Equity Valuations (R27 & R28)

Beta

A measure of systematic (nondiversifiable) risk for a security. A beta less than 1 indicates that the security has less‐than‐average SYSTEMATIC risk. * do not confuse this with unsystematic risk which can be diversified away.

True Mispricing

A true mispricing exists when there is a difference between the intrinsic value and the observed market price. True Mispricing = Intrinsic Value - Observed Market Price

Absolute Valuation Models

Absolute Valuation Models: A) Present value models 1) Dividend discount models (DDM - expected dividends discounted at required return on equity) 2) Free cash flow models (FCFF discounted at WACC or cost of equity) 3) Residual income models (excess of accounting earnings over the dollar cost of capital for each forecasted year is discounted at the cost of equity) B) asset based valuation models Absolute Valuation Models look to estimate intrinsic value of an asset based on IT'S OWN UNDERLYING CHARACTERISTICS. These models do not rely on information from comparable assets.

Situational Adjustments

After running various sensitivity analysis tests, an analyst should adjust the equity value for certain SITUATIONAL reasons: - Control Premium - (lack of) Marketability Discount - Illiquidity Discount

Equity Valuation Process: Step 5 - APPLYING

After the analyst has completed the equity valuation and reached a conclusion about what they believe the intrinsic equity value of the company to be they must make certain to communicate their results through an EFFECTIVE RESEARCH REPORT: - Contains timely information - Written clearly with incisive language - Objective and well researched; key assumptions identified clearly - Distinguishes between fact and opinion - Contains analysis, forecasts, valuation, and final recommendation that are all internally consistent - Present sufficient information for the reader to critique the valuation - States key risk factors involved with investment - Discloses any potential conflicts of interest

Sources of Information

Analysts can get information from many places including, but not limited to: - company disclosures; regulatory filings; press releases; investor relations material; and discussions with analysts - industry organizations - regulatory agencies - commercial providers of market intelligence

Reasons for Equity Valuation

Applications of Equity Valuation: 1) Selecting stocks to invest in 2) Inferring market expectations 3) Evaluating corporate events (mergers/acquisitions) 4) Rendering opinions (undervalued/ overvalued) 5) Evaluating business strategies and models 6) Communicatig with analysts/shareholders 7) Appraising a private business 8) Calculating value of share-based payments

Arbitrage Price Theory (APT)

Arbitrage Price Theory (APT): multi-factor models that estimates required return on equity by added various 'risk premiums' to the risk free rate.

Investment Value

Assets may be worth more than their fair (market) value to an individual investor. Investment Value is the unique value that a particular buyer may place on an asset depending upon her own needs (i.e. the asset may be needed to diversify her portfolio and would, for its diversification qualities specific to her situation, be valued higher for her than for someone else)

Macroeconomic Multi-Factor Model: BIRR

BIRR is a FIVE factor macroeconomic model used to estimate required return on equity. The five factors are (CTIBM): 1) Confidence risk (risk of unexpected change in difference between the return on risky corporate bonds and government bonds with same maturity) 2) Time horizon risk (risk of unexpected change in difference between yield on 20 year gov bond and 30 day T-bill; stocks generally have negative sensitivity to time horizon risk) 3) Inflation risk (higher-than-expected inflation is negative for stocks; stocks generally have negative sensitivity to inflation risk) 4) Business cycle risk (unexpected change in level of real business activity) 5) Market timing risk (almost all stocks have a positive sensitivity to market timing risk) BIRR re = Rf + (Sc * C) + (St * T) + (Si * I) + (Sb * B) + (Sm * M) Sx → sensitivity to risk

Beta Estimation: Non-Public or Thinly Traded Companies

Beta Estimation for... Nonpublic or Thinly Traded Companies: estimated using the PURE PLAY METHOD (see flashcard) This method requires adjusting a comparable public company's beta for differences in financial leverage. Steps to Pure Play: 1) find comparable public company (should face similar business risk) 2) Unlever the comparable company beta (to remove all elements of financial risk) to determine the asset beta 3) Relever the asset beta using the target company's financial leverage

Beta Estimation: Public Companies (Blume Method)

Beta Estimation for... Public Companies: estimated through ordinary least squares (OLS) regression of returns on the stock vs the returns on the market. This results in an UNADJUSTED (RAW) BETA. Influenced by choice of index, length of data period, frequency of observations Because betas tend to revert to 1 over time the BLUME ADJUSTMENT may be applied: Adjusted beta = (2/3)(Unadjusted beta) + (1/3)(1.0)

Capital Asset Pricing Model (CAPM)

CAPM is a single factor model that only prices SYSTEMATIC RISK (β; non-diversifiable risk). CAPM = rf + β(rm - rf) rf → risk free rate β → equity beta of target company (project) rm - rf → equity risk premium; market risk - risk free rate

Strengths and Weaknesses of Methods Used to Estimate Required Return on Equity

CAPM: strengths - simple, widely accepted weaknesses - low explanatory power, poor predictor of future returns Multifactor models: strengths - more explanatory variables weaknesses - more complex & costly, doesn't necessarily lead to better results Macroeconomic and statistical models: strengths - higher explanatory power weaknesses - more complex & costly Build up models: strengths - very simple, can be applied to closely held companies weaknesses - use historical estimates which may not continue to be relevant

Efficient Market Theory

Efficient Market Theory asserts that an asset's market price is the best available estimate of its intrinsic value. However, markets are not always efficient and therefore mispricing, if identified, can lead to additional returns (above what is anticipated by the market) for investors.

Error in the Estimate of Intrinsic Value

Error in the Estimate of Intrinsic Value refers to the difference between estimated intrinsic value (unique to the analyst) and the actual intrinsic value. Example: Cassie thinks a stock, currently trading at $15, is worth $20. The perceived mispricing is equal to +5. The stock price goes up to $18. The true mispricing is equal to +3 and the error in Cassie's estimate of intrinsic value is equal to 2.

Required Return on Equity Estimation: International Considerations

Estimating required return on equity in a global context requires that an analyst take certain concerns into accounts -- exchange rate fluctuations and data/model issues A COUNTRY RISK PREMIUM is applied to capture the added risk of a non domestic investment. Equity risk premium (ERP) estimate = ERP for developed market + country risk premium The country risk premium is estimated as the SOVEREIGN YIELD SPREAD: = developed market government bond yield - developing market government bond yield

Sources of ESG Information

Evaluating Environmental and Social Governance (ESG) Information about a company is part of the first step (understanding) of the equity valuation process. Analysts can determine potential risks and practices that may produce long term competitive advantages. Sources of ESG information: - Corporate sustainability reports (CSRs) - Labor union boycott lists and disclosures from OSHA and the EEOC - the Sustainable Accounting Standards Board (SASB) - The Carbon Disclosure Project - Ceres (org committed to sustainability research and advocacy)

Expected Alpha

Expected Alpha = Expected Return - Required Return Example: If an asset's current price is greater than its perceived value, the required return should be greater than the expected return, and alpha should be negative as long as the stock converges to its intrinsic value over the investor's time horizon.

Expected Inflation (EINFL)

Expected Inflation (EINFL) = [(1 + YTM of 20-year maturity T-bonds)/ (1 + YTM of 20-year maturity TIPS)] - 1 TIPS → treasury inflation protected securities

Expected Return

Expected Return = Required Return + Return from Convergence (aka alpha) E(Rt) = rt + [(V₀ - P₀)/P₀] ** Make sure to calculate FULL expected return before unannualizing or annualizing. For example, if a problem asks what the one year return would be if a stock price converges over 3 years, calculate the three year (rt), add the 3 year HPR, and THEN raise it to the power of 1/3 to achieve the 1 year return.

Fama-French Model (FFM)

FFM uses THREE factors to estimate the required return on equity: 1) Market Beta 2) Size Beta 3) Value Beta FFM re = rf + (βmkt * equity risk premium) + (βsize * small cap return premium) + (βvalue * value return premium) Equity Risk Premium: Same as CAPM, it equals (rm - rf) Small-Cap Return Premium: (Rsmall - Rbig), accounts for differences in company market capitalizations. Estimated as difference between average return on three small cap and three large cap portfolios. (USUALLY POSITIVE for small cap stocks, negative for large cap) →SMALLER COMPANY = ↑ REQUIRED RETURN Value Return Premium: (Rhbm - Rlbm), difference between return on two high book-to-market (hbm) that represent VALUE bias and two low-book-to-market (lbm) portfolios that represent GROWTH bias. (USUALLY POSITIVE for stocks with high book-to-market values [VALUE STOCK], negative for stocks with low book-to-market values [GROWTH STOCK]) →BOOK-TO-MARKET ↑ = ↑ REQUIRED RETURN *the value return premium can also be interpreted to encompass a premium for financial distress.

Financial Statement Analysis

Financial Statement analysis is used in step 1 of the 5 step equity valuation process. It helps an analyst determine how well a company's strategy is being executed. FS analysis provides a basis for evaluating a company's success (review of the income statement), past performance, and forecasted future performance. NOTE: financial statements do not reflect non-numeric qualitative value (i.e. brand value) When reviewing accounting information analysts must always check for EARNINGS QUALITY. - How accurately does reported information reflect economic reality? - How sustainable are the company's earnings? (see 'Earnings Quality Indicators on pg. 127 of Wiley Vol. 3)

Bond Yield Plus Risk Premium

For companies with publicly traded debt, the cost of equity can be calculated by adding an equity risk premium to the company's long term debt yield. BYPRP Re = YTM on company's long term debt + risk premium *DO NOT use the coupon on the company's bonds unless the bonds are trading at par. Use the yield. CAPM uses the risk free rate, not the yield on corporate debt and the resulting Re will be different between the two methods.

Recession Economy and Equity Risk Premium

Generally speaking, during a recession, dividend yields tend to be high (due to low equity market prices → D₁/P₀), growth expectations tend to be low (due to a weak economy), and government bond yields tend to be low. With a high dividend yield and low growth rate and bond yields, the equity risk premium is 'normally' higher: equity risk premium using Gordon Growth Model (GGM) = (D₁/P₀) + g - rf

Going Concern Value vs Liquidation Value

Going Concern Value is the value of a company that is assumed to continue doing business for the foreseeable future. - the more value generated by business operations, the greater the positive difference between Going Concern Value and Liquidation Value (PV of future cash flows makes the value of a going concern company higher than a liquidating company) Liquidation Value is the value of a company if it were to be dissolved (all assets sold off) immediately. - the sooner the firm must liquidate assets, the lower the liquidation value (discounts might be taken if assets need to be sold fast)

Nonstationarity

Historical estimates of the equity risk premium are exposed to the possibility that the mean and variance of returns over the relevant sample period were not constant (nonstationarity). Forward‐looking estimates are free from data biases such issues.

Equity Risk Premium: Historical Estimates

Historically estimated equity Risk Premium is the geometric MEAN difference between the return on the broad equity market and the risk-free rate of return. Risk free rate is generally determined by a proxy such as the rate on long term government bonds. A market value weighted index is generally used to determine estimated equity market returns. A DOWNWARD ADJUSTMENT for survivorship bias is made if the index removes poorly-performing companies.

Situational Adjustment: Marketability Discount

If a stock is traded publicly there is no need to discount it for lack of marketability. If a stock is NOT traded publicly then an analyst may need to discount the calculated equity value to reflect the lack of marketability.

Situational Adjustment: Control Premium

If an investor is trying to determine the equity value of a company in which she has/will have a controlling interest (which allows her additional rights) than a control premium should be ADDED to the estimated equity value. Valuation models will not capture the added value of a controlling interest.

Equity Risk Premium: Developed Economy

In a developed economy, when the growth rate is expected to be stable in to perpetuity, the following formula (GGM) can be used to estimated equity risk premium: = (D₁/P₀) + g − risk free rate

Equity Risk Premium: Developing Economy

In a developing economy, when the growth rate is expected to vary over time (fast growth, followed by transition growth, followed by mature stage stable growth) a MULTI-STAGE MODEL is used to estimate equity risk premium: 1) Equity index price =[PV Fast growth stage CF discounted at r + PV Transition stage CF discounted at r + PV Mature stage CF discounted at r] 2) determine IRR from step 1 3) subtract risk free rate from step 2

Intrinsic Value

Intrinsic ("true") value of an asset is the value based on a hypothetically complete understanding of the asset's investment characteristics. Different investors may derive different intrinsic values for the same asset (due to different assumptions; available information; investor needs/desires)

Equity Risk Premium: Macroeconomic Estimates (Ibbotson & Chen - aka Supply Side Estimate of Equity Risk Premium)

Macroeconomic Models (aka Supply Side Models such as the Ibbotson & Chen model below) use relationships between macroeconomic variables and financial variables (in equity valuation models) to estimate equity risk premium. Equity risk premium ={[(1+ EINFL) (1 + EGREPS) (1 + EGPE) −1] + EINC} − Expected RF EINFL → expected inflation (see flashcard) EGREPS → expected growth rate in real earnings per share (expected real domestic growth (GDP)) EGPE → expected growth rate in P/E ratio (market undervalued or overvalue by X%) EINC → expected income component (estimated as the expected dividend yield on market index PLUS reinvestment return (if any)) Expected RF → expected risk free rate; generally the rate on LONG TERM government bonds **DO NOT FORGET TO SUBTRACT THIS TO DETERMINE EQUITY RISK PREMIUM**

Pastor-Stambaugh Model (PSM)

PSM uses FOUR factors to estimate the required return on equity. The three included in the FFM (market risk premium, size premium, and value return premium) PLUS it adds a LIQUIDITY PREMIUM Liquidity beta for stocks with below-average liquidity is positive. → LIQUIDITY ↓ = ↑ REQUIRED RETURN PSM re = rf + (βmkt * equity risk premium) + (βsize * small cap return premium) + (βvalue * value return premium) + (βliquidity * liquidity premium)

Pairs Trading

Pairs trading involves buying an undervalued stock and shorting an overvalued stock in the same industry.

Perceived Mispricing

Perceived Mispricing = True Mispricing + Error in the Estimate of Intrinsic Value

Corporate Strategies

Porter identifed three generic corporate strategies (competetive strategies) that a company may choose to follow in order to compete/obtain more market share: 1) Cost Leadership: become the low cost producer of a product (keeping quality similar to that of the higher priced competitors) 2) Differentiation: offer a unique product that adds enough value such that customers will pay a premium for it 3) Focus: establish an advantage in a particular segment of an industry based on cost focus or differentiation focus for that space alone

Porter's Five Forces

Porter's Five Forces measure identify and analyze competitive forces faced by an industry. 1) Intra-industry rivalry (how intense is the current competition) 2) Threat of new entrants (low or high barriers to entry) 3) Threat of substitutes 4) Supplier power 5) Buyer power

Positive Excess Risk Adjusted Return

Portfolio managers hope to earn positive excess risk adjusted returns (aka alpha or abnormal return) by trading on a PERCEIVED mispricing.

Situational Adjustment: Illiquidity Discount

Publicly traded stocks that have low market volumes should be discounted to reflect lack of liquidity. The intrinsic value should be adjusted down by the analyst to reflect the illiquidity.

Estimating Required Return on Equity

R28 identifies the following ways that required return on equity can be estimated: Single Factor Model: CAPM Multi-Factor Models: Arbitrage Price Theory(APT); Fama-French Model (FFM); Pastor-Stambaugh Model (PSM); macroeconomic models (BIRR) Build-Up Method & Bond yield + risk premium

Realized Alpha

Realized Alpha = Actual HPR - Required Return for the period

Relative Valuation Models

Relative Valuation Models ("relative" to something else): 1) Price Multiples (P/E; P/BV; P/Sales; P/Cash Flow) 2) Enterprise Multiplies (determining multiples from industry averages, such as EV/EBITDA) Relative Valuation Models are based on the premise that similar assets should trade at similar prices. NOTE: there is a difference between being "undervalued" and being "relatively undervalued" -- if an industry as a whole is overvalued (think tech boom), then a relatively undervalued company in that industry might not be undervalued at all.

Sensitivity Analysis

Sensitivity Analysis involves changing inputs in a valuation model one at a time in order to gauge the impact that each variable has on the company's equity value.

Equity Valuation Process: Step 2 - FORECASTING

Step 2 of the equity valuation process is FORECASTING company performance. - TOP DOWN approach: starting with international and national macroeconomic forecasts, followed by industry forecasts, following by individual company and asset forecasts - BOTTOMS UP approach: opposite of above

Equity Valuation Process: Step 3 - SELECTING

Step 3 of the equity valuation process is SELECTING the appropriate valuation model: - Absolute Valuation Models - Relative Valuation Models - Sum-of-the-Parts Valuation (aka Breakup Value or Private Market Value)

Equity Valuation Process: Step 4 - CONVERTING

Step 4 of the equity valuation process is CONVERTING forecasts into a valuation: After selecting the appropriate valuation model to use and entering the basic fundamental information, an analyst should perform SENSITIVITY ANALYSIS and subject the data to SITUATIONAL ADJUSTMENTS.

Equity Valuation Process

The Equity Valuation Process involves these steps: 1) UNDERSTANDING the business 2) FORECASTING company performance 3) SELECTING the appropriate valuation model 4) CONFERTING forecasts to a valuation 5) APPLYING valuation conclusions mnemonic: U.F.S.C.A. ("oofska")

Pure Play Method

The Pure Play Method is used to estimate the equity beta of a non-public or thinly traded company. 1) find comparable publicly traded company 2) unlever the comparable company's beta βasset = βequity[1/(1+ (1-t)(D/E))] *D/E & t → use comparable company data 3) relever the asset beta calculated in step 2 βequity = βasset[1+ (1-t)(D/E)] *D/E & t → use target company data *Remember, this only calculates β. You will need to insert β into CAPM to find Re. Then continue to insert Re into WACC if needed.

Rational Efficient Markets Theory (Formulation)

The Rational Efficient Markets Formulation argues that markets are not efficient. It asserts that investors will not incur the costs of gathering and analyzing market information if mispricings did not exist in the market.

Sum Of The Parts Valuation (aka Breakup Value or Private Market Value)

The Sum of the Parts Valuation approach might be selected by an analyst trying to determine the equity value of a conglomerate (company made up of a number of different seemingly unrelated businesses) This method involves evaluating all of the various segments of a company separately and then summing them to determine the company's total value. A "Conglomerate Discount" may need to be applied in order to account for: - the company's lack of focus - the inefficiencies in captal allocation across business divisions - endogenous factors such as the fact that a company acquiring unrelated entities is normally doing quite poorly themselves.

Build Up Method

The build up method is generally applied to closely held companies (where betas are not available) Re = Rf + equity risk premium + size premium + company specific premium equity risk premium → usually estimated with reference to equity indices of publicly traded companies size risk premium → inversely related to the size of the company (smaller company = larger size risk premium) company specific risk premium → a premium for unsystematic risk that cannot be diversified away for a privately-held company

Equity Valuation Process: Step 1 - UNDERSTANDING

The first step in the equity valuation process involves gaining an UNDERSTANDING of the business that is being evaluated and the environment (industry, competition, location, economic cycle, etc.) that it operates in. -How attractive are the inudstry(ies) in which the company operates in? Are there prospects for sustained profitability? (see Porter's 5 Forces) - What is the company's relative competitive position in the industry? What is it's competitive strategy? (see Corporate Strategies) - How well has company executed it strategy and what are the prospects for future execution? (see Financial Statement Analysis, Sources of Information, Sources of ESG Information)

Fair Market Value

The price at which an asset can be exchanged between knowledgeable, willing parties in an arm's length transaction. Market prices tend to reflect Fair Value. Fair Value is appropriate for measuring the value in buy-sell agreements among owners of private business and in assessing taxes. Fair Value is also used in impairment testing.

Selecting A Discount Rate

Valuing a Firm (FCFF) → Use WACC to discount the forecasted future cash flows to the firm: = FCFF / (1 + WACC) Valuing equity only (FCFE) → Use required return on equity (Re) to discount the forecasted future cash flows to equity: = FCFE / (1 + Re) NOTE: Cash flows may be stated in NOMINAL (includes effects of inflation) or REAL (does not include effects of inflation) terms. If cash flows are in NOMINAL (REAL) terms you must use the NOMINAL (REAL) discount rate.

Weighted Average Cost of Capital (WACC)

WACC = Rd(1-t)(Wd) + Re(We) Wd = (D/E) / (1+ D/E) We = 1 - Wd NOTES: Marginal tax rates are preferred over effective tax rates when calculating WACC. When calculating WACC make sure to use the MARKET VALUE OF DEBT and EQUITY, *not* the book value. If target debt to equity ratio is given, that may be more appropriate to use since actual D/E can change over time.