CFA Lvl 2 - Equity Valuation

Cost of Debt (Rd)

-return creditors demand on new borrowing -directly observable by computing the YTM on the bonds outstanding

Going-concern value

A business's value under a going-concern assumption.

Market efficiency

A finance perspective on capital markets that deals with the relationship of price to intrinsic value. The traditional efficient markets formulation asserts that an asset's price is the best available estimate of its intrinsic value. The rational efficient markets formulation asserts that investors should expect to be rewarded for the costs of information gathering and analysis by higher gross returns.

Spin-off

A form of restructuring in which shareholders of a parent company receive a proportional number of shares in a new, separate entity; shareholders end up owning stock in two different companies where there used to be one.

Bond indenture

A legal contract specifying the terms of a bond issue.

Duration

A measure of the approximate sensitivity of a security to a change in interest rates (i.e., a measure of interest rate risk).

Discounted cash flow model

A model of intrinsic value that views the value of an asset as the present value of the asset's expected future cash flows.

Present value model

A model of intrinsic value that views the value of an asset as the present value of the asset's expected future cash flows.

Free cash flow to equity model

A model of stock valuation that views a stock's intrinsic value as the present value of expected future free cash flows to equity.

Residual income model (RIM)

A model of stock valuation that views intrinsic value of stock as the sum of book value per share plus the present value of the stock's expected future residual income per share.

Free cash flow to the firm model

A model of stock valuation that views the value of a firm as the present value of expected future free cash flows to the firm.

Absolute valuation model

A model that specifies an asset's intrinsic value.

Relative valuation models

A model that specifies an asset's value relative to the value of another asset.

Dividend Discount Model (DDM)

A present value model of stock value that views the intrinsic value of a stock as present value of the stock's expected future dividends.

Illiquidity discount

A reduction or discount to value that reflects the lack of depth of trading or liquidity in that asset's market.

Economies of Scale

A situation in which average costs per unit of good or service produced fall as volume rises. In reference to mergers, the savings achieved through the consolidation of operations and elimination of duplicate resources.

Leveraged Buyout (LBO)

A transaction whereby the target company management team converts the target to a privately held company by using heavy borrowing to finance the purchase of the target company's outstanding shares.

Sum-of-the-parts valuation

A valuation that sums the estimated values of each of the company's businesses as if each business were an independent going concern

Top-down investing

An approach to investing in which an investor first looks at trends in the general economy, and next selects industries and then companies that should benefit from those trends

Bottom-up investing

An approach to investing that focuses on the individual characteristics of securities rather than on macroeconomic or overall market forecasts.

Pairs trading

An approach to trading that uses pairs of closely related stocks, buying the relatively undervalued stock and selling short the relatively overvalued stock.

Asset-Based Valuation

An approach to valuing natural resource companies that estimates company value on the basis of the market value of the natural resources the company controls.

Factor betas

An asset's sensitivity to a particular factor; a measure of the response of return to each unit of increase in a factor, holding all other factors constant.

Factor sensitivity

An asset's sensitivity to a particular factor; a measure of the response of return to each unit of increase in a factor, holding all other factors constant.

Bond yield plus risk premium method

An estimate of the cost of common equity that is produced by summing the before-tax cost of debt and a risk premium that captures the additional yield on a company's stock relative to its bonds. The additional yield is often estimated using historical spreads between bond yields and stock yields.

Catalyst

An event or piece of information that causes the marketplace to re-evaluate the prospects of a company.

Lack of marketability discount

An extra return to investors to compensate for lack of a public market or lack of marketability.

Blockage factor

An illiquidity discount that occurs when an investor sells a large amount of stock relative to its trading volume (assuming it is not large enough to constitute a controlling ownership).

Control premium

An increment or premium to value associated with a controlling ownership interest in a company.

Industry structure

An industry's underlying economic and technical characteristics.

Sensitivity analysis

Analysis that shows the range of possible outcomes as specific assumptions are changed; involves changing one assumption at a time.

Sell-side analysts

Analysts who work at brokerages.

Buy-side analysts

Analysts who work for investment management firms, trusts, and bank trust departments, and similar institutions.

Mispricing

Any departure of the market price of an asset from the asset's estimated intrinsic value.

Discount rate

Any rate used in finding the present value of a future cash flow.

Growth Capital Expenditures

CapEx needed for growth/expansion

Maintenance Capital Expenditures

Capital expenditures needed to maintain operations at the current level

Abnormal earnings

Earnings for a given time period, minus a deduction for common shareholders' opportunity cost in generating the earnings.

Fundamentals

Economic characteristics of a business such as profitability, financial strength, and risk.

Due diligence

Investigation and analysis in support of a recommendation; the failure to exercise due diligence may sometimes result in liability according to various securities laws.

The reading defined intrinsic value as "the value of an asset given a hypothetically complete understanding of the asset's investment characteristics." Discuss why "hypothetically" is included in the definition and the practical implication(s)

No matter how diligent the analyst, some uncertainty always exists concerning 1) the accuracy of the analyst's forecasts and 2) whether an intrinsic value estimate accounts for all sources of risk reflected in market price. Thus, knowledge of a stock's investment characteristics is always incomplete. The practical consequences are that an investor can only estimate intrinsic value and active security selection carries the risk of making mistakes in estimating value.

Normalized Earnings

Normalized earnings are adjusted to remove the effects of seasonality, revenue and expenses that are unusual or one-time influences. Additionally, normalized earnings can be thought of as a firm's earnings that take into account seasonal or cyclical sales cycles.

Return on Invested Capital (ROIC) [Formula]

ROIC = (EBIT - Taxes) / Invested Capital

Holding Period Return (HPR)

Rate of return over a given investment period. Found by calculating-- (Ending Price - Beginning price + Cash dividend) / Beginning Price.

Internal Rate of Return (IRR)

Rate of return that discounts future cash flows from an investment to the exact amount of the investment; the discount rate that makes the present value of an investment's costs (outflows) equal to the present value of the investment's benefits (inflows).

Merger

The absorption of one company by another; two companies become one entity and one or both of the pre-merger companies ceases to exist as a separate entity.

Fair value

The amount at which an asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale; as defined in IFRS and US GAAP, the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

Going-concern assumption

The assumption that the business will maintain its business activities into the foreseeable future.

Brokerage

The business of acting as agents for buyers or sellers, usually in return for commissions.

Free Cash Flow to Equity (FCFE)

The cash flow available to a company's common shareholders after all operating expenses, interest, and principal payments have been made, and necessary investments in working and fixed capital have been made.

Free Cash Flow to the Firm (FCFF)

The cash flow available to the company's suppliers of capital after all operating expenses have been paid and necessary investments in working capital and fixed capital have been made.

Equilibrium

The condition in which supply equals demand.

Conglomerate discount

The discount possibly applied by the market to the stock of a company operating in multiple, unrelated businesses.

Orderly Liquidation Value

The estimated gross amount of money that could be realized from the liquidation sale of an asset or assets, given a reasonable amount of time to find a purchaser or purchasers.

Factor Risk Premium

The expected return in excess of the risk-free rate for a portfolio with a sensitivity of 1 to one factor and a sensitivity of 0 to all other factors.

Expected Holding Period Return

The expected total return on an asset over a stated holding period; for stocks, the sum of the expected dividend yield and the expected price appreciation over the holding period.

Initial Public Offering (IPO)

The initial issuance of common stock registered for public trading by a formerly private corporation.

Quality of earnings analysis

The investigation of issues relating to the accuracy of reported accounting results as reflections of economic performance; quality of earnings analysis is broadly understood to include not only earnings management, but also balance sheet management.

Explain how the procedure for using a valuation model to infer market expectations about a company's future growth differs from using the same model to obtain an independent estimate of value.

The key difference is that for inferring investor expectations the market price is used as the model input for value whereas for obtaining an independent estimate of value, value is left as the unknown in the model. In the latter case, value is estimated based on the analyst's estimates for the variables that determine value.

Fair market value

The market price of an asset or liability that trades regularly.

Required Rate of Return (RRR)

The minimum rate of return required by an investor to invest in an asset, given the asset's riskiness.

Valuation

The process of determining the value of an asset or service on the basis of variables perceived to be related to future investment returns, or on the basis of comparisons with closely similar assets.

Return on Capital Employed (ROCE)

The profit of a business as a percentage of the total amount of money used to generate it.

Acquisition

The purchase of some portion of one company by another; the purchase may be for assets, a definable segment of another entity, or the purchase of an entire company.

Return on Invested Capital (ROIC)

The ratio of after-tax operating income to total invested capital; it measures the total return that the company has provided for its investors.

Cost of equity (Re)

The required rate of return on common stock.

Abnormal return (alpha)

The return on an asset in excess of the asset's required rate of return; the risk-adjusted return.

Divestiture

The sale, liquidation, or spin-off of a division or subsidiary.

Breakup value

The value derived using a sum-of-the-parts valuation.

Private market value

The value derived using a sum-of-the-parts valuation.

Liquidation value

The value of a company if the company were dissolved and its assets sold individually.

Intrinsic value

The value of an asset given a hypothetically complete understanding of the asset's investment characteristics; the value obtained if an option is exercised based on current conditions. The difference between the spot exchange rate and the strike price of a currency.

Investment value

The value to a specific buyer, taking account of potential synergies based on the investor's requirements and expectations.

Hybrid Approach

With respect to forecasting, an approach that combines elements of both top-down and bottom-up analysis.

Sensitivity Analysis

a special case of what-if analysis, is the study of the impact on other variables when one variable is changed repeatedly

Traditional efficient markets formulation

an asset's price is the best available estimate of its intrinsic value.

Rational efficient markets formulation

investors should expect to be rewarded for the costs of information gathering and analysis by higher gross returns.

Scenario Analysis

involves changing two or more assumptions at the same time

Residual Income Model (RIM)

states that a stock's value is book value per share plus the present value of expected future residual earnings.

Weighted Average Cost of Capital (WACC)

the weighted average of the cost of equity and the after-tax cost of debt

Survivorship bias

upward bias in average fund performance due to the failure to account for failed funds over the sample period