Company Valuation (Ch. 1-36)

9.9. Describe the three-step approach to estimating PP&E.

1) Forecast the 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 increase in net PP&E plus depreciation.

7.8. Which are the five primary areas in calculating investments in invested capital?

Change in operating working capital (Cash, inventory and other components of working capital, excluding excess cash, nonoperating assets etc.), Net capital expenditures (Investment in PP&E less BV of any PP&E sold), Change in capitalized operating leases (Include investments in capitalized operating leases in gross investment), Investment in goodwill and acquired intangibles, Change in other long-term operating assets, net of long-term liabilities.

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

Changes in currency values, mergers and acquisitions, and changes in accounting policies.

11.1. What is the most important principle underlying a successful implementation of the cost of capital (WACC)?

Consistency between the components of the WACC and free cash flow.

23.7. There are three types of financial coverage ratios, which?

Coverage = EBITA / Interest or EBITDA / Interest or Net Debt / EBITDA

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

Create a separate account for the accumulated tax loss carry-forwards, forecast the development for this account by adding any future losses and subtracting any future taxable profits on a year-by-year basis. For each year the account is used to offset taxable profits discount the tax savings as the cost of debt.

36.6. Rank the following loan types according to historical loan losses, from high to low: a) mortgage loans, b) business loans, c) consumer loans, and d) credit card loans.

Credit card loans. Consumer loans. Business loans. Mortgage loans.

2.11. Define invested capital.

Cumulative amount invested in the core operations, primarily PP&E and working capital (WC).

35.1. What is the reason volatility in earnings does not transfer into volatility in a DFC-calculated value?

DCF reduces future expected cash flows to a single value, any single year volatility is unimportant. Only the long-term trend really matters.

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

To avoid distortion by changing prices.

11.9. How do you estimate the risk-free rate? What time frame is most common?

To estimate the risk-free rate we use government "default free" bonds. Ideally each cash flow should be discounted using a government bond with the same maturity. In reality we often use the 10-year zero coupon government bond (STRIP) to estimate the risk-free rate. Always use government bond yields denominated in the same currency as the company´s cash flows. This way inflation will be modeled in accordingly.

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

Top-down, estimating the size of the total market, determining the market share, and forecasting the prices. Bottom-up, use the company's own forecast of demand from existing customers, customer turnover and the potential for new customers.

3.1. Define TRS.

Total shareholder returns includes any increase in share price with any dividend paid during a period to provide a true picture of shareholders return over the period.

26.10. In what category does "restructuring charges" fall into and what is the preferred treatment in NOPLAT, invested capital and in valuation?

Treat the one-time provision as nonoperating and treat the corresponding reserve as debt equivalent. The restructuring expense must be valued separately on a cash basis. To convert the accrual-based restructuring expense to cash, start with restructuring expense and subtract the increase in the restructuring reserve. Then estimate the present value of the cash-based restructuring provision using suitable discount factors, the present value of the cash-based restructuring provisions must then be deducted from the value of operations to determine the equity value.

15.4. How much has corporate America reinvested each year?

Typically around 50% to achieve the growth mentioned above.

25.3. What is the problem with using the statutory rate?

Typically leads to an upward-biased estimate of operating taxes, fails to recognize that foreign earnings are often taxed at different levels.

15.1. What is the average return on US equities the past 200 years, adjusted for inflation?

US equities over the past 200 years have on average achieved total returns to shareholders of about 6,5% annually adjusted for inflation over the period.

13.4. If a group has multiple businesses in different business segment, how should that affect your calculation of the cost of capital?

Each business unit should be valued at its own cost of capital, because the systematic risk (beta) of operating cash flows and their ability to support debt - that is, the implied capital structure - will differ by business unit. To determine each business units cost of capital, you need the units target capital structure, the units cost of equity and cost of borrowing.

16.5. In a US study between 1992-1997, how large part of the share price volatility was explained by earnings surprises in the four weeks surrounding the announcement? How large part of the companies with positive earnings surprises had negative return?

Earning surprises explained less than 2% of the share price volatility, More than 40% of companies delivering a positive earnings surprise actually had negative return.

6.8. Define Economic Profit in relation to NOPLAT.

Economic profit measures the value created by the company in a single period. Economic Profit=Invested Capital × (ROIC-WACC) Can be rewritten as: Economic Profit=NOPLAT- (Invested Capital × WACC)

36.3. Explain the equity DCF-method used in valuing banks.

Equity value equals the PV of its future cash flow to equity discounted at the cost of equity.

11.16. If a stock is rarely traded, is it better to calculate beta on a monthly, weekly or daily basis?

Estimates of beta measured on illiquid stocks are biased downward, since there are days that there could be no trading beta = 0. Therefore it is recommended to use monthly data which lessen this effect. Can also used lagged betas.

7.5. Name some non-operating assets

Excess cash and marketable securities, certain financing receivables, nonconsolidated subsidiaries and equity investments, prepaid and intangible pension assets, tax loss carry forwards.

11.14. In a study of US companies between 1962 and 2008 the inflation adjusted market return of equity was calculated. How high was it? How can you use this figure to calculate the market risk premium? How high was the market risk premium, calculated this way? How does that compare to the calculation in assignment 10, above?

Expected market return averaging 7%, when risk free rate (measured through US inflation-protected securities) are subtracted (-1,6%) we end up with an estimated risk premium of 5,4%

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

Few companies can be expected to have a higher growth than the economy for long periods of time. The best estimate is to set the expected long-term rate of consumption growth for the industry plus inflation. Also do a sensitivity analysis.

25.4. What is the problem with using the effective tax rate?

Handles foreign earnings properly but does not exclude one-time non-operating items. Can lead to a biased (and volatile) estimate of operating taxes.

4.1. What is the SCP-structure and which researcher developed the structure further in the beginning of the eighties?

Michael Porter further developed the SCP-framework in the eighties, SCP stands for Structure-Conduct-Performance. The intensity of competition in an industry is determined by five forces, threat of new entry, pressure from substitute products, bargaining power of buyers, bargaining power of suppliers and the degree of rivalry among existing competitors. Companies needs to choose strategies that creates/builds competitive advantages to mitigate the pressure of these forces and achieve greater profitability.

23.2. Is there an optimal capital structure in practice, and does it matter?

No, and no (empirical evidence) except for companies at the far ends of the interest coverage spectrum.

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

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

20.2. Which are the short-term value drivers?

Sales Productivity, Operating Cost of Productivity, Capital Productivity.

22.5. What is a carve-out of a business and what is the down-side risk?

Sometime parent companies do not want to give up control over a business unit. Reason could be a desire to maintain some synergies, shelter the subsidiary from market forces such as M&A. If the parent company don't want to give up control it should consider Carve-out. Altough a minority carve-out might initially shelter the unit from market forces such as acquisitions, it is very unlikely that the parent can hold on to its majority stake for long.

20.3. Which are the long-term value drivers?

Strategic Health *Core Business, *Growth Opportunities.

23.1. What are the key benefits with increased leverage?

Tax savings & Reduction of corporate overinvestment due to fiscal discipline created by increased debt.

14.6. Compared to a EV/EBITA-multiple, what additional important restrictions does the Price/Sales-multiple require?

The Price/Sales or EV/Revenues multiple implies that the operating margin on the company's existing business is similar all over. Limiting to the EV/Sales multiple limits the analysis and when the earnings are volatile it fails to represent the long-term operating potential of the firm.

1.2. Describe how companies in the United States and the United Kingdom are governed, compared to companies in Continental Europe, for example in the Netherlands and Germany.

The U.S. and the U.K. focuses on shareholder value maximization, whereas in Europe all stakeholders are considered. (city, workers etc.)

6.3. How is the WACC calculated?

The WACC blends the rates of return required by debt holders and equity holders. WACC= D/(D+E) k_d (1-T_m )+E/(D+E) k_e This is the case when the company is solely financed by Debt and Common Equity. D & E are measured using market values.

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

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

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

The capital structure affects the enterprise DCF only through the Weighted Average Cost of Capital (WACC), thus only a change to WACC will change the valuation.

27.5. Why are the improved key-ratios from a receivable securitization misleading?

The improved accounting metrics are misleading. In reality the company pays a fee for the arrangement, reduces borrowing capacity and pays higher interest rates on unsecured debt

11.10. Within what interval does the market risk premium for equity varies?

The market risk premium is believed to vary between 4.5-5.5%.

5.2. Which factor of these three explains most of the growth for large companies in 1999-2006? How much of the growth rate of 10.1 percent was explained by this factor? Which factor was least important?

The most important factor to achieving the high 10,1% growth is the Portfolio momentum factor, second to most important factor is the M&A and the least important factor is the Market share performance.

21.3. Some empirical studies have examined the stock market reaction to M&A announcements. What was the conclusion?

The value-weighted average deal lowers the acquirer's stock price between 1-3%.

13.2. There are four steps to take, to secure the model is economical consistent, which?

*Are the patterns intended? E.g. Does invested-capital turnover increase over time because of sound economic reasons (economies of scale) or simply because your modeled future capital expenditures as a fixed percentage of revenues? *Are the patterns reasonable? Avoid large step changes in key assumptions from one year to the next, because these will distort key ratios and could lead to false interpretations. *Are the patterns consistent with industry dynamics? *Is steady state reached for the company´s economics by the end of the explicit forecasting period? A company achieves steady state only when the FCF grows at a constant rate.

13.1. There are three steps to take, to secure the valuation model is technical robust, which?

*In the unadjusted financial statement: the balance sheet should balance every year, historically and forecast years. Check that net income flows corresponds the dividends paid and retained earnings. *In the rearranged financial statements: check that the sum of invested capital plus non-operating assets equals the cumulative source of financing. Is NOPLAT identical calculated top down from sales and bottom up from net income? *Does change in excess cash and debt line up with the cash flow statement?

11.2. To assure consistency the cost of capital must meet six criteria - which?

-> Include the opportunity cost of all investors. Debt, Equity and so on. -> Must weight each security´s required rate of return by its target market-based weight, not book value. -> Any financing-related benefits or costs, e.g. Interest tax shields not included in the FCF must be embedded into the WACC. -> Must be computed after corporate taxes. -> Must be based on the same expectations of inflation as those in the FCF forecast. -> The duration of the securities used to estimate the cost of capital must match the duration of the cash flows.

17.1. What three major patterns regarding share price deviations from fundamentals has the authors found?

-Individual company share prices deviate significantly from the company´s fundamentals only in rare circumstances, typically when barriers to trading, such as to limited free float of shares prevent rational investors from moving in to correct price. -Market-wide price deviation from fundamental valuations, e.g. Dot-Com Bubble. Soaring prices was triggered by expectations of unsustainable profits. -Price deviations from fundamentals are temporary. Market-wide deviation usually corrected within three years, company specific deviation usually last as long as the barriers preventing a price correction exists.

35.4. Describe the two-scenario approach in four steps for valuing cyclical companies.

1) Construct and value the normal cycle scenario, using information bout past cycles. Pay particular attention to the long-term trend lines of operating profits, cash flow and ROIC. 2) Construct and value a new trend line scenario based on the recent performance of the company. Focus primarily on the long-term trend line. 3) Develop the economic rationale for each of the two scenarios, considering factors such as demand growth, companies entering or exiting the industry and technology changes that will effect supply and demand. 4) Assign probabilities to the scenarios, and calculate their weighted value.

30.1. Which four issues arise in cross-border valuations?

1) Forecasting cash flows in foreign currency and domestic currency. 2) Estimating the cost of capital in foreign currency. 3) Incorporation foreign-currency risk in valuation. 4) Using translated foreign-currency in financial statements.

5.7. There are three possible explanations to why the inflation adjusted average growth rate of 5.2 percent 1963-2007 is higher than the GDP growth in the U.S of 3.2 percent - which are they?

1) High growth companies are more likely to be publicly traded, and in the survey they only measure publicly traded companies. 2) Outsourcing of services, which does not show up in the aggregated GDP growth of US but show up in the sample measured. 3) Global expansion, many companies create products and generate revenues outside the US, will not affect the GDP growth but the sample growth.

27.6. Which are the three steps involved in how to incorporate excess pension assets and unfunded pension liabilities into enterprise value?

1) Identify excess pension assets and unfunded liabilities on the balance sheet. Excess pension assets should be treated as nonoperating and unfunded pension liabilities should be treated as debt equivalent. 2) Add excess pension assets to and deduct unfunded pension liabilities from enterprise value. 3) To reflect accurately the economic expenses of pension benefits given to employees, remove the accounting expense from cost of sales and replace it with the service cost and amortization of prior service costs reported in the notes.

21.7. Which are the five archetypes that constitutes an acquisition that creates value?

1) Improve the performance of the target company. 2) Create market access for the target´s (or in some cases, the buyer´s products) 3) Acquire skills or technologies more quickly or at lower cost than they could be built in-house. 4) Pick winners early and help them develop their business. (2)) Consolidate to remove excess capacity from an industry, can create substantial value but often the value are captured by the sellers shareholders and not the buyer.

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

1) Market value 2) Black-Scholes value 3) Conversion value

14.7. There are two cautionary notes about using non-financial multiples to analyze and value a company, which?

1) Nonfinancial multiples should be used only when they provide incremental explanatory power over financial multiples. If they cant translate the nonfinancial multiples into financials then the multiple is useless. 2) Nonfinancial multiples like all multiples are relative valuation tools, they measure one valuation against another firm's valuation.

9.2. Which are the six steps in the forecasting process?

1) Prepare and analyze historical financials 2) Build the revenue forecast 3) Forecast the income statement 4) Forecast the balance sheet: Invested capital and non operating assets 5) Forecast the balance sheet: Investor funds 6) Calculate ROIC and FCF

27.3. Which are the three steps in adjusting financial statements for operating leases?

1) Reorganize the financial statements to reflect operating leases appropriately. Capitalize the value of leased assets on the balance sheet make corresponding adjustment to long-term debt. Adjust operating profit upward by removing implicit interest in rental expense. 2) Build a weighted average cost of capital (WACC) that reflects adjusted debt-to-enterprise value. 3) Value the enterprise by discounting free cash flow (based on the newly reorganized financial statement) at the adjusted cost of capital. Subtract traditional debt and the current value of operating leases from enterprise value to determine equity value.

26.2. Describe the three-step process to find non-operating expenses.

1) Reorganize the income statement into operating and nonoperating items. 2) Search the notes for embedded one-time items. 3) Analyze each extraordinary item for its impact on future operations.

23.10. Investors typically interpret share purchases positively for four major reasons, which?

1) Share buybacks indicates to investors that management believes the company´s shares are undervalued. 2) Share buybacks signals that managers are confident of strong future cash flows to support future investments and debt commitments. 3) Signals that the company will not spend it excess cash on value-destroying investments. 4) Can result in lower taxes for investors than dividend payment in countries where capital gains are taxed at lower rates.

21.5. Which are the three characteristics that can be identified that differentiate deals that are successful, in terms of the return to the acquirer's shareholders?

1) Strong operators are more successful, acquirers whose earnings and share price grow at a rate above industry average for three years before the acquisition earn statistically significant positive returns on announcement. 2) Low transaction premiums are better, acquirers paying high premiums earn negative returns on announcement. 3) Being the sole bidder help, acquirer stock returns are negatively correlated with the number of bidders, the more companies attempting to buy the target, the higher the price.

28.1. There are three reasons for capitalizing R&D, which?

1) The represent historical investment more accurately. 2) To prevent manipulation of short-term earnings. 3) To improve performance assessments of long-term investments.

16.1. Companies try to avoid earnings surprises in three ways, which? Which of the three affect current and future cash flow, and possible the value? Give an example.

1) Try to lead analyst to adjust their earning forecast by gradually providing new information. 2) Manage the earnings toward the analyst´s target, but in a manner that have no impact on value. E.g. Firms can decide when to recognize sales and earnings on long contracts. They can also choose to capitalize customer acquisition costs and R&D expenses, in a way of boosting reported earnings. These action do not directly affect the cash flows of the company. 3) Changes to a firms business, actions that directly effects a firms current and future cash flows and possibly value. E.g. reducing marketing expenses, providing customer incentives, or deferring divestments to meet a profit target. They can also time sale of real estate, assets or whole businesses.

19.1. What makes an owner the best? Explain the five factors that are recognized in the book, regarding what makes an owner "the best".

1) Unique links with other businesses - links to other business within their portfolio. Such unique links can be made across the value chain, from R&D to manufacturing and distribution to sales. 2) Distinctive skills - May have distinctive functional or managerial skills from which the new business can benefit. May reside anywhere within the business system, including product development, manufacturing process, sales and marketing. 3) Better governance - Add value through an better overall governance structure, better governance refers to the way owners interact with the management team to create maximum value in the long term. 4) Better insight and foresight - Companies that have insight into how a market and industry will evolve and then act on that insight so expand existing businesses or develop new ones can be better owners because they capitalize on their innovative ideas. 5) Influence on Critical Stakeholders - Applies primarily to companies in emerging markets. Owners with better connections and ways of handling all of the stakeholders can further enhance value creation.

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

1) Value the company´s operations by discounting the free cash flow using the WACC. 2) Value nonoperating assets, summing the value of operations and nonoperating assets gives enterprise value. 3) Value all debt and other non-equity claims against the enterprise value. Debt and non-equity claims include, interest bearing debt, unfunded pension liabilities, employee options and preferred stock. 4) Subtract the value of non-equity from the enterprise value to determine the value of common equity. To estimate the price per share, divide by number of shares.

21.4. In a McKinsey study the researchers found that some acquisitions created value. How many of the deals created value?

1/3 Created value for the acquiring firm, 1/3 did not create any value, and 1/3 had empirical results that where inconclusive.

15.3. How much has real corporate profits in the US grown the last 70 years?

3%-3,5%

16.3. How much of total return to shareholders (TRS) over a five year period was explained by long-term earnings growth, ROIC and industry sector? How much of TRS was explained by earnings variability?

34 % was explained by long-term earnings growth, ROIC and industry sector. Earnings variability did not explain market performance to any significant degree at all.

23.3. How many of the companies in Standards & Poors population has credit ratings between A+ and BBB-?

72%

36.7. Explain the term Risk Weighted Assets (RWA).

A bank's asset portfolio weighted by the riskiness of different classes of borrowers or investments.

36.5. Explain the pitfalls of equity DCF valuation relating to the impact of leverage and the business risk.

A bank's equity beta is a weighted averaged of the betas of all its loan and deposit businesses. Projecting significant changes in a bank's asset or liability composition or equity capital ratios you cannot leave the cost of equity unchanged.

27.2. What effect has an operational lease on profits and assets, compared to owning the asset?

A company that chooses to lease its assets will have artificially low operating profits (because rental expenses include and implicit interest expense) and artificially high capital productivity (because the assets do not appear on the lessee´s balance sheet). Although the effects counteract each other, the net effect is an artificial boost in ROIC.

23.8. What median interest coverage ratio (EBITA/interest) has companies in the group S&P AAA rating (approximately)? What is the median ratio for companies in S&P BBB and BB rating respectively (approximately)?

AAA approximately 24, BBB approximately 6 and BB approximately 4.

22.1. What the conclusion from academic research, regarding a company's possibility to create value through divestitures?

Academic research provide abundant evidence for divestures´ potential to create value. Found significant positive excess returns around announcement of divestures.

1.1. What is the theme that links most major financial crises and how does the pattern looks?

Aggressive use of leverage, Short term debt is invested in illiquid assets, financing long-term assets with short-term debt and then when interest rates goes up or the l oans have to be repaid the investor is forced into a firesale causing the assets to be sold if possible to sell at large underprice.

4.9. What is the conclusions regarding superior performance in ROIC over time? What is the conclusion regarding the group of high-performing companies?

Although a reversion to the mean can be traced, high ROIC companies are most likely to continue to achieve high ROIC over time, as well as low ROIC companies will continue to achieve low ROIC over time.

26.1. Which are the typical non-operating expenses?

Amortization expense, restructuring charges, unusual charges (e.g. litigation expense), asset write-offs, goodwill impairments and purchased R&D.

16.9. In a research in the US the effect on share prices from stock splits was analyzed. What was the conclusion and what is the theory behind the effect?

An article published in 1969 by Fama et al shows that stock splits are often followed by positive returns, the theory they present is that the split brings the stock back to "optimal trading range", that lowering the price of the share makes it more attractive to capital constrained investors. Later studies provides no evidence of this theory, instead they present two reason for the positive return. 1) The firm signals a change in the economic fundamentals. 2) Self-selection, that the firm have had a prolonged period of positive return following up to the split and this positive return just keep on going.

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

As the business approaches maturity the P/E will probably decline as the business growth and ROIC will decrease. So what P/E ratio should you use? Using an arbitrary P/E is not something that is recommended. Also when a company make an acquisition to make some improvement to the revenues and then sell it on thinking it will sell for the same P/E this is also not the case since they have already made the improvements the P/E or the overprice will decline

6.5. In what way is an SPE (SPV) (like the SIV's) a problem when non-equity claims is to be calculated?

As they may hide potential claims against the companys cash flows, which need to be incorporated in to the valuation to get a fair value.

3.3. Explain why the company Target ended up with higher total shareholder return than Wal-Mart, although Wal-Mart had better development of important value drivers.

Because it started the given period with lower performance expectations than Wal-Mart, improving its performance it raised the expectations of future performance in its P/E-ratio.

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

Because the estimate of the continuing value accounts for a large percentage of a company´s total value. E.g in the book between 56%-125%. This is because early cash inflows are offset by high cash outflows, in CAPEX and Working capital

2.9. 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 increase in leverage will make the equity cash flows more volatile (have to pay interest before paying dividend) and investors wants to be compensated for this by demanding a higher return which will push up the Required return on Equity and thereby the WACC, offsetting the increase in cheap debt. This will push down the P/E, although there is an increase in EPS this is offset by the higher P/E leaving the value constant.

36.2. Why is it not possible to do an enterprise discounted cash flow valuation (DCF-valuation) on a bank?

Because we cannot value a banks operations separately from interest income and expense, them being a bank's core operations. Operating and financing decisions are not separable in the valuation of a bank.

34.1. Describe the four areas in the valuation process for high-growth companies?

Begin with the future, not the past (sizing potential market, level of sustainable profitability, necessary investments). Then work backward to link the future to current performance (also try to find expensed investments and capitalize theses). Develop multiple scenarios of the market's development (total size, competitive entry etc.). Apply probabilistic weights to each scenario (use weights consistent with long-term historical evidence on corporate growth).

11.7. What is the beta value?

Beta represents a stock´s incremental risk to a diversified investor, where risk is defined as the covariance with the aggregated stock market. Beta measures how much the stock and the market moves together.

14.2. Within what interval did the EV/EBITA-multiple fell for a majority of the non-financial companies in the S&P index in December 2009? What was the most frequent single EV/EBITA-multiple at that time?

Between 7 and 11 times EBITA, single most frequent was 9 times.

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

CV= NOPLAT_(t+1) / WACC We expect that the return on new investment will eventually converge to the cost of capital. This is often the case when there is not a sustainable competitive advantage.

11.11. Which are the three steps for calculating the historical market risk premium?

Calculate the premium relative to long-term government bonds, use the longest period possible, use an arithmetic average for longer-dated intervals.

28.2. Will the accounting treatment of R&D affect the valuation of the company - why or why not?

Changing the accounting treatment of R&D can change perception of a company´s performance, it will not affect the company´s valuation. Cash outflows related to R&D will appear either in the income statement when expensed or in the investing section when capitalized. Thus FCF and consequently the valuation are unaffected by how R&D is treated.

14.5. There are two major techniques for finding the correct peer group to a company, which?

Check if the firm discloses competitors in its annual report. Check industry classification systems, such as Standard Industry Classification (SIC) or Global Industry Classification Standards (GICS).

23.9. What are the drawbacks in using leverage (debt to market value of equity) as a way to measure and target a company's capital structure?

Companies can have very low leverage in terms of market value but still be at high risk if their short term cash flow is low relative to interest payments. Secondly, the market value can change radically, making leverage a fast-moving indicator.

35.3. What did surprise the authors, regarding analyst consensus estimates for cyclical companies?

Consensus earnings forecast for cyclical companies appeared to ignore cyclicality entirely.

11.22. If you adjust your capital structure for debt-equivalent claims, what other adjustment is necessary?

Consistency is required between the free cash flow and the cost of capital, if you make any adjustments for pension in the free cash flow this must be properly represented in the debt portion of cost of capital also.

10.2. Write the recommended formula for calculating the continuing value?

Continuing Value_t=((NOPLAT_(t+1) (1-g/RONIC)) / ((WACC-g)) RONIC = Expected rate of return on new invested capital.

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

Conversion of line items into some type of ratio, e.g. each line item can be taken as a percentage of revenues. For easier comparison overtime and against peers.

25.5. How can we convert operating taxes to operating cash taxes?

Converting operating taxes to operating cash taxes, subtract the increase in net operating deferred tax liabilities from operating taxes. To determine the portion of deferred taxes related to ongoing operations, investigate the income tax footnote.

4.4. Which are the four sources of competitive advantage, to cost and capital efficiency?

Cost efficiency sell products and services at a lower cost than the competition. Capital efficiency selling more products per dollar invested capital than competitors. Innovative business method (Dell), unique resources, economies of scale (A greater market share on a small market is better than a low marketshare worldwide), scalable product/process (Low or negligable cost of adding one more customer, e.g. Microsoft Office or Media companies).

11.21. 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?

Decide how quickly the company may achieve its target weights. In the simplest scenario, the company will rebalance immediately and maintain the new capital structure. In this case use the target weights as this will give a reasonable valuation rather than make expectations of the future. If not the simplest scenario you have to start making assumptions on how quick they will return to target and make the valuation based on those assumptions.

7.7. Which are the most common "non- cash operating expenses", that you add back when calculating NOPLAT?

Depreciation, gains or losses related to pensions, embedded interest expenses from operating leases and restructuring charges.

23.12. Which are the three groups of financial instruments that are used?

Derivatives Instruments (forwards, swaps and options) Off-Balance-Sheet Financing (operating leases, synthetic leases, securitization and project finance) Hybrid Financing (convertible debt, convertible preferred stock, callable perpetual debt)

11.8. 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?

E(R_i )= r_f+ β (E(R_m )-r_f ) E(R_i )=3.9%+0.6 (5.4%)= 7.14% E(R_i) = Cost of equity

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

EBITDA to interest, measures the company's ability to pay interest using profits without taking from capital expenditures intended to replace depreciating equipment. EBITDAR to interest and rental expense measures the ability to meet short-term financial commitments.

23.4. What does a stable credit rating imply for the possibility to use gearing to increase value?

Enterprise value does not change dramatically with the level of debt funding except at very low levels of interest coverage (below 2).

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

Equity value = Enterprise value - the value of non-equity financial claims. Non-equity financial claims are found on the liabilities side of the balance sheet and make sure to search through the footnotes for undisclosed liabilities.

12.1. Which are the most common non-operating assets? What other non-operating assets do you probably need to add, to end up with the total enterprise value?

Excess cash and marketable securities, Excess real estate, nonconsolidated subsidiaries, financial subsidiary, tax loss carry-forwards, discontinued operations. To determine enterprise value add to the value of core operations the value on non-operating assets. E.g. excess cash and nonconsolidated subsidiary.

12.3. Why is it necessary to treat a finance subsidiary, even 100 percent controlled, as a non-operating asset in the enterprise value?

Financial subsidiaries differ greatly from e.g. manufacturing or service business, it is critical to separate them. Failing to do this can distort return on invested capital, free cash flow and the valuation of the company.

12.10. If the value of employee stock options are subtracted from the enterprise value as a non-equity claim, what other adjustment must be done to avoid double accounting?

First, the value of the options that will be granted must be captured in the free cash flow projections of 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 non equity claim. Secondly, the value of options currently outstanding must be subtracted from enterprise value as a non-equity claim.

15.8. Assume a three years investment horizon, what is most important for total return to shareholders (TRS) - a high ROIC or to exceed expectations? Within which time-horizon will probably a high achieved ROIC be the best investment tool?

For a short investment period of 3 years to exceed expectations will be more important to shareholders return. As the period increases the higher ROIC becomes more important, and in the long run moving toward 10 yrs the ROIC is the most important factor where as the expectations have low effect.

11.19. If a company has debt below investment grade (rated BB or lower) what method is recommended when calculating the cost of capital?

For companies with below-investment-grade debt it is recommended to use adjusted present value (APV) based on the unlevered cost of equity rather than the WACC to value the company.

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

Forecast as either a percentage of revenues or as a percentage of PP&E.

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

Free cash flow is independent of financing and non-operating items. Unlike cash flow from operations. (The after-tax cash flow - as if the company held only core operating assets and financed the business entirely with equity) FCF = NOPLAT + Noncash Operating Expenses - Investments in Invested Capital.

5.3. Which three types of growth strategies have a value creation below average?

Gain share from rivals through incremental innovation, gain share from rivals through product promotion and pricing, make large acquisitions.

26.5. Which are the two major write-offs?

Goodwill impairments, Purchased R&D Expenses

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

Higher ROIC will always mean higher value, everything else the same.

2.14. Define IR in relation to NOPLAT

IR = Net investment / NOPLAT, the portion of NOPLAT invested back into the business.

2.4. 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?

If a company have a higher cost of capital than achieved ROIC means that growth will destroy value rather than add to the value.

12.2. If a non-consolidated subsidiary, accounted for according to the equity method, is privately held - how can you incorporate it in the enterprise value?

If access to financial statement, then perform a separate DCF-analysis of the subsidiary with WACC based on the subsidiary's cost of financing. Include only the value of owned equity when calculating the total value of the subsidiary for the main firm. If no access to financials, use either Simplified cash-flow-to-equity valuation, Multiples valuation, Tracking portfolio.

28.3. What other expenses are suitable for capitalization?

If access to internal company data the same process can be applied to any expense resulting in long-term benefits. E.g. building a brand, expanding distribution channels or developing internal talent.

12.11. 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? ...if it is not publicly traded?

If publicly traded use the proportional market value owned by outsiders to deduct from enterprise value. If not publicly traded perform a separate DCF-analysis, Multiples or Tracking portfolio valuation and remember to deduct the third party outside ownership.

16.6. In a study 2007 both long-term and short-term earnings revisions were studied. If a company failed to meet earnings expectations in one quarter, the share price normally did not fall. However, if one other factor was in place, the share price fell, which other factor?

If the analyst´s expectation of the firms earnings within a two year period also fell then the share price fell sharply. Opposite also true, thereby if the expectations changed then the effect was much stronger.

26.7. Is litigation charges operating or non-operating? What is important to consider?

If the litigation charge recurs frequently and grows with revenue, treat the charge as operating. If the litigation cost is truly a one-time expense treat is as nonoperating and value any claims against the company separately from core operations.

26.6. Is restructuring charges operating or non-operating? What is important in that decision?

If the restructuring charge is unlikely to recur treat is as nonoperating. If however a pattern of ongoing restructuring emerges, further analysis is needed.

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

If we would divide it with the diluted number now we would double count the options´ value and thereby understate the value true (theoretical) value of the shares.

22.3. If a company have the possibility to divest a business either through a private transaction or a public, what should they choose, and why?

In most cases companies should choose a private transaction, if they can identify other parties that are better owners of the business. Private transactions allow the company to sell the business unit at a premium and capture value immediately. If the company cannot find better owners, it will have to choose a public restructuring alternative.

26.3. How should you treat amortizations of acquired intangibles when calculating NOPLAT?

In most circumstances you should not deduct amortization from operating profits to determine NOPLAT.

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

In the book they use the Capital Asset Pricing Model, and within the CAPM you adjust to each company´s specific risk through the use of the Beta (β).

4.3. Which are the five sources of competitive advantage, to allow companies to charge price premiums?

Innovative products (protected by patents or difficult to copy, e.g. Pharmaceuticals through patents, Apple Ipod hard to copy through design, patents and software). Quality (quality means real or perceived difference between one product or service and another for which consumers are willing to pay a premium for. E.g. BMW) Brand - Hard to distinguish from quality, E.g. Coco-Cola, Perrier, Lacoste and Mercedes-Benz) Customer lock-in - Locking in the customers through hard/expensive/time consuming to change from the current solution to another. E.g. Medical Equipment, Microsoft Windows/Office, Bloomberg terminals. Allows current solution provider to charge premium compared to competitors. Rational price discipline - There are industries that manages to overcome the forces of competition and sets their prices so that they earn a reasonable return. Rational pricing discipline works when one competitor acts as the leader and other quickly replicate its price moves. In addition there must be barriers of entry. Highly unstable situation.

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

Invested Capital=Debt and its equivalents+Equity and its equivalents-Nonoperating Assets.

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

Investment Rate = Growth / Return on Invested Capital ROIC = Growth/Investment Rate Growth = Investment Rate * ROIC

23.6. What is the default probability in the highest and the lowest investment grade category, according to Standard and Poor?

Investment grade range from 0,12%-3,84% of default within 5 years. Sub investment grade 14,45-61,35% of default within 5 years.

15.6. How has the actual P/E-ratio for the US stock market developed since 1962, compared to the "fundamental" P/E calculated by the use of a DCF-model?

It fits really well, short period of times where a deviation from the fundamentals can be observed followed by a correction towards the fundamentals in a few years.

27.4. Explain receivables securitization.

It is a process where the company sells its account receivables to another company, although the receivables are owned by someone else, the original company continues to process and collect them. By selling a portion of the receivables the company reduce accounts receivables on the balance sheet and increase cash flow from operations on the accountant´s cash flow statement.

4.5. Which are the three factors determining if a company can have a sustainable high ROIC?

Length of product life cycle (Cheerios, Palladium, Microsoft), persistence of competitive advantage, potential for product renewal.

15.2. What is the median P/E-ratio in the US stock market over time?

Long-term average P/E around 15, The median over the time is slightly less than 15.

20.1. Which are the financial value drivers?

Long-term growth, Return on Invested Capital (ROIC), Cost of Capital (WACC)

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

Many companies pay taxes at rates below their local statutory rate because of foreign rates and operating tax credits. Not taking this into account will cause a miscalculation of the FCF.

22.2. According to a study by McKinsey, most executives seem to shy away from an active approach to divestitures - why?

Many managers dislike divestiture because these transactions dilute corporate earnings (EPS gets lower). However if another party is willing to pay more for the subsidiary than the value the parent company expects to extract the divesture will create value.

34.4. In the case of Amazon, what were the reasons the company showed an accumulated deficit of USD 3.0 billion, although revenues had been growing steadily, as well as the gross profit?

Marketing- and technology-related expenses significantly outweighed gross profits.

11.17. 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. (95,8% correlation). Thus the choice of index will only have a small effect on the beta. Local indexes could be heavily dependent on a few industries or a few companies, this will show the company´s sensitivity to that industry or that other companies. Therefore it is better to use a larger, non local one

2.12. Define FCF.

NOPLAT - Net investments, cash flow generated by core operations after deducting investments in new capital.

2.10. Define NOPLAT.

NOPLAT = Invested Capital * ROIC, profits generated by the core operations after subtracting the related income taxes.

7.2. Net earnings is the profit available to equity holders. To whom is NOPLAT available to?

NOPLAT is the profit available to all investors. Debt holders, Equity holders and any other types of investor financing.

36.1. Which are the three types of activities that generate income in a bank?

Net interest income (difference between deposits and loans, net interest income) Fee and commissions income (for services including advisory, underwriting etc.) Trading income (trading of instruments over the counter, exotic products)

10.9. 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, it is saying that 15% is attributable to the time we can assume the company to make a return higher than the cost of capital. Have to look broader, look at the Business component approach and the Economic Profit Approach to get the bigger picture. pp. 222-224.

6.4. Why are non-operating assets valued separately?

Non-operating assets are valued separately since their cash flows are presented separately from the cash flow from operations. But they do have values that need to be taken into account when valuing the firm. E.g. equity investments (nonconsolidated subsidiaries), excess cash, tradable securities, customer financing arms.

26.9. The authors categorize provisions into four categories, which?

Ongoing operating provisions (product returns and warranties), Long-term operating provisions (Plant decommissioning, cost and unfunded pension plans), Nonoperating restructuring provisions (Restructuring charges, e.g. expected severance due to layoffs), Income-Smoothing provisions (provisions sole purpose of smoothing income).

7.6. What is the difference between "operating taxes" and "operating cash taxes"?

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.

27.1. Which are the two most common forms of off-balance-sheet debt?

Operating leases and securitized receivables.

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

Organic growth has generally higher returns as investments can be scaled or rolled back depending on the success in progress. Acquisitions require the entire investment plus a premium to be made up front pushing the ROIC down closer to the cost of capital. Acquisitions also mean higher risk.

15.5. If you take the factors 2, 3 and 4 above, what is the conclusion regarding the US equity markets long-term performance compared to economic fundamentals?

Over the long-term the equities market follows the simple economic fundamentals principles it is driven by return on capital, growth, and via the cost of capital interest rates.

14.1. Why is it better to evaluate the valuation by using a multiple based on EBITA, than a multiple based on net earnings?

P/E multiple has two flaws, P/E is affected by a company´s capital structure, not just operating performance. Second, unlike EBITA, net income is calculated after non-operating items such as amortization of intangible assets and one-time gains and losses. P/E mix capital structure and non-operating items with expectations of operating performance, a comparison of P/E is a less reliable guide to companies´ relative value than a comparison of EV to EBITA.

23.5. What analyzes does a company need to perform to create an effective capital structure?

Peer group comparison, credit-rating analysis, cash-flow analysis (financial flexibility and robustness).

34.2. In the first area of the valuation process, some examples of key-ratios are recognized - which?

Penetration rates, average revenues per customer and sustainable gross margins.

4.2. Grade the following three sectors according to historical ROIC the past 38 years - Pharmaceuticals, consumer goods and commodities. What is the reason for the differences in performance?

Pharmaceuticals, Consumer Goods, Commodities. The reason lies in competitive advantage, differentiation. Pharmaceuticals can develop innovative products that are subsequently protected by patents, in the consumer goods companies have developed strong brands that makes it hard for new competitors to gain marketshare. Commodities are standardized products with low differentiations thereby making it hard to charge any premiums.

4.7. Which type of industry tend to have a high median ROIC? What is the characteristic for this group of companies?

Pharmaceuticals, software, consumer brand companies and generally industries where sustainable advantages can be built up such as patents or strong brands.

5.1. It is important to understand the reasons for variations in growth. Which are the three main components for growth?

Portfolio momentum - organic revenue growth because of overall expansion. Market share performance - organic revenue growth by gaining or losing share in any particular market. Mergers & Acquisitions (M&A) - inorganic growth a company achieves when it buys or sells revenues through acquisitions or divestments.

23.11. How is "financial engineering" defined by the authors?

Pragmatically as managing a company´s capital structure for maximum shareholder value with financial instruments beyond straight debt and equity. Typically involves more complex instrument such as synthetic leasing, mezzanine financing, securitization, currency derivatives etc.

30.2. Describe the so-called spot rate method for valuing foreign cash flows.

Project foreign cash flows in the foreign currency and discount them at the foreign cost of capital. Then convert the present value of the cash flows into domestic currency using the spot exchange rate. (Calculate EVforeign => Convert using spot rate)

2.13. Define ROIC.

ROIC = NOPLAT / Invested Capital, the return the company earns on each dollar invested in the business core operations.

26.4. What effect has write-downs of goodwill on ROIC the coming years? What is the recommended treatment to avoid this?

ROIC can dramatically rise following a write-down, the resulting balance sheet value understates the historical investment made by shareholders. To counteract this effect treat assets write-downs and write-offs as nonoperating, and add cumulative write- downs to invested capital.

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

ROIC is driven by its ability to maximize profitability (EBITA divided by revenues, operating margin), optimize capital turnover, or minimize operating taxes. ROIC=(1-Operating Cash Tax Rate) * EBITA/REVENUES * REVENUES/(INVESTED CAPITAL)

4.8. Which is most stable over time - ROIC or growth?

ROIC tends to be more stable over time.

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

ROIC with goodwill measures the companys ability to create value over and above premiums paid for acquisitions. ROIC without is a better measure of the company´s core performance compared to its peers.

21.8. How to pay for an acquisition - in cash or stock? What does the research show? What does the authors believe?

Research show that on average the acquirers stock return are greater when the acquirer offers cash than when it offers shares. When the acquiring company pays in cash the acquiring's shareholders carry the entire risk of capturing synergies and paying to much. If the companies exchange shares, the target´s shareholders assume a portion of the risk. The authors believe that two key issues should influence the choice First, do you believe that the target and/or your company are overvalued? During a bubble you will be inclined to pay in shares, then both parties will bear the burden of a market correction. Secondly, how confident are you that the acquisition will create value overall? The more confident you are the more inclined you should be toward paying cash.

5.4. Explain the so-called S-curve in sustaining growth and how it relates to market penetration.

Resembles the PLC curve with early adaptors, then growth takes of. As the product penetration increases, the growth decreases and the company has to introduce new products or/and find new markets to keep up the growth.

36.4. In using the equity DCF-method the key-ratio ROIC is replaced by another key-ratio - which?

Return on equity (ROE)

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

Revenues, some line items will be economically tied to a specific asset, e.g. Interest income is usually generated by cash and marketable securities, thereby tied to them.

21.1. Acquisitions tend to occur in waves. What three factors tend to drive these waves?

Rising stock prices, managers want to further tap into the rising stock price by extending the firms. Low interest rates stimulate acquisitions. Especially highly leveraged ones. One large acquisition in one industry tends to encourage others in the same industry

6.6. Which are the six most common non-equity claims?

Short-term and long-term Debt, Operating leases, Unfunded retirement liabilities, Preferred stock (resembles unsecured debt, goes ahead of common equity), Employee options, Minority interest.

34.3. How far in the future does stable economics probably lie for a start-up?

Since mot high-growth companies are start ups stable economics lie at least 10-15 years in the future.

13.3. If a group has multiple businesses in different business segment, how should that affect your valuation?

Since the economics for each company´s segments are different, you must determine the company´s aggregate operating value one business unit at a time. By valuing the entire company with a single forecast, you risk missing critical trends and consequently distorting the valuation.

21.6. Which four characteristics do not matter?

Size of the acquirer relative to the target, Whether the transaction increases or dilutes EPS, The price-to-earnings (P/E) ratio of the acquirer relative to the target´s P/E, The relatedness of the acquirer and target, based on Standard Industrial Classification (SIC) Codes.

30.3. How does the spot rate method differ from the forward rate method?

Spot rate calculates all cash flows to present value and then converts them using the current spot rate. The forward rate method uses information about future cash flows and converts each future cash flow to domestic currency using estimates of forward exchange rates. The converted cash flows are then used to estimate the enterprise value. Spot method is less complex and needs less information. Forward-rate method often requires that synthetic forward exchange rates to be calculated because there is often only up to 18 month provided.

19.2. In constructing the corporate portfolio, the authors suggest a five-step strategy. Which are the five steps?

Start with cleaning up the current portfolio. 1) Determine the company´s current market value and compare it with the company´s value as is. (DCF value) any gaps imply company managers have a different perspective on the value of the business than investors. 2) Identify and value opportunities to improve operations internally. 3) Evaluate whether some businesses should be divested. 4) Identify potential acquisitions or other initiatives to create growth, and estimate their impact on value. 5) Estimate how the company´s value might be increased through changes in its capital structure or other financial strategy changes.

25.1. The majority of corporate taxes are related to earnings (the statutory rate), but the authors gives some examples of non-operating tax effects that are not included in the statutory rate, which?

Taxes related to unfunded pensions, net operating loss carry-forwards, non deductible amortization.

9.11. What is "the plug" when estimating investors funds?

The "plugg" is the last items that can be used to balance the balance sheet, these are excess cash, short-term debt, longterm debt, a new account labeled "newly issued debt" and common stock.

16.10. What does academic research show, regarding the long-term and short-term share price performance in companies that are either included or excluded from a share price index (like the S&P 500)?

The academic research is non-conclusive. Koller et al study found that the inclusion could create a short-term boost of share price but in the long-term the effect was negligible. This is the case for both inclusion to and index and exclusion.

11.12. If returns are volatile, which calculation of the market risk premium gives the highest outcome - the arithmetic (simple) average or a geometric average?

The arithmetic (simple) average will always yield a higher outcome than the geometric average. Since the geometric average squares the measurement error.

16.7. Did the change in accounting treatment of goodwill in the US in 2001, affect share prices?

The change in accounting treatment did not affect the share price much, a small change could be traced immediately following the change but within a two week period this change had diminished.

9.1. 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 each year. And earns a constant rate of return on both existing capital and new capital invested. Resulting in that the FCF grows at a constant rate and can be value using a growth to perpetuity.

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

The current rates may merely reflect a short-term swing in the company´s stock price, a swing that has yet to be rebalanced by management. Using todays estimates may cause you to under-/overestimate the value of for example the tax shield. To derive the target, look at the current market-value based capital structure, compare with other companies within the same industry and review management explicit and implicit approach to financing.

14.4. Why should you use a forward-looking multiple, than an historical multiple?

The denominator should use forecast profits, unlike backward looking multiples, forward-looking multiples are consistent with the principles of valuation. In particular that a company´s value equals the present value of future cash flows, not sunk costs. Second, forward looking earnings are typically normalized, meaning they better reflect long-term cash flows by excluding one-time past charges. Empirical evidence exists.

3.2. Describe in general the expectations treadmill

The expectations treadmill is that expectations of future high performance are most likely already incorporated in the stock price whereby to make the value of the company go up the performance goals constantly increase creating an ever faster growing treadmill of higher and higher expectations on the company.

10.4. 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. Economic theory suggests that competition will eventually eliminate abnormal returns. Many companies set RONIC equal to WACC. However for companies with sustainable competitive advantages, brands, patents etc. You might set RONIC equal to the return the company is forecast to earn during later years of the explicit forecast period.

15.7. What is the relationship between companies achieved ROIC and the relative market value for a given level of revenue growth? At what level of ROIC does an increase in revenue result in a decrease in value?

The greater the positive spread between ROIC and WACC the greater valued will an increase in growth add, similarly if ROIC is less than WACC, negative spread a higher growth will destroy value.

17.2. What was the difference between the technology bubble in 2000 and the credit bubble in 2007?

The high-tech bubble of 2000 was a valuation bubble, in which the stock market priced companies at levels that where unjustified by underlying performance and growth. Expectations of future earnings where far above current earnings an where thereby unrealistic. The credit bubble was not a valuation bubble but an earnings bubble, stock market values where not unreasonable. Unfortunately the underlying performance was not sustainable.

2.2. 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?

The higher ROIC for Value Inc allows it to have lower investments to earn the same level of profits generating higher cash flows.

10.10. 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?

The increase in working capital is far to large, since Revenues are growing more slowly, the proportion of gross cash flow devoted to increasing working capital should decline significantly. The increase in working capital should be the amount necessary to maintain the year-end working capital at a constant percentage of revenues.

10.8. Does length of (explicit) forecast affect a company's value?

The length of the forecast is important but it doesn't affect the value of the company, it only affects the distribution of the company´s value between the explicit forecast period and the years that follows. (Forecast period being, number of years before perpetuity.)

10.3. What is important to take into consideration regarding NOPLAT, when calculating the continuing value?

The level of NOPLAT should be based on a normalized level of revenues and sustainable margin and return on invested capital (ROIC). The normalized level of revenues should reflect the midpoint of the company´s business cycle and cycle average profit margins.

11.15. When calculating beta for Home Depot, monthly data for five years was used. Why not weekly data? Why not a ten year period?

The measurement period should include at least 60 data points, should be based on monthly data, using more frequent return periods leads to systematic biases. Using a longer period than 10 years would underestimate the risk of the company´s business model if they have changed the capital structure or business model during the period.

5.6. In a study of US-based non-financial companies 1963-2007, there were some conclusions regarding the sustainability for high growth - which?

The median growth was 5,4%. High growth rate decay very quickly, Extremely large companies struggle to grow.

30.4. What inflation and interest rate assumptions should a Swedish company use, when estimating the WACC when valuing cash flows coming from the euro area - Swedish based or euro based?

The monetary assumptions for all the currencies (areas) involved need to be consistent. Since most of Swedish firms cash flows are generated outside Sweden the appropriate inflation and interest rate to use is the European general one.

22.4. What is the most common form of public restructuring of a business, and how is it conducted?

The most common form of public restructuring is a Spin-off, in this case the parent company gives up control over the business unit by distributing the subsidiary to the parent shareholders. Making the subsidiary self-sufficient, but the parent company might help out the subsidiary in different ways and the equity of the subsidiary is distributed amongst the parents shareholders.

5.5. What is the only way to sustain consistently high growth?

The only way to achieve consistently high growth is to consistently find new products and new markets, enter them successfully in time.

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

The replacement cost approach sets the continuing value equal to the expected cost to replace the company´s assets. The drawbacks are 1) Not all tangible assets are replaceable, e.g. the organizational capital can only be valued on the basis of the cash flows. If not the replacement cost may greatly understate the value of the company. 2) Not all the company´s assets will ever be replaced.

16.8. In a research of 54 companies, write-down of goodwill was analyzed. What was the conclusion regarding the share price effect at the time when the write-down was announced?

The research found no statistically significant drop in share price following the announcement, the write down had already been incorporated into the share price in the 6 month following up to the announcement by an average drop at 35% in share price.

11.4. The cost of equity is determined by three factors, which?

The risk-free rate of return, the market-wide risk premium and risk adjustments that reflects each company´s riskiness relative to the average company. (In CAPM through the Beta).

35.2. In practice, does the share prices follow the stable DCF-calculated value or the volatile earnings?

The share price of cyclical are less stable than the DCF-model would predict. The share price are affected by the EPS.

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

The stock approach forecast end-of-year receivables as a function of revenues where as the flow approach forecasts the change in receivables as a function of the growth in revenues. Koller favors the as experience shows that the relationship between balance sheet account and revenues (or other volume measures) is more stable than that between balance sheet changes and changes in revenues.

16.2. What was the conclusion regarding earnings volatility and market value in a research conducted by Koller and Rajan on 1500 European companies between 2000 and 2007? Did this study confirmed or rejected earlier studies?

The study confirmed earlier studies, the variability in earnings growth rate have no meaningful effect on shareholder returns or value.

11.13. What is the survivorship premium and how high is it, calculated for the US stock market between 1900-2005?

The survivorship bias refers to the fact that the observable sample used for estimating historical returns only includes countries with strong historical returns, and not all the stock markets during the period for various reasons. The survivorship premium of us stock market is 0,8%. (p. 246)

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

The value of operation equals the discounted value of future free cash flow. PV of FCF during the explicit forecast period, and PV of FCF after explicit forecast period. Discounted using the WACC.

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

The value should not change solely upon change in debt and equity unless the overall cash flows generated by the company also change. (Excluding the tax-shield and other motivational effects). "How well a company does should not be dependent on how it decides to finance.

2.6. 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 will remain the same, since increase in growth is offset by cost of capital.

19.3. Why is diversification regarded as "a myth"?

There are not empirical evidence of that diversified firms have historically performed better than non diversifiers, there are on the other hand signs of the opposite. A well diversified firms intends to be less volatile by being effected by more than one business cycle the downturns are believed to be less extreme, which could be true. But the expenses of having a diverse portfolio are very real and expensive, management often don't have the ability or knowledge to use the diversification. It is much cheaper for the individual investor to diversify their respective portfolio rather than the firm.

1.3. What is the correlation in the U.S and Europe between total return to shareholders and employment growth?

There is a positive correlation between shareholders return and employment growth. Companies with high TRS also have strong employment growth.

21.2. What was the conclusion in a study by McKinsey between 1997 and 2009, regarding the value creations from acquisitions?

They found that the combined value of the acquirer and target increased by about 4% on average.

9.6. 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?

Tie the interest expense/income to the assets/liabilities that generates the income not to total revenues. Tie the Interest expense to the prior years total debt.

11.6. 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 estimate the cost of debt of investment-grade firms with infrequent traded bonds we use the company´s debt rating to estimate the yield to maturity. We adjust this with the marginal tax rate to get the after tax cost of debt.

11.18. When calculating the beta in Home Depot the result was that, within two standard deviations, the beta was between 0.85 and 1.71, which was not particularly useful. How did they proceed to come up with something more useful? In this concept there is one factor you need to adjust for, to come up with a beta for an individual company. Which factor?

To improve the precision of betas estimation, use the industry betas since within the same industry companies should have the same operating beta. To be able to compare them you first have to strip out the leverage effect. Only then can you compare them.

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

Under U.S. GAAP and 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, the most recent book value is a reasonable approximation to include.

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

Unfunded retirement liabilities should be treated as debt equivalent and deducted from enterprise value to determine equity value. Since future contributions to fill unfunded liabilities are tax deductible, multiply unfunded pension liabilities by 1 minus the marginal tax rate.

25.2. There are two unsuitable alternatives to calculating taxes, which?

Using the company's statutory tax rate or the company's effective rate with no adjustments.

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

Using this formula can substantially overstate continuing value since is assumes that NOPLAT can grow without any incremental capital investments. This is highly unlikely since any growth will require additional working capital and fixed assets.

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

Value = FCF / (WACC - Growth), Gordons Formula.

6.9. 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)

11.3. Write down the formula for calculating the WACC in its simplest form.

WACC=D/V×k_d×(1-T_m )+E/V×k_e V = Enterprise value, D and E using market-based values not book values. TARGET LEVELS Tm = Marginal tax rate Kd = Pretax cost of debt, Ke= Cost of equity.

16.4. How many companies in the study had stable earnings growth during the seven years period? How many had stable earnings growth for a four-year period?

Walgreens was the only with steady earning growth in the 7-year period. Including Walgreens another four firms hade a stable earnings growth for a four-year period.

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

We set revenue growth from acquisitions to zero and hold goodwill constant at its current level. This approach is preferred since empirical literature shows that the typical acquisition fails to create value. By assuming growth we also make implicit assumptions about the present value of acquisitions. If you decide to forecast, first asses what proportion of future they are likely to provide, by measuring historical values and comparing.

26.8. Why should gains and losses on the sale of assets be treated as non-operating?

When an asset´s sale price differs from book value, the company recognize a gain or loss. Since current gains and losses are backward looking (value have been created/destroyed in the past) treat them as nonoperating.

30.5. What is best - analyzing the historical performance for a foreign business in the foreign currency or in the parent company's currency?

When analyzing performance of a foreign business it is best to use the foreign currency.

12.8. 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. Assessing the probability of such cash flows are difficult, the valuation should be interpreted with caution.

35.5. Explain why it can be stated that, in many cyclical industries, it is the companies themselves that drives the cyclicality?

When prices are high the companies invest heavily in increasing their supply this in turn leads to "flooded" markets where supply overshadows demand and this in turn drives the prices down.

2.1. What was the reason the fast growing company Walgreen and the significantly slower growing company Wrigley, between 1968-2007 had nearly the same shareholder return?

Wrigley had a higher ROIC that compensated for the lower growth in creating shareholders return.

14.3. a) Why EV/EBITA and not EV/EBIT? b) Why EV/EBITA and not EV/EBITDA?

a) Because Amortization (depreciation of intangibles) is an accounting artifact that will distort an enterprise multiple. For most firms EBITA leads to a better EV multiple than EBIT. b) Depreciation is a noncash expense, reflecting sunk costs, not future investment. For many industries, depreciation of existing assets is the accounting equivalent of setting aside the future capital expenditure that will be needed to replace the assets. Thereby subtracting depreciation from the earnings of such companies therefore is necessary to understand their true value. (Leasing a fleet vs Buying a fleet, e.g. Ryanair vs EasyJet)

10.7. What is the recommended formula for economic-profit valuation?

〖CV〗_t=Economic Profits in Year t+1+Economic Profits beyond Year t+1= =(〖IC〗_t (ROIC-WACC))/WACC+PV(〖Economic Profit〗_(t+2) )/(WACC-g) PP. 217-218, Koller et al.

4.6. What was the median ROIC between 1963-2008 for US-based non-financial companies?

10%