period and/or sample stocks is uncertain 2. relationships between P/E and variables change over time 3. multicollinearity is often a problem

What are the strengths and weaknesses of the residual income model?

Strengths: - terminal value does not dominate the intrinsic value estimate - accounting data used and usually easy to find - applicable to firms who do not pay dividends, with negative cash flows, or volatile cash flows - focuses on economic profitability instead of just accounting profitability Weaknesses - accounting data can be manipulated - reliance on accounting data required many adjustments - assumes the clean surplus relation holds (ending book value = beginning + earnings - dividends)

What is the Fed Model as it related to the 10-year US Treasury?

The Fed Model considers the market to be overvalued when the earnings yield of the S&P 500 is lower than the yield on the 10y treasury bond.

Explain and calculate the weighted average cost of capital.

The cost of capital is the overall required rate of return for suppliers of capital (equity investors or lenders). WACC = (MV of debt / MV of debt & equity) * r * (1-tax r) + (MV of equity / MV of debt & equity) * r where the r's are required returns on debt or equity

Implied Growth Rate in Residual Income

The implied growth rate of a firm can be found through algebraic reorganization of the formula to estimate value from book value and residual income. *An important assumption here is that intrinsic value V0 is equal to price. When given price to book, you essentially have V0/B.

Holding Period Return

The increase in price of an asset plus any cash flow, divided by the initial price of the asset, over some period of time. **if cash flow is received prior to the end of the period, you must also add the interest received during that time

Justified P/E Multiple

The justified P/E multiple can be derived from the single state GGM. The fundamental factors that affect P/E are the growth rate and required return. - positively related to the growth rate - inversely related to required return

Calculate and interpret the sustainable growth rate.

The rate at which earnings (and dividends) can continue to growth indefinitely, assuming the firm's debt to equity ratio is unchanged and it doesn't issue new equity.

Continual Residual Income

The residual income that is expected to persist over the long term under some simplifying assumptions about its shorter term pattern and a persistence factor. The value of the persistence factor depends on the assumption of long term residual income. 1. persists at current level -> w = 1 2. drops to zero -> w = 0 3. declines to zero over time -> w is between 0 - 1 4. declines to long run level in mature industry -> "" ""

How are the free cash flow measures adjusted when a firm has preferred stock?

The use of preferred stock requires revisions to reflect the payment of preferred dividends. These dividends are NOT tax deductible, but should otherwise be treated like debt. Preferred dividends are added back to FCFF. FCFE calculations must modify net borrowings to reflect the new debt borrowing and net issuance by the amount of preferred stock.

Blume Method

This method can compensate for beta drift (tendency of beta to revert to 1.0 over time) but calculating adjusted beta.

Gordon Growth Model

This model assumes that: - the firm expects to pay a dividend, D1, in one year - dividends grow indefinitely at a constant rate, g (may be less than zero) - the growth rate, g, is less than the required rate of return, r **remember to use D1, or calculate D1 before plugging into the mode. Do not use the current period dividend.

Explain the concept of underlying earnings.

Underlying earnings exclude nonrecurring components of earnings to identify a firm's true earning power. This should remove things such as gains/losses from sales, asset write-downs, provisions for future losses or changes in accounting estimates, extraordinary expenses etc. Molodovsky Effect: By nature, earnings often contain a transitory portion that is due to cyclicality. Although technically nonrecurring, business cycles are expected to repeat. This creates the tendency to have high P/Es due to lower EPS at the bottom of the cycle, and lower P/Es at the top.

Guideline Public Company Method

Values private companies using price multiples from trade data for public companies, with adjustments to the multiples to account for differences between the subject firm and the comparables. A control premium should be estimated here (difference between pro rate value of a controlling interest vs non-controlling interest). Consider: - a public transaction should be used where a firm was acquired - transaction type - industry conditions - type of consideration (stock, cash etc) - reasonableness Control premium adjustments should be made on equity portion only.

Guideline Transaction Method

Values private companies using prior acquisition values for entire (public or private) companies that already reflect any control premiums used. Considerations: - transaction type (strategic or financial?) - contingent consideration (performance targets?) - type of consideration - availability of data - date of data

What are some questions that should be asked when conducting industry and competitive analysis?

What are the elements of industry structure? - threat of new entrants - threat of substitutes - bargaining power of buyers - bargaining power of suppliers - rivalry among existing competitors What is a company's advantage for generating profits? - cost leader, product differentiation, or focus What is the quality of a firm's financial statements?

How are industry and company sales/costs forecasted when subject to price inflation?

When a company does not hedge its costs or is not vertically integrated, factors need to be accounted for: - how rapidly and to what extent increased costs can be passed on to the customer - monitor costs by product category and geographic region. this can highlight things such as regulation, weather, tax rates, tariffs etc. - for short-term cost increases, will a company cut costs in other areas - elasticity of the product

Calculate and interpret the present value of growth opportunities. What is its related component to leading P/E?

When a firm has opportunities to earn in excess of the required rate of return, they benefit more from retaining earnings vs paying dividends. The fundamental value therefore represents not only any future dividends, but also the PV of these growth opportunities. The value of a firm has two components: 1. the value of its assets in place (E/r), equal to the PV of a perpetual cash flow, E. 2. PV of its future investment opportunities To find the % of leading P/E that is attributable to PVGO: - divide the firms PVGO multiple by its overall P/E multiple (PVGO is just PVGO/EPS)

What are the important considerations in using and discounting FCFF and FCFE.

When aiming to find the firm value, you must find the present value of the expected future free cash flow to the FIRM. This must be discounted at the WACC (which is the weighted average of the required returns of both equity and after-tax debt). The value of the firm's EQUITY is the present value of the expected future free cash flow to equity. It must be discounted only by the required return on equity.

What are the general steps in equity valuation?

1. Understand the business. 2. Forecast the company performance. 3. Select the appropriate valuation model. 4. Convert the forecasts into a valuation. 5. Apply the valuation conclusions.

What are the four definitions of cash flow and their limitations with EV or price multiples.

1. Earnings plus noncash charges CF = net income + depreciation + amortization - ignores some items that affect cash flow 2. CFO cash flow from operations often adjusted for nonrecurring flows - GAAP requires interest items/dividends to be classified as operating expenses (IFRS more flexible) 3. FCFE free cash flow to equity FCFE = CFO - FCinv + net borrowing - more volatile than straight cash flow 4. EBITDA - represents flows to both equity and debt, so is better suited as an indicator of total firm value rather than just equity value

How do you estimate a beta for a thinly traded stock or nonpublic company?

1. Identify a benchmark company that is publicly traded and similar in operation. 2. Estimate beta of the benchmark company. 3. Unlever the beta estimate: beta * [1/(1+debt/equity)] 4. Lever up the unlevered beta for the benchmarck company using the debt and equity measures for the thinly traded company. new beta = unlevered beta + (1 + debt/equity)

What are the two major sources of error in valuation analysis?

- Estimating the future growth in FCFF/FCFE. Growth forecasts depend on the firm's future profitability, which in turn depends on various components. - The chosen base years for FCFF/FCFE are important. A representative base year must be chosen or all subsequent analysis will be flawed. Sensitivity analysis will show how sensitive the valuation results are to changes in the inputs.

What are the fundamental drivers of residual income?

- if ROE is equal to return on equity, the justified market value of a share of stock is its book value. When ROE is higher than required return, the firm will have positive residual income and will be valued higher than book value - the residual income portion in brackets represents the additional value generated by the firm's ability to produce returns in excess of cost of equity, and consequently, is the present value of the firm's expected economic profits

What are the signs to look for as indication of using a free cash flow approach over a dividend discount approach?

- if the firm is a takeover target, always use free cash flow approach. - always check to see if dividends are volatile, or if they are not correlated with the firm's profitability. Use FCFF over FCFE when: - FCFE is volatile and/or negative - when there is significant leverage used

Explain the factors that require adjustment when estimating the discount rate for private companies.

- size premiums - availability and cost of debt - acquirer vs target (some acquiring firms will incorrectly use their lower cost of capital in valuation) - projection risk (increase discount rate to account for scarcity of information) - lifecycle stage (for firms in early stage of development)

Describe the flow of cash from revenue to free cash flow to equity holders.

1. Cash revenues into the firm from operating activities. 2. The firm pays operating expenses (including taxes but not interest expense). The firm also makes short term investments in working capital and fixed capital. 3. The remaining balance is considered FCFF, the cash flow generated by the firm's core operations. 4. The firm will then pay interest payments to its bondholders. 5. After meeting creditor obligations, the remaining cash flow is FCFE. This amount is also supplemented by net new borrowings from bondholders. The firm can pay dividends or retain earnings from this balance.

GGM Equity Risk Premium

Forward-looking estimate of risk premium. Estimates will change through time and have to be updated. The assumption of a stable growth rate can also be problematic, especially in rapidly growing economies.

Describe forecasting of different costs for a bsuiness: COGS, SG&A, financing.

COGS: estimated as a percentage of revenue, and analysts should consider past trends or margins of competitors. Selling, General, & Administration: generally more fixed than COGS, and tend to grow gradually as the firm expands. Financing: gross vs net debt and interest expense

Yardeni Model

A measure of whether the market is overvalued. It demonstrates that P/E is negatively related to interest rates and positively related to growth.

Fama-French Model

A multifactor model that attempts to account for the higher returns generally associated with small cap stocks. *The Pastor-Stambaugh model adds a liquidity factor to the Fama-French model.

What are the advantages/disadvantages of using the price to sales ratio in valuation?

Advantages: - sales always positive, not as volatile, and not easy to manipulate - appropriate for valuing mature companies as well as startups with no record of earnings Disadvantages: - high growth sales does not mean high operating profits - does not capture different cost structures across companies - revenue recognition can still distort sales

Multi-Period DDM

Can be adapted to any number of holding periods by adjusting the discount factor to match the time to receipt of each expected return. Pn here is the GGM for multi stage -> D0 * (1+g)^t for however many growth periods there are, divided by r-g where the denominator g is the final LT constant growth rate.

What are the advantages/disadvantages of EV/EBITDA?

Advantages: - EV/EBITDA may be more useful than P/E when comparing firms with different leverage - EBITDA is useful for valuing capital intensive businesses with high levels of depreciation/amortization - EBITDA usually positive even when EPS is not Disadvantages: - if working capital is growing, EBITDA will overstate CFO and ignore how different revenue recognition policies affect CFO - FCFF is more strongly linked with valuation theory because it captures the amount of capital expenditures *remember to add preferred stock and/or minority interest in calculating enterprise value if they are given

What are the advantages/disadvantages of using the price to book ratio in valuation?

Advantages: - more stable than EPS and usually positive even when EPS is negative - more appropriate for firms holding liquid assets, and useful in valuing firms going out of business Disadvantages - does not reflect value of intangible economic assets (ie. human capital) - accounting conventions can obscure true investments made by the firm (ie. R&D expensed under GAAP, or one firm using LIFO while another using FIFO) - inflation/tech change can cause book and market value to differ substantially, meaning book value is not an accurate measure of shareholder investment

What are the considerations of a forecast horizon?

An analyst's horizon should be considered in conjunction with firm investment strategy. Forecasting for a portfolio with 25% annual turnover would necessitate a horizon of 4 years. For companies that are highly cyclical, the forecast horizon must be long enough that the effects of the current phase are not driving above or below trend effects. It should be long enough to cover mid-cycle levels where normalized earnings are expected.

Build-Up Method

An approach to risk premium applied when stock beta is not readily attainable (beta assumed to be 1). Beginning with expected return on the market, premiums are added for size, industry, and firm specific factors.

H-Model Valuation

Approximates the value of a firm assuming the initially high growth rate declines linearly over a specified period. Important to note that this model only produces an approximate value. To find the exact value of the stock, you would need to forecast and discount each dividend in the period at its own linearly declining rate.

Justified P/S Multiple

Can be derived from GGM because net profit margin is equal to E/S. P/S will increase when: - profit margin increases - earnings growth rate increases

Historical Estimate of Risk Premium

Looking at past returns is objective and simple, but also assumes the mean and variance are constant over time. Evidence shows this is actually countercyclical (low in good times...), and also subject to survivorship bias over longer periods.

Calculating FCFF from CFO

CFO represents net income plus noncash charges less working capital investment. Because it already accounts for WCinv, we only have to deduct FCinv.

Discount for Lack of Marketability

DLOMs are applied when an interest in a firm cannot be easily sold. These are often applied in tandem with DLOC. Three methods of estimation: 1. price of restricted shares 2. price of pre-IPO shares is comparable to post-IPO 3. price of a put option divided by the stock price, where the put is used at-the-money

PRAT Model

Demonstrates that the sustainable growth rate is a function of profit margin, retention rate, asset turnover, and financial leverage.

DuPont Formula

Demonstrates the relationship between margin, sales, and leverage in determining ROE.

Justified P/B Multiple

Derived from GGM and from the sustainable growth relation that g = ROE * b - P/B increases as ROE increases - a larger spread between ROE and r creates a higher P/B (intuitive when thinking that ROE is the firm's return on investments and r is just the required return)

Market Value Added

Difference between market value of a firm's long term debt and equity, and the book value of invested capital supplied by investors. MVA = market value - total capital *use year end total capital

Discount for Lack of Control

Discounts are needed when valuing a minority stake in a private firm when comparable firm values are for the purchase of the entire company.

Calculating FCFE from FCFF

Starting with FCFF, we have to adjust for the two cash flows to bondholders to calculate FCFE. We only subtract the after-tax interest paid because paying interest reduces the firm's tax bill and reduces cash available to shareholders by the interest paid minus the taxes saved.

Calculating FCFF from EBITDA

EBITDA is before depreciation, so we only need to add back the depreciation tax shield.

ROE, Earnings, & Book Value Relationship

Earnings = ROE * BVPS ROE = Earnings / BVPS BVPS = Earnings / ROE

Required Return on Equity Derived from IRR

Forward-looking estimate appropriate for economies with multiple growth rates (rapidly growing, emerging economies).

Describe the asset based approach to private company valuation.

Estimates the value of firm equity as the fair value of its assets minus fair value of liabilities. Generally not used for going concerns. Also generally results in the lowest valuations, because a firm's assets in combination usually result in value creation. Can be appropriate for: - minimal profit companis - banks - investment companies

General Dividend Discount Model

Estimates the value when extending the holding period indefinitely. This is theoretically correct, but becomes impractical to forecast dividends this far out. Using growth models such as Gordon constant growth, Two-stage growth, H-model, Three-stage growth, we can appropriately forecast the dividends up until the end of the investment horizon after which we no longer have confidence.

Cannibalization Rate

Evaluates the introduction of new substitutes for a company's products.

Explain the ownership perspectives implicit in the FCFE and dividend discount approaches.

FCFE approach implies a control perspective, ie. acquirer or potentially minority shareholders of a company who is a takeover target. From this perspective, you have control over free cash flow decisions. The current dividend policy will not matter to you because you can set your own. DDMs take the minority shareholder perspective who have no control over dividend policy. The will estimate firm value from these dividend discount models.

Supply-Side Estimates of Risk Premium

Forward-looking estimate of risk premium that utilizes proven models with current macro data. This method is only appropriate for developed economies where public equity represents a large share of the economy. Ways to estimate inputs: - inflation: [(1+YTM of 20year T-bonds) / (1+YTM of 20year TIPS)] - 1 -EPS: should be approximately equal to real GDP growth - and ^ growth in GDP: sum of labor productivity growth and growth in labor supply

What are the advantages and disadvantages of free cash flow as a measure of cash flow, and when is it appropriate to use as a basis for valuation?

Free cash flow to the firm or free cash flow to equity Advantage: free cash flow models can be applied to many firms regardless of dividend policy or capital structure. Model's may be more pertinent to majority shareholders who can influence the distribution and application of the flow. Disadvantage: hard to use for firms who may have negative cash flow for many years Appropriate for: - firms that do not have dividend paying history or have a paying dividend that is not clearly or appropriately related to earnings performance - firms with free cash flow that corresponds with their profitability - when the valuation perspective is that of a controlling shareholder

Compare the "growth relative to GDP" and "market growth and market share" approaches for forecasting revenue.

Growth relative to GDP growth: first forecasts an expected growth rate of GDP, and then estimates how fast revenues will grow in relation. So GDP * (1 + x%) Market growth and market revenue: Estimates industry sales and then an estimate of revenue as a percentage of sales, defined as the company's market share.

Calculate the value of a private company using the income approach and its various methods.

Income approach is based on the value of an asset being the present value of its future income. 1. Free cash flow method: discounted by a rate that reflects risk, typically higher than a public company. Terminal value usually estimated 5 years out. 2. Capitalized cash flow method: a single measure of economic benefit is divided by a capitalization rate (required rate of return - growth rate). 3. Excess earnings method: takes earnings minus the earnings required to provide the required rate of return on working capital and fixed assets. Excess earnings are then used with a growing perpetuity formula to calculate intangible assets. The sum of intangibles, working & fixed capital is assumed to be firm value.

Weighted Harmonic Mean

Index P/E is best calculated as the weighted harmonic mean. The harmonic mean puts more weight on smaller values, so the weighted harmonic mean balances this out.

Calculate and interpret justified leading and trailing P/E using GGM.

Leading is based on next period's earnings, trailing based on the past period's. If earnings are expected to grow, E1 will be larger than E0, and will cause justified leading P/E to be smaller than trailing P/E, because you are dividing by a larger number in the denominator. Any time earnings are growing, trailing P/E will be larger than leading by a factor of (1+g). Trailing P/E is not useful for valuation if the firm's business has changed meaningfully. Leading P/E is not useful if a firm's earnings are volatile.

Economic Value Added

Measures the value added for shareholders by management during a given year. *use beginning year total capital Noncash charges should be added back to get NOPAT: - capitalize R&D vs expensing it - add back charges on strategic investments that will generate returns in the future - eliminate deferred tax - treat operating leases as capital leases - add LIFO reserve to invested capital and add back to NOPAT

Forecasting free cash flow.

Method 1: forecast historical free cash flow and apply a growth rate (assumes fundamental factors will be maintained and growth is constant) Method 2: forecast underlying components of free cash flow and calculate each separately, so that each component is allowed to grow at a separate rate, more flexible. - capital expenditures have an outlay needed to maintain current production and another outlay to support growth - assumed that the firm will maintain its target capital structure **FCFF and FCFE are usually forecasted at different growth rates

Distinguish between the method of comparables and the method based on forecasted fundamentals as approaches to using price multiples in valuation.

Method of comparables values a stock based on the average price of similar companies. The Law of One Price - similar assets should have similar prices & multiples. This is a relative valuation that only asserts value relative to a benchmark. Method of forecasted fundamentals values a stock based on the ratio of its value from a DCF model to some fundamental variable. The rationale being that this value used in the numerator is the present value of expected future cash flows discounted at the appropriate rate of return.

Describe momentum indicators and their use in valuation.

Momentum indicators relate the market price or a fundamental variable to the time series of historical or expected value (ie. earnings surprise). The economic rationale is that positive surprises can lead to persistent abnormal returns. Standardized Unexpected Earnings SUE can normalize this measure across firms.

Explain how to find terminal value using valuation multiples.

Multiply the multiple by its denominator. Such as price to earnings by earnings in this example. The numerator will be the value that can be otherwise derived from a forecasting model. When estimating terminal value from a justified multiple, you will use the benchmark multiple when multiplying by the denominator. *note the difference in formula for leading vs trailing

Calculating FCFF from Net Income

Noncash charges reduce net income without any cash paid (most often depreciation, but also restructuring charges, G/L on investment, amortization of intangibles or bond discounts, deferred taxes). Fixed capital inv does not appear on the income statement but does represent cash leaving the firm, so it must be deducted. - equals capital expenditures - proceeds from LT asset sales - also beginning PP&E - ending PP&E + depreciation - ***do not add depreciation when given expenditures & sales Working capital is equal to the change in working capital excluding cash & equivalents, notes payable, and current portion of long term debt

Explain the adjustments that may be needed during a private acquisition to estimate normalized earnings.

Normalized Earnings: firm earnings IF the firm were acquired Adjustments - exclude nonrecurring or unusual expenses - real estate may merit separate treatment - expenses like compensation or lease payments should be adjusted up/down to the market rate - strategic buyers will recognize any gains from synergies All adjustments increase or decrease firm EBITDA

Calculate and interpret normalized earnings.

Normalized earnings are an adjustment for cyclicality, to estimate EPS in the middle of the busines cycle. Two methods: 1. Historical Average EPS: takes the average EPS over some recent period 2. Average Return on Equity: estimated as the average ROE times the current book value per share

What are the choices in developing projections beyond the short-term horizon?

One can forecast future financial results by assuming a trend growth rate over the past cycle will continue. Analysts will typically value a stock using earnings etc over a period, along with the terminal value at the end of the horizon. Terminal value can be estimated through a multiples approach or discounted cash flows. *an important part of these projections is trying to recognize inflection points, where the future will no longer be like the past, and the growth rate must be updated.

Calculate and interpret the PEG ratio.

PEG is the P/E per unit of expected growth. This standardizes the P/E ratio for stocks with different growth rates. Implied valuation is that stocks with lower PEG ratios are more attractive than high ones, assuming risk is similar (higher g denominator creates a lower value). *PEG lower than median benchmark signifies undervalue

Describe the relationship between ROIC and competitive advantage.

ROIC will be the net operating profit less adjusted taxes (NOPLAT) divided by invested capital (operating assets - op liabilities) ROIC is preferred to ROE in some cases because it is a return to both equity and debt, which allows comparison across firms with different capital structures. Firms with higher ROIC are likely exploiting some competitive advantage. *further, Return on Capital Employed uses pretax operating earnings which facilitates comparison between firms with different tax rates as well.

Explain dividend yield, and calculate both the trailing and leading ratio.

Ratio of common dividend to the market price. Contributes to total return, but the measure is incomplete because it ignores capital appreciation.

Calculate and interpret residual income.

Residual income explicitly deducts all capital costs where as net income does not reflect dividends or other equity capital-related funding costs. Recognizes the cost of equity capital, or the opportunity cost of shareholders providing the firm capital, by subtracting total equity * cost of equity from net income.

What are the advantages and disadvantages of residual income as a measure of cash flow, and when is it appropriate to use as a basis for valuation?

Residual income represents the amount of earnings that exceeds an investor's required return. Advantages: can be used for firms with negative free cash flow or ones that do not pay dividends. Disadvantages: difficult to apply because they require knowledge of the firm's accruals, which are also at management discretion. Appropriate for: - firms that do not have dividend histories - firms with negative free cash flow for the foreseeable future - firms with transparent financial reporting and high quality earnings

Calculate the intrinsic value of common stock using residual income model.

Residual income valuation breaks the intrinsic value of a stock into (1) current book value and (2) present value of expected future residual income. Simply - a stock's value is its current book value plus present value of all future residual income.

Price Convergence

Return from convergence to intrinsic value. This is a factor in expected return, along with required return.

What is the value of non-callable fixed-rate preferred stock?

Similar to a firm with no additional opportunities to earn returns in excess of the required rate, it should distribute all earnings back to shareholders as dividends. With this assumption, the growth rate is zero.

Single-Stage FCFF Model

Simply the GGM with FCFF replacing dividends and WACC replacing required return on equity.

Bond Yield Risk Premium Method

Simply: YTM (of long term debt) + equity risk premium A type of build-up method that can be appropriate when a company has publicly traded debt. The logic is that, in absense of measurable beta, a company's long term YTM will include the effects of inflation, leverage, and sensitivity to the business cycle.

Calculating FCFF from EBIT

Starting with EBIT, it is not necessary to take out interest because it is considered an financing flow for these purposes. We only must add back depreciation, and adjust for taxes.

Define the 3 primary tax rates and what can be inferred between them.

statutory tax rate: percentage rate charged in country of domicile effective tax rate: tax expense as a percentage of pretax income on income statement cash tax rate: cash taxes paid as percentage of pretax income - changes in deferred taxes account for differences in income tax and cash taxes. - differences between statutory and effective rates can arise for various reasons and will be reconciled in the footnotes. special attention should be given when the effective rate is consistently lower

Macroeconomic Factor Models

ex. Burmeister, Roll, Ross model factors: 1. Confidence risk 2. Time horizon risk 3. Inflation risk 4. Business cycle risk 5. Market timing risk A stock will have a sensitivity factor to each variable.