QUIZ Financial Analysis

How can you calculate ROIC, using the relationship to revenue?

ROIC = (1 − operating cash tax rate) ∗ EBITDA /Revenues ∗ Revenues /Invested capital This is one of the most powerful equations in financial analysis. It demonstrates to which extent the company is driven by its ability to maximize profitability.

The amount of value a company creates is dependent by two factors - which?

ROIC and revenue growth (and the ability to sustain both over time)

If ROIC is calculated without goodwill, what does it measure, compared to if goodwill is included in the calculation?

ROIC without goodwill and acquired intangibles measures the competitiveness of the underlying business. ROIC with goodwill and acquired intangibles measures a company's ability to create value after paying acquisition premiums

The WACC is separated into two major parts - which?

Rates of return required by the company's debt and equity holders.

What is the difference between reported taxes and operating taxes?

Reported taxes are calculated after interest and nonoperating income. Nonoperating taxes - the difference between operating taxes and reported taxes - are not included in NOPAT, but instead as part of income available to investors.

When estimating the income statement, to what factor is the most line items tied to?

Revenue.

How can you value tax losses carried forward and incorporate them in the enterprise value?

Since tax savings will increase future cash flows, estimate their value using discounted cash flow, and add your result to the company's value of operations. The potential tax loss carryforward is recorded on the balance sheet as a deferred-tax asset. Use the deferred-tax asset as a starting point to value the tax loss carryforwards. If the company is unlikely to use the tax loss carryforward, the company will record a valuation allowance against the deferred-tax asset. Both numbers can be found in the note on taxes that accompanies the company's financial statements. Because tax savings are recorded on an undiscounted basis, apply discounted cash flow to estimate their value as of today.

Define FCF.

The cash flow generated by the core operations of the business after deducting investments in new capital: FCF = NOPAT - net investment.

What are the characteristics relating to "the steady state" in the estimation process?

The company grows at a constant rate by reinvesting a constant proportion of its operating profits into the business each year. The company earns a constant rate of return on both existing capital and new capital invested.

What is the reason the calculation of WACC should rely on target weights for debt to value rather than current weights?

The cost of capital should rely on a forecast of target weights, rather than current weights, because at any point a company's current capital structure may not reflect the level expected to prevail over the life of the business. The current capital structure may merely reflect a short-term swing in the company's stock price, a swing that has yet to be rebalanced by management. Thus, using today's capital structure may cause you to overestimate (or underestimate) the value of tax shields for companies whose leverage is expected to drop (or rise).

The cost of equity is determined by two factors, which?

The cost of equity is determined by estimating the expected return on the market portfolio, adjusted for the risk of the company being valued. Costequity = Rf +β *riskpremium Riskpremium = Rm - Rf Rf = risk free rate Rm = stock market return (expected) Beta = stocks sensitivity to the market

In the example of GlobalCo's cash-flow to equity value, one factor was kept constant - which?

The debt-to-value ratio.

How should you incorporate a discontinued business in the enterprise value?

The earnings from discontinued operations are explicitly shown in the income statement, and the associated net asset position is disclosed on the balance sheet. Because discontinued operations are no longer part of a company's operations, their value should not be modeled as part of free cash flow or included in the DCF value of operations.

What is important to take into consideration when the RONIC is included in the calculation of continuing value?

The expected rate of return on new invested capital (RONIC) should be consistent with expected competitive conditions beyond the explicit forecast period. Economic theory suggests that competition will eventually eliminate abnormal returns, so for companies in competitive industries, set RONIC equal to WACC. However, for companies with sustainable competitive advantages, such as brands and patents, you might set RONIC equal to the return the company is forecast to earn during later years of the explicit forecast period.

Which are the most common non-operating assets?

The most common nonoperating assets are excess cash, investments in nonconsolidated companies, and tax loss carry forwards. What other non-operating assets do you probably need to add, to end up with the total enterprise value? One-time receivables, excess pension assets, discontinued operations, and financial subsidiaries.

The cost of capital (WACC) should be calculated in a manner consistent with the principle of free cash flow. What does that mean?

The most important principle underlying successful implementation of the cost of capital is consistency between the components of WACC and free cash flow. Always estimate the WACC in a manner consistent with the principles of free cash flow. For example, since free cash flow is the cash flow available to all financial investors, the company's WACC must also include the expected return for each class of investor.

Up until the financial crises 2007-2009, how was the risk-free rate measured?

The risk-free rate was measured by adding the historical risk premium to the current Treasury yield.

What differs the top-down approach for revenue forecasting, to the bottom-up approach?

The top-down is market-based, and the bottom-up approach is customer-based. To build a revenue forecast, you can use a top-down forecast, in which you estimate revenues by sizing the total market, determining market share, and forecasting prices. Alternatively, with the bottom-up approach, you can use the company's own forecasts of demand from existing customers, customer turnover, and the potential for new customers. When possible, use both methods to establish bounds for the forecast

What was the conclusion drawn from the work of Miller and Modigliani, regarding the relationship between debt, equity, cash flow and value?

The value of a company shouldn't be affected by changing the structure of debt and equity ownership unless the overall cashflows generated by the company also changes.

Define the Value of Operations using estimates of free cash flow.

The value of operations equals the discounted value of future free cash flow. Free cash flow equals the cash flow generated by the company's operations, less any reinvestment back into the business. Free cash flow is the cash flow available to all investors—equity holders, debt holders, and any other investors — so it is independent of how the company is financed. Consistent with this definition, free cash flow must be discounted using the weighted average cost of capital, because the WACC represents rates of return required by the company's debt and equity holders blended together. It is the company's opportunity cost of funds.

Define the Continuing value?

The value of the company's expected cash flow beyond an explicit forecast period.

Assume a company has a cost of capital that is equal to the achieved ROIC. What will happen to value if growth increases?

The value stays the same. Value is neither created nor destroyed.

What is important to remember when the WACC is included in the calculation of the continuing value?

The weighted average cost of capital should incorporate a sustainable capital structure and an underlying estimate of business risk consistent with expected industry conditions.

In some cases the replacement cost approach is used for calculating the continuing value. What is the problem with this approach?

This approach ignores the future potential of the company. The replacement cost approach sets the continuing value equal to the expected cost to replace the company's assets. This approach has at least two drawbacks. First, not all tangible assets are replaceable. The company's organizational capital can be valued only on the basis of the cash flow the company generates. The replacement cost of just the company's tangible assets may greatly understate the value of the company. Second, not all the company's assets will ever be replaced. Consider a machine used by a particular company. As long as it generates a positive cash flow, the asset is valuable to the ongoing business of the company. But the replacement cost of the asset may be so high that replacing it is not economical. Here, the replacement cost may exceed the value of the business as an ongoing entity.

If an investment-grade firm with infrequent traded bonds is to be valued, how do you calculate the cost for debt? What adjustment for tax is necessary?

To approximate the after-tax cost of debt for an investment-grade firm, use the company's after-tax yield to maturity on its long-term debt. For companies whose debt trades infrequently or for nontraded debt, use the company's debt rating to estimate the yield to maturity. Since free cash flow is measured without interest tax shields, use the after-tax cost of debt to incorporate the interest tax shield into the WACC.

Why is it better to calculate the ratio for the inventory to cost of goods sold, rather than to sales?

To avoid distortion (sw. förvridning) by changing prices

How is the synthetic risk-free rate calculated?

To build a synthetic risk-free rate, add the expected inflation rate of 1.7 to 2.3 percent presented in the previous section to the long-run average real interest rate of 2 percent, which leads to a synthetic risk-free rate of between 3.7 and 4.3 percent.

What is "the plug" when estimating investors funds?

To complete the balance sheet, forecast the company's sources of financing. After estimating the equity after the rules of accounting, four line items on the balance sheet remain: excess cash, short-term debt, long-term debt, and a new account titled "newly issued debt." Some combination of these line items must make the balance sheet balance. For this reason, these items are often referred to as "the plug." In simple models, existing debt either remains constant or is retired on schedule, according to contractual terms. To complete the balance sheet, set one of the remaining two items (excess cash or newly issued debt) equal to zero. Then use the primary accounting identity—assets equal liabilities plus shareholders' equity— to determine the remaining item.

Why should we not divide the equity value by the diluted number of shares?

To determine a share price, divide the intrinsic equity value by the number of undiluted shares outstanding. Do not use diluted shares. Convertible debt, convertible preferred stock, and employee stock options should be valued separately. If you were to subtract the value of these claims and use diluted shares, you would double-count the options' value.

What is recommended to "reduce the noise around beta estimates"?

To reduce the noise around beta estimates, use industry, rather than company-specific, betas. Companies in the same industry face similar operating risks, so they should have similar operating betas. If estimation errors across companies are uncorrelated, overestimates and underestimates of individual betas will tend to cancel, and an industry median (or average) beta will produce a superior estimate.

How do you value the discontinued business?

Under U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS), the assets and liabilities associated with the discontinued operations are written down to their fair value and disclosed as a net asset on the balance sheet, so the most recent book value is usually a reasonable approximation.

What is the difference between "free cash flow" and "cash flow from operations", reported in the annual report?

Unlike "cash flow from operations" reported in a company's annual report, free cash flow is independent of financing flows and nonoperating items.

Using five- to ten-year holding periods, what is the average annual excess return?

Using five- to ten-year holding periods, the average annual excess return is 5.5 to 5.7 percent.

Define the value of the company at time 0 using economic profit for year 1.

Value 0= Invested Capital 0 + (Economic Profit_1) / (WACC-g)

In the chapter there is an example comparing the two companies Value Inc and Volume Inc. Both have the same earnings growth. Which of the two companies has the highest value, and why?

Value Inc has the highest value because the cash flows of the companies are so different. Value Inc generates higher cashflows because it doesn't have to invest as much as volume Inc does.

How should you treat a possible liability from pending litigation in the calculation of the equity value?

When possible, estimate the associated expected after-tax cash flows (if the costs are tax deductible), and discount these at the cost of debt. Unfortunately, assessing the probability of such cash flows materializing is difficult, so the valuation should be interpreted with caution.

Does length of forecast affect a company's value?

While the length of the explicit forecast period you choose is important, it does not affect the value of the company; it affects only the distribution of the company's value between the explicit forecast period and the years that follow.

If you are an external analyst (not working in the company), which are the two suggested ways to calculate estimated depreciation?

You can forecast depreciation as either a percentage of revenues or a percentage of property, plant, and equipment (PP&E).

. How does the "stock approach" to estimating assets differ from "the flow approach"? Which method is recommended?

the stock approach forecasts end-of year receivables as a function of revenues, while the flow approach forecasts the change in receivables as a function of the growth in revenues. We favour the stock approach. The relationship between the balance sheet accounts and revenues (or other volume measures) is more stable than that between balance sheet changes and changes in revenues.

If you use EBITDA and EBITDAR to measure ability to meet short-term obligations, which factors do you compare them to?

- EBITDA to interest: to measure the company´s ability to meet short-term financial commitments. - EBITDAR to interest and rental expense, to measure the company´s ability to meet its known future obligations (important specially for retailers and airlines, as rental expenses is a critical part to understand their financial health)

When should you measure ROIC including goodwill? What is the perspective?

- ROIC with goodwill measures the company´s ability to create value over and above premiums paid for the acquisition. - ROIC without goodwill measures the company´s core performance compared to its pears.

Which are the three major factors that can distort the analysis of year-to-year revenue growth?

1, The effect of changes in currency values. 2, Mergers and acquisitions. 3, Change in accounting policies.

Which cash flow is used when the cash-flow to equity valuation model is applied?

1. Cash flow to equity starts with net income. 2. Add back noncash expenses to determine gross cash flow. 3. Next, subtract investments in working capital, fixed assets, and nonoperating assets. 4. Finally, add any increases in debt and other nonequity claims, and subtract decreases in debt and other nonequity claims. Unlike free cash flow, cash flow to equity includes operating, nonoperating, and financing items in the calculation. Alternatively, you can compute cash flow to equity as dividends plus share repurchases minus new equity issues. The two methods generate identical results.

Which are the five primary areas when calculating investments that is included in invested capital?

1. Change in operating working capital. Growing a business requires investment in operating cash, inventory, and other components of working capital. Operating working capital excludes nonoperating assets, such as excess cash, and financing items, such as short-term debt and dividends payable. 2. Capital expenditures, net of disposals. Capital expenditures represent investments in property, plant, and equipment (PP&E), less the book value of any PP&E sold. One way to estimate net capital expenditures is to add depreciation to the increase in net PP&E. Do not estimate capital expenditures by taking the change in gross PP&E. Since gross PP&E drops when companies retire assets, the change in gross PP&E will often understate the actual amount of capital expenditures. 3. Change in capitalized operating leases. To keep the definitions of NOPAT, invested capital, ROIC, and free cash flow consistent, include investments in capitalized operating leases in gross investment. Capitalized operating leases are discussed later in the chapter. 4. Investment in goodwill and acquired intangibles. For acquired intangible assets, where cumulative amortization has been added back, you can estimate investment by computing the change in net goodwill and acquired intangibles. For intangible assets that are being amortized, use the same method as for determining net capital expenditures (by adding amortization to the increase in net intangibles). 5. Change in other long-term operating assets, net of long-term liabilities. Subtract investments in other net operating assets. As with invested capital, do not confuse other long-term operating assets with other long-term nonoperating assets, such as equity investments and excess pension assets. Changes in nonoperating assets need to be evaluated—but should be analysed separately.

Which are the six most common non-equity claims?

1. Debt. If available, use the market value of all outstanding debt, including fixed- and floating-rate debt. If that information is unavailable, the book value of debt is a reasonable proxy, unless the probability of default is high, or interest rates have changed dramatically since the debt was originally issued. Any valuation of debt, however, should be consistent with your estimates of enterprise value. 2. Leases. Rather than purchase assets outright, many companies lease certain assets for a fixed period. Any lease payments recorded as interest expense and not rental expense must be valued separately and deducted from enterprise value. 3. Unfunded retirement liabilities. Companies with defined-benefit pension plans and promised retiree medical benefits may have unfunded obligations that should be treated like debt. 4. Preferred stock. For large stable companies, preferred stock more closely resembles unsecured debt. For small start-ups, preferred stock contains valuable options. In both situations, value preferred stocks separately from common stock. 5. Employee options. Many companies offer their employees compensation in the form of options. Since options give the employee the right to buy company stock at a discounted price, they can have great value and must also be factored into equity value. 6. Noncontrolling interests. When a company has majority control of a subsidiary but does not own 100 percent, the entire subsidiary must be consolidated on the parent company's balance sheet. The funding other investors provide for this subsidiary is recognized on the parent company's balance sheet as noncontrolling interests (formerly called minority interest). When valuing noncontrolling interests, it is important to realize that the minority interest holder does not have a claim on the company's assets, but rather a claim on the subsidiary's assets.

In the chapter, six non-operating assets are presented - which?

1. Excess cash 2. Marketable securities 3. Receivables from financial subsidiaries (for example, credit card receivables) 4. nonconsolidated subsidiaries 5. overfunded pension assets 6. Tax loss carry-forwards

There are four methods used to value convertible debt in the calculation of equity value, which?

1. Fair value. Companies report the "fair" value of financial instruments, including convertible debt, in the notes to the financial statements. Companies value these investments using quoted market prices or pricing models, and they disclose the methodology used. Use this value if enterprise value has not changed significantly since the last financial report. 2. Market price. Many convertible bonds are actively traded with quoted prices. For U.S. convertible debt, use the TRACE database to determine the market value of debt when the enterprise value has materially changed since the last filing. 3. Black-Scholes value. When the fair value or market value is inappropriate,21 we recommend using an option-based valuation for convertible debt. Accurate valuation of convertible bonds with option-based models is not straightforward. That said, by following methods outlined by DeSpiegeleer, Van Hulle, and Schoutens, you can make a reasonable approximation applying an adjusted Black-Scholes option-pricing model. 4. Conversion value. The conversion value approach assumes that all convertible bonds are immediately exchanged for equity and ignores the time value of the conversion option. It leads to reasonable results when the conversion option is deep in the money, meaning the bond is more valuable when converted into equity than when held for future coupon and principal payments.

Describe the three-step approach to estimating PP&E (property, plant, equipment)

1. Forecast net PP&E as a percentage of revenues. 2. Forecast depreciation, typically as a percentage of gross or net PP&E. 3. Calculate capital expenditures by summing the projected increase in net PP&E plus depreciation.

There are two ways to define the investment rate (IR) - which?

1. IR = Nest Investemnet / NOPAT 2. IR = g / ROIC ( G is growth)

To assure consistency the cost of capital must meet five criteria - which?

1. It must include the cost of capital for all investors—debt, preferred stock, common stock, and so on—since free cash flow is available to all investors, who expect compensation for the risks they take. 2. Any financing-related benefits or costs, such as interest tax shields, not included in free cash flow must be incorporated into the cost of capital or valued separately using adjusted present value. 3. WACC must be computed after corporate income taxes (since free cash flow is calculated in after-tax terms). 4. It must be based on the same expectations of inflation as those embedded in forecasts of free cash flow. 5. The duration of the securities used to estimate the cost of capital must match the duration of the cash flows.

There are four classes of provisions - which?

1. Ongoing operating provisions (such as for warranties and product returns). 2. Long-term operating provisions (e.g., plant-decommissioning costs). 3. Nonoperating provisions (in cases such as restructuring charges resulting from layoffs). 4. Income-smoothing provisions should be eliminated from NOPAT.

In the sub-chapter "Advanced issues" four areas are singled out - which?

1. Ongoing operating provisions. Operating provisions such as product warranties are part of operations. Therefore, deduct the provision from revenue to determine NOPAT, and deduct the corresponding reserve from net operating assets to determine invested capital. 2. Long-term operating provisions. For certain liabilities, such as expected plant decommissioning costs, deduct the operating portion from revenue to determine NOPAT, and treat the interest portion as nonoperating. Treat the corresponding reserve as a debt equivalent. 3. Nonoperating provisions. Unless deemed as ongoing, provisions such as one-time restructuring charges related to severance are nonoperating. Treat the expense as nonoperating and the corresponding reserve as a debt equivalent. 4. Income-smoothing provisions. Classify any provisions identified for the purpose of income smoothing as nonoperating, and their corresponding reserve as an equity equivalent. Since income-smoothing provisions are noncash, they do not affect value.

Which are the six steps in the forecasting process?

1. Prepare and analyze historical financials. Before forecasting future financials, you must build and analyze historical financials. A robust analysis will place your forecasts in the appropriate context. 2. Build the revenue forecast. Almost every line item will rely directly or indirectly on revenues. Estimate future revenues by using either a top-down (market-based) or a bottomup (customer-based) approach. Forecasts should be consistent with evidence on growth. 3. Forecast the income statement. Use the appropriate economic drivers to forecast operating expenses, depreciation, nonoperating income, interest expense, and reported taxes. 4. Forecast the balance sheet: invested capital and nonoperating assets. On the balance sheet, forecast operating working capital, net property, plant, and equipment, goodwill, and nonoperating assets. 5. Reconcile the balance sheet with investor funds. Complete the balance sheet by computing retained earnings and forecasting other equity accounts. Use excess cash and/or new debt to balance the balance sheet. 6. Calculate ROIC and FCF. Calculate ROIC on future financial statements to ensure your forecasts are consistent with economic principles, industry dynamics, and the company's ability to compete. To complete the forecast, calculate free cash flow as the basis for valuation. Future FCF should be calculated the same way as historical FCF.

Explain the four parts in valuing a company according to the DCF-model.

1. Value the company's operations by discounting free cash flow at the weighted average cost of capital. 2. Identify and value nonoperating assets, such as excess cash and marketable securities, nonconsolidated subsidiaries, and other nonoperating assets not incorporated into free cash flow. Summing the value of operations and nonoperating assets gives enterprise value. 3. Identify and value all debt and other nonequity claims against the enterprise value. Debt and other nonequity claims include fixed rate and floating-rate debt, debt equivalents such as unfunded pension liabilities and restructuring provisions, employee options, and preferred stock. 4. Subtract the value of debt and other nonequity claims from enterprise value to determine the value of common equity. To estimate value per share, divide equity value by the number of current shares outstanding.

If the "survivor ship premium" is subtracted from the calculation of excess returns in the U.S - what is then the market risk premium?

5 percent.

In some cases multiples are used for calculating the continuing value. What is the problem with this approach?

A common approach is to assume that the company will be worth a multiple of earnings or book value based on the multiple for the company today. Suppose we choose today's industry average enterprise-value-to-EBITDA ratio. This ratio reflects the economic prospects of the industry during the explicit forecast period as well as the continuing-value period. In maturing industries, however, prospects at the end of the explicit forecast period are likely to be very different from today's. Therefore, a different EV-to-EBITDA is needed; one that reflects the company's prospects at the end of the forecast period. What factors will determine that ratio? The primary determinants are the company's expected growth, the rate of return on new capital, and the cost of capital. The same factors are in the key value driver formula. Unless you are comfortable using an arbitrary multiple, you are much better off with the value driver formula.

A company is estimated to grow at a rate of 10 percent per year, each year 1 to 10. From year 10 to year 11, the continuing value year, you calculate the growth in revenue of 5 percent and an increase in investment in working capital by 5 percent. What is the problem with this estimation technique for working capital, the continuing year?

A common, yet incorrect, forecast for year 11 (the continuing-value base year) simply increases every line item from year 10 by 5 percent. This forecast is wrong because the increase in working capital is far too large, given the smaller increase in sales. Since revenues are growing more slowly, the proportion of gross cash flow devoted to working capital requirements should decline significantly, as shown in the last column. In the final column below, the increase in working capital should be the amount necessary to maintain the yearend working capital at a constant percentage of revenues.

What is important to think of when "g", the growth rate, is included in the calculation of continuing value?

A company's growth rate typically reverts to industry growth rates very quickly, and few companies can be expected to grow faster than the economy for long periods. The best estimate is probably the expected long-term rate of consumption growth for the industry's products, plus inflation. Sensitivity analyses are useful for understanding how the growth rate affects continuing-value estimates.

Why is it essential to have a thoughtful estimate of continuing value?

A thoughtful estimate of continuing value is essential to any company valuation. It serves as a useful method for simplifying the valuation process while still incorporating solid economic principles.

if it is not publicly traded?

Alternatively, you can perform a separate valuation using a DCF approach, multiples, or a tracking portfolio, depending on the amount of information available. Remember, however, that a noncontrolling interest is a claim on a subsidiary, not the entire company. Thus, any valuation should be directly related to the subsidiary and not to the company as a whole.

In a study of US companies between 1962 and 2018 the inflation adjusted market return of equity was calculated. How high was it?

An average of 7 percent.

Why is it necessary to treat a finance subsidiary, even 100 percent controlled, as a nonoperating asset in the enterprise value?

Because if you don't, you will distort the return on invested capital, free cash flow, and ultimately your perspective on the company's valuation.

Why is it not possible to increase the value of a company by borrowing capital and repurchase shares, even if this leads to an increase in earnings per share?

Because the total cashflow of the business has not increased. By borrowing capital, the company´s dept has increased as well. With higher leverage (ratio of company´s debt to the value of its ordinary shares), the company´s equity cashflows will be more volatile, and investors will demand higher return. This will bring down the company´s P/E (company´s value), offsetting the increase in EPS. Because the share purchase and the EPS increase will be neutralized by an increase in debt, which increase the volatility and the risk.

What is the beta value?

Beta measures how a company's stock price responds to movements in the overall market. Stocks with high betas have expected returns that exceed the market return; the converse is true for low-beta stocks.

How can you write the formula for calculating the continuing value, if RONIC is equal to WACC?

CV = NOPATt+1 / WACC

What model and what factor in that model is used to estimate the company specific risk?

Capital asset pricing model (CAPM). The CAPM adjusts for company-specific risk using the beta factor, which measures how a company's stock price responds to movements in the overall market.

How does the capital structure (debt or equity) affect the DCF-model? Which factor in the valuation model is affected?

Capital structure affects enterprise DCF only through the weighted average cost of capital. Thus, only an adjustment to WACC will lead to a change in valuation.

Define the value formula when the cash flow in a company is growing at a constant rate.

Cashflow perpetuity formula: Value = FCF t=1 / WACC - g

How was revenue affected (and why) in cell phones companies from the introduction of a new revenue standard?

Cell phone providers experienced a one-time increase in revenue as cell phone equipment sales can now be recognized immediately, rather than over the life of the contract.

If a company has a beta of 0.6 and the risk-free rate of return is 3.9 percent and the market risk premium is 5.4 percent, what is the cost of equity?Costequity = Rf +β *riskpremium = 3.9 +0.6 * 5.4 = 7.14 Rf = risk free rate Rm = stock market return (expected) Beta = stocks sensitivity to the market

Costequity = Rf +β *riskpremium = 3.9 +0.6 * 5.4 = 7.14 Rf = risk free rate Rm = stock market return (expected) Beta = stocks sensitivity to the market

If a subsidiary with a minority interest is publicly traded, how can you adjust for the minority interest in the calculation of the equity value?

Deduct the proportional market value owned by outsiders from enterprise value to determine equity value.

Which are the most common "non-cash operating expenses" that you add back when converting NOPLAT to cash flow?

Depreciation, depletion, amortization of capitalized assets and share-based employee compensation.

Why should you not use the statutory tax rate when estimating operating taxes?

Do not use the statutory tax rate to forecast operating taxes. Many companies pay taxes at rates below their local statutory rate because of low foreign rates and operating tax credits. Failure to recognize operating credits can cause errors in forecasts and an incorrect valuation. Also, if you use historical tax rates to forecast future tax rates, you implicitly assume that these special incentives will grow in line with EBITA. If this is not the case, EBITA should be taxed at the marginal rate, and tax credits should be forecast one by one.

What is the authors opinion of using local market index when calculating beta, and why?

Do not, use a local market index, which some data services provide. Most countries are heavily weighted in only a few industries and, in some cases, a few companies. Consequently, when measuring beta versus a local index, you are not measuring marketwide systematic risk, but often a company's sensitivity to a particular set of industries.

Describe a "line items analysis" for factors in the balance sheet?

Each line in the balance sheet can be converted to a % of the revenue. For operating assets and liabilities, you can also convert each line into days. Days = 365* Balance sheet item / Revenue This can help demonstrate how much cash is tied up in the business, and for how long.

Define Economic Profit in relation to NOPAT.

Economic profit = Invested capital x (ROIC - WACC).

Explain how employee stock options affects free-cash-flow projections?

Employee stock options affect a company valuation in two ways. First, the value of options that will be granted in the future needs to be captured in the freecash-flow projections or in a separate DCF valuation. If captured in the free-cash-flow projections, the value of future options grants is included in the value of operations and should not be treated as a nonequity claim. Second, the value of options currently outstanding must be subtracted from enterprise value as a nonequity claim. Note, however, that the value of the options will depend on your estimate of enterprise value. Your option valuation should reflect this.

What is the difference between the total enterprise value and the equity value?

Enterprise value represents the value of the entire company, while equity value represents the portion owned by shareholders. Enterprise value is the value of a company's core business operations that is available to all shareholders (debt, equity, preferred, etc.), whereas equity value is the total value of a company that is available to only equity investors. Total Enterprise Value = You add up the market capitalization, or market cap, plus all of the debts in the company. Think of enterprise value as a business' balance sheet, accounting for all of its current stocks, debt, and cash. Equity Value = You add enterprise value to redundant assets and then subtracts debt net of cash available.

Explain the survivor ship bias when calculating the historical returns on shares by the help of the stock market performance?

Exhibit 15.3 presents the average cumulative returns of the U.S. stock market, the U.S. bond market, and excess returns (stocks minus bonds) between 1900 and 2018. Using five- to tenyear holding periods, the average annual excess return is 5.5 to 5.7 percent. Blume's estimator for longer-date cash flows is slightly higher, at just above 6 percent. Even with the best statistical techniques, however, this number is probably too high, because the observable sample includes only countries with strong historical returns. Statisticians refer to this phenomenon as survivorship bias. Survivorship bias or survivor bias is the tendency to view the performance of existing stocks or funds in the market as a representative comprehensive sample without regarding those that have gone bust.

What is the recommended timeframe for calculating Beta in a raw regression based on monthly data?

Five years of monthly returns.

If a company has debt below investment grade, what capital structure is recommended to use when calculating the cost of capital?

For companies with below-investment-grade debt, we recommend one of two methods: If the debt-to-value ratio is uncharacteristically high, estimate the cost of debt using a target capital structure that better reflects the long-term dynamics of the industry. If the company's strategy includes substantial leverage, value the company using adjusted present value (APV) discounted at the unlevered cost of equity, rather than the WACC

If the industry multiple based on NOPAT is 13, how does that help you when you are valuing Company A in the same sector?

For example, assume the company's NOPAT equals $100 million and the typical enterprisevalue-to-NOPAT multiple for companies in the industry with similar growth and ROIC prospects is 13 times. Multiplying 13 by $100 million leads to an estimated value of $1.3 billion.

How should you treat acquisitions in the estimation process? What is the reason for this treatment?

For most companies, we choose not to model potential acquisitions explicitly, so we set revenue growth from new acquisitions equal to zero and hold goodwill and acquired intangibles constant at their current level. We prefer this approach because of the empirical literature documenting how the typical acquisition fails to create value.

Describe how growth, return on invested capital (ROIC) and the investment rate are tied mathematically.

Growth = ROIC x investment rate

What are the conclusions regarding growth strategies based on organic growth, compared to acquisitions. Which strategy has normally the highest return, and why?

Growth strategies based on organic growth have often the highest returns (as the don't require much new capital, like adding a new product to an existing product line). But acquisitions require that the entire investment is made up front. In this case, the rate of return is typically only a small amount higher than its cost of capital. Strategies based on organic new-product growth

Why is it wrong to calculate the continuing value the following way: CV = NOPLAT(t+1)/(WACC-g)

Here, g is the inflation rate. This formula can substantially overstate continuing value, because it assumes that NOPAT can grow without any incremental capital investment. This is unlikely, or impossible, because any growth will probably require additional working capital and fixed assets.

If a non-consolidated subsidiary owned between 20-50 percent of the voting rights, is privately held - how can you incorporate it in the enterprise value?

If the subsidiary is not listed but you have access to its financial statements (for instance, through a public bond offering or private disclosure), perform a separate DCF valuation of the equity stake. Discount the cash flows at the appropriate cost of capital (not necessarily the parent company's weighted average cost of capital). When completing the parent valuation, include ONLY the value of the parent's equity stake and not the subsidiary's entire enterprise value or equity value.

If a company has a debt to value ratio that differs from the target weight, in a simple scenario, how can you adjust your valuation?

In this case, using the target weights and a constant WACC (for all future years) will lead to a reasonable valuation. If you expect the rebalancing to happen over a long period of time, then use a different cost of capital each year, reflecting the capital structure at the time

To what should interest expenses be tied to in the estimation process and what is the so-called circularity problem related to this? What is the suggested solution to avoid this problem?

Interest expense (or income) should be tied directly to the liability (or asset) that generates the expense (or income). If the company uses debt to fund short-term needs, total debt will rise to cover the financing gap caused by lower profits. This increased debt load will cause interest expense to rise, dropping profits even further. The reduced level of profits, once again, requires more debt. This is the circularity problem. To avoid the complexity of this feedback effect, compute interest expense as a function of the prior year's total debt. This shortcut will simplify the model and avoid circularity.

Define invested capital from the equity liability side of the balance sheet

Invested capital represents the investor capital required to fund operations, without regard to how the capital is financed. Invested Capital=Debt and its equivalents + Equity and its equivalents - Nonoperating Assets.

Define ROIC. (Return on invested capital)

Is the return the company earns on each dollar invested in the business: ROIC = NOPAT / Invested Capital

Assume a company has a cost of capital that is higher than achieved ROIC. What will happen to the value of the company if the growth increases?

It means that the company is investing more at a value-destroying return. It will not change

Define invested capital.

It represents the cumulative amount the business has invested in its core operations, primarily property, plant and equipment and working capital. Property, plant, equipment and working capital

Assume a company has a constant growth rate, what will happen to the value if ROIC increase?

It will increase value if ROIC increases, while growth stays the same (constant).

Why are non-operating assets valued separately?

Many companies own assets that have value but whose cash flows are not included in accounting revenue or operating profit. As a result, the cash generated by these assets is not part of free cash flow and must be valued separately.

Why is it unnecessary to calculate the beta using a global index, instead of a local well diversified index, like the S&P 500 or MSCI Europe?

Most well-diversified indexes, such as the S&P 500 and MSCI World Index, are highly correlated (the two indexes had a 97 percent correlation between 2000 and 2018). Thus, the choice of index will have only a small effect on beta.

Explain how multiples are used in valuations.

Multiples can be a great check on your DCF valuation if done properly. Suppose the value estimated by multiples is $1.3 billion, but your DCF value is $2.7 billion. This might be a clue that there is something wrong with your DCF valuation model. Alternatively, it could be that the company you are valuing is expected to perform differently than the comparable companies. Finally, it could be that investors have a different outlook for the entire industry than you do (in which case the multiples of all the comparable companies would be out of line with their DCF value). Of course, it could just be that your multiples valuation wasn't performed properly. In a nutshell, to use multiples properly, you need to carefully choose the multiple and the comparable companies. In the case of earnings multiples, we recommend using ratios of enterprise value to NOPAT rather than price to earnings or enterprise value to earnings before interest, taxes, depreciation, and amortization (EBITDA). We also urge you to be careful when choosing the comparable companies. The comparable companies not only should be in the same industry, but also should have similar performance, as measured by ROIC and growth.

Net earnings are the profit available to equity holders. To whom is NOPAT available to?

NOPAT is the profit available to all investors, including providers of debt, equity, and any other types of investor financing. To all investors

What is important to take into consideration regarding NOPAT, when calculating the continuing value?

NOPAT. The level of NOPAT should be based on a normalized level of revenues, sustainable margin, and return on invested capital (ROIC). This is especially important in a cyclical business; revenues and operating margins should reflect the midpoint of the company's business cycle, not its peak or trough.

Write the recommended formula for calculating the continuing value.

NOPATt+1 = net operating profit after taxes in the first year after the explicit forecast period g = expected growth rate in NOPAT in perpetuity RONIC = expected rate of return on new invested capital WACC = weighted average cost of capital

Define NOPAT.

Net operating profit after taxes. It represents the profit generated from the company´s core operations after subtracting the income taxes related to those core operations. Earnings from core operations after subtracting the taxes related to those core operations.

If a company has 85 percent of the total value connected to the calculation of the continuing value at the end of the specific estimation period, is this the same as saying that part of the value is related to a very distant and uncertain future?

No. Value shifts from the continuing value to the explicit forecast period, but the total value always remains the same.

How should you treat unfunded retirement liabilities when calculating the equity value?

Nonequity claims are financial claims against enterprise value whose expenses are not included in EBITA and consequently are excluded from free cash flow. Traditional debt contracts like bank debt and corporate bonds are the most common nonequity claims. Other debt like claims, known as debt equivalents, include the present value of operating leases, unfunded pension and other retirement liabilities, and environmental remediation liabilities, among others. Because these claims do not scale with revenue or can affect the cost of capital, they are best valued separately from free cash flow.

Explain how multiples are calculated.

One simple way that investors and executives value companies is to value a company in relation to the value of other companies, like to the way a real estate agent values a house by comparing it with similar houses that have recently sold. To do this, first calculate how similar companies are valued as a multiple of a relevant metric, such as earnings, invested capital, or an operating metric like barrels of oil reserves. Then apply that multiple to the company you are valuing. For example, assume the company's NOPAT equals $100 million and the typical enterprisevalue-to-NOPAT multiple for companies in the industry with similar growth and ROIC prospects is 13 times. Multiplying 13 by $100 million leads to an estimated value of $1.3 billion.

What is the difference between "operating taxes" and "operating cash taxes"? Which tax should be applied when calculating NOPAT?

Operating cash taxes is the amount of tax actually paid during a period. To derive this number, subtract the increase in net operating deferred tax liabilities (DTLs) from operating taxes. Operating taxes is the taxes reported in the Income Statement, while the cash taxes is the actual tax paid during the period, that is why you look at the change in deferred taxes. Cash-based taxes should be applied when calculating NOPAT.