L2 flash cards equity - SS 10

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  • 1. Sum of Parts Valuation (SOTP) The sum-of-the-parts analysis is used to value a company with business segments in different industries that have different valuation characteristics. It is a useful methodology to gain a quick overview of a company by providing a detailed breakdown of each business segment's contribution to earnings, cash flow, and value. Many companies can be viewed as a candidate for break-up valuation. Study Session 10, Reading 30
  • 2. Conglomerate Discount Sometimes a SOTP valuation does not equal the value of the whole company. This is called the conglomerate discount. The conglomerate discount occurs because investors can achieve diversification on their own. As a result, the whole is often worth less than the sum of its parts. Investors often point to the conglomerate discount as a market inefficiency and view the discount as a way to buy undervalued stocks. The conglomerate discount is the reason why many conglomerates spin off or divest subsidiary holdings. Study Session 10, Reading 30
  • 3. Characteristics of a Good Model Analysts can often choose between a range of valuation models when undertaking valuation of a particular stock. A good valuation should:  Fit the characteristics of the company like dividend payout, earnings growth estimate, intangible assets of the company. Fit the quality and availability of data. Fit the purpose of analysis  Should be selected after evaluation multiple models  Study Session 10, Reading 30
  • 4. Different Return Concepts 1. Holding Period Return 2. Realized and Expected Holding Period Return 3. Required Returns 4. Price Convergence 5. Discount Rate and the Internal Rate of Return (IRR) Study Session 10, Reading 31
  • 5. Types of Return Concepts 1. Holding Period Return - is the increase in price of an asset plus any cash flow received from that asset, divided by the initial price. - measurement of a holding period can be a day, month or even a year. - cash flow is usually received at the end of period Study Session 10, Reading 31
  • 6. 2. Realized and Expected Holding Period Return - A realized return is a historical return s a historical return based on past observed prices and cash flows - Expected returns are based on forecasts of future prices and cash flows. 3. Required Returns - assets required return is the minimum return an investor requires given the assets risk. - can also be seen as the opportunity cost for investing in the asset. Study Session 10, Reading 31
  • 7. 4. Price Convergence - If the expected return is not equal to the required return, investors can generate a return from convergence of price to intrinsic value. 5. Discount Rate and the Internal Rate of Return (IRR) - The discount rate is the rate used to find the present value of an investment. - The IRR is a market determined rate of return that equates the present value of discounted cash flows to the current price of the security. - If markets are efficient, then IRR represents the required return. Study Session 10, Reading 31
  • 8. Preliminary Steps in Estimating the Historical Equity Risk Premium • • • • Select an equity index Select a time period Calculate the mean return of an index Select a proxy for risk free rate Study Session 10, Reading 31
  • 9. Historical Estimate of Equity Risk Premium • The historical equity risk premium is the difference between the historical mean return of a broad based equity market index and the risk free rate over a given time period. • Objective and simple, it will be unbiased if the investors were rational. • Assumes that mean and variance will be constant over time (assumes stationarity). However the equity risk premium is actually counter cyclical (ie low during good times and high during bad times). Study Session 10, Reading 31
  • 10. Historical Estimate of Equity Risk Premium (cont.) • The equity risk premium is susceptible to survivorship bias. If stocks with depressed stock prices (and hence high equity risk premiums) drop out of the index, the returns from the index may be artificially high, hence artificially boosting the equity risk premium. • The equity risk premium is lower if the geometric average mean is used instead of a historical mean. • If the yield curve is upward sloping, the use of longer term bonds rather than shorter term bonds to estimate the risk free rate will cause the estimated risk premium to be smaller. Study Session 10, Reading 31
  • 11. Forward Looking Estimates • Forward looking estimates of the equity risk premium use current information and expectations concerning economic and financial variables. • The forward looking equity risk premium does not assume stationarity and are less susceptible to survivorship bias. Study Session 10, Reading 31
  • 12. Three Types of Forward Looking Estimates 1. Gordon Growth - estimates risk premium as expected dividend yield plus expected growth rate minus current long term government bond yield 2. Supply side estimate - (macroeconomic model): estimates equity risk premium based on relations between macroeconomic variables and financial variables 3. Survey estimates - use the consensus of opinions from a sample of people Study Session 10, Reading 31
  • 13. Methods Used to Estimate the Required of Return Capital Asset Pricing Model CAPM Multifactor Models (Has greater explanatory power than CAPM.)  Fama Fench Model (The Fama and French Model is a multifactor model that attempts to account for higher returns generally associated with small cap stocks.) Study Session 11, Reading 31
  • 14. Methods Used to Estimate the Required of Return (Continuation) Pastor Stambaugh Model  The Pastor Stambaugh Model adds a liquidity factor to the Fama French Model.  The baseline factor for the liquidity factor beta is zero. Less liquid assets should have a positive beta while more liquid assets should have a negative beta.  Therefore, investors in less liquid assets require compensation via higher returns. Study Session 11, Reading 31
  • 15. Methods Used to Estimate the Required of Return (Continuation) Macroeconomic Multifactor Models  Macroeconomic multifactor models use factors associated with economic variables that can reasonably be believed to affect cash flows and appropriate discount rates.  The model by Burmeister Roll and Ross incorporates the following factors: confidence risk, time horizon risk, inflation risk, business cycle risk and market timing risk. Study Session 11, Reading 31
  • 16. Methods Used to Estimate the Required of Return Built Up Method (Continuation) (Similar to risk premium approach) Study Session 11, Reading 31
  • 17. Preliminary Steps in Estimating Beta for Public Companies Select an equity index (popular choice being S&P 500 and NYSE composite) Select the length and frequency of sample data (popular choice being 2 weeks of data) Adjusted Beta for Public Companies Beta is often adjusted for beta drift which refers to the observed tendency of beta to revert to a value of 1.0 over time.  Adjusted beta = (2/3 * regression beta) +(1/3*1.0)   Study Session 10, Reading 31
  • 18. Beta Estimates for Thinly Traded Stocks and Nonpublic Companies  Identify a publicly traded benchmark company  Estimate the beta of the benchmark company  Unlever the beta using the relationship unlever beta = beta / (1+debt/equity)  Lever the beta using the same relationship as above but different weights of debt and equity Study Session 10, Reading 31
  • 19. Typically Trade Offs Between the Different Models Used to Estimate Required Returns  Capital Asset Pricing Model (CAPM)  simple as it uses only one factor  however it may not be simple selecting that one factor (for e.g. the stock may trade in more than one market thus making the choice of one index particularly difficult).  it also tends to have low explanatory power. Study Session 10, Reading 31
  • 20. Typically Trade Offs Between the Different Models Used to Estimate Required Returns  Multifactor Models  have higher explanatory power  they are more complex and expensive • Built Up Models  simple and can be applied to closely held companies   use historical estimates and may not be relevant to current  markets. Study Session 10, Reading 31
  • 21. Exchange Rate Risks International investments expose investors to exchange rate risks if not hedged.  To compensate for anticipated changes in exchange rates, an analyst should compute the required return in home currency and then adjust it using forecasts for changes in the relevant exchange rates. Two Methods for Building Risk Premia Into Required Returns     Country spread model: use a developed market as a benchmark and add premium for emerging markets.  Country risk rating model: estimate a regression equation using the equity risk premium for developed countries as dependent variable and risk ratings for those countries as independent variables. Study Session 10, Reading 31
  • 22. Weighted Average Cost of Capital (WACC) WACC is defined as:  Tax rate is the marginal tax rate, which better reflects the cost of raising funds.  WACC is appropriate for valuing a total firm. Which Discount Rate When? The discount rate needs to correspond to the type of cash flow being discounted.  Cash flows to the entire firm should be discounted by the WACC.  Cash flows in excess of debt service costs should be treated as cash flows to equity and discounted at the required return to equity. Nominal cash flows should be discounted at nominal discount rate and real cash flows should be discounted at real discount rates. Study Session 10, Reading 31
  • 23. Porter’s Five Forces Threat of new entrants in the industry: likelihood of new entrants emerging to alter the competitive landscape in a way that reduces the share of value added realized by a firm Threat of substitutes: do currently available alternative products put a ceiling on the price buyers are willing to pay for industry’s current products. Bargaining power of buyers: how strong is the negotiating power of the buyers of the firm or industry’s output Bargaining power of suppliers: how strong is the negotiating power of the suppliers of the industry Rivalry among existing competitors: will existing firms compete away the value added component Study Session 10, Reading 32
  • 24. Factors Affecting the Threat of New Entrants Economies of scale make it difficult for new entrants to achieve critical mass. Product differences and brand identity may deter customers from switching to new brands without costly inducements. Switching costs that the product user will incur if they decide to use new entrants. Capital requirements to construct facilities and other infrastructure requirements. Access to distribution channels may be difficult for new entrants. Government policy may require licensing or other approvals to enter the industry. Cost and quality advantages for incumbent firms that may not be realized by new entrants. Study Session 10, Reading 32
  • 25. Factors Affecting the Threat of Substitutes  Relative price performance of substitutes.  Buyer’s propensity to substitute.   Switching costs incurred by the buyers.  Factors Affecting Bargaining Power of Buyers Low switching costs and readily available substitutes give the buyers leverage. Buyers price sensitivity depending upon qualitative factors such as brand identity, product differences, quality and performance. Study Session 10, Reading 32
  • 26. Factors Affecting Bargaining Power of Suppliers Differentiation of inputs that are acceptable to the industry. Presence of substitute inputs. Smaller number of suppliers increases supplier power. The more the volume sought by the employer, the harder they will work to maintain this volume and lower their bargaining power. Threat of forward integration. The greater the switching costs, the greater the supplier power. Study Session 10, Reading 32
  • 27. Factors Affecting the Degree of Rivalry Among existing competitors The more competitors, the greater the potential for rivalry. Industry growth means less competition between existing players.  High degree of operating and financial leverage.  Greater the participants commitment to business, the greater the likelihood of competitive behaviour.  Product differences make it more difficult to compete directly on price.  The shorter the shelf life, the greater the potential for price competition.  Existence of exit barriers will increase the potential for competition. Study Session 10, Reading 32
  • 28. Factors That Shape Industry Structure  Short Term Factors High industry growth diminishes rivalry but does not assure profitability if other forces are detrimental to profits. Improved technology can improve profitability but not if there is increased competition. Some low tech sectors can be profitable if other forces are favourable. Government policies can be good or bad and are prone to changes through time. Complementary products can be used in conjunction with firms products. Study Session 10, Reading 32
  • 29. Typical Reasons for Changes in Industry Structure Changes in the threat of new entrants can typically be due to the expansion of capacity by distributors. Changes in the bargaining powers of buyers or suppliers can be due to consolidation in the number of buyers or suppliers in the industry. Changes in technology may cause substitutes to become more or less viable. Changes in the number of competitors or changes in the leverage of an industry may make the rivalry in an industry more or less intense. Study Session 10, Reading 32
  • 30. Three Types of Strategy Altering the firm’s existing position: intentionally create changes in the five forces. Capitalizing the changes in the industry: whether the firm is able to capitalize on a change depends on its current positioning. Creating changes in the industry structure: either by enhancing overall value or by redistributing the value added in favour of industry participants. Study Session 10, Reading 32
  • 31. Three Prominent Categories of Future Cash Flows Dividends  These direct cash payments are a key component of an investor’s returns.  Dividends are typically more stable than earnings; small individual shareholders cannot influence dividends, so dividend based valuation may be most appropriate from their perspective.  Lot of companies do not pay dividends, but opt to reinvest 100% of earnings; different countries have different dividend cultures and dividend tax policies, so dividend valuation presents some inconsistencies in an international context. Study Session 10, Reading 33
  • 32. Three Prominent Categories of Future Cash Flows Free Cash Flows  Free cash flows are appropriate when the company pays no dividend, pays an unsustainable dividend, cash flows track company profits, and/or the investor is large and has the ability to perform a controlling interest.  There are two types of free cash flows for valuation: free cash flow to the firm and free cash flow to equity. Residual Income  Residual income attempts to capture the extra value that an investor can receive beyond the opportunity cost. Study Session 10, Reading 33
  • 33. Value of a Common Stock Using the Dividend Discount Model (DDM) One Period DDM  To determine the value of a stock using the DDM, we must estimate the dividend to be received during the period (D1), the expected sale price at the end of the holding period (P1), and the investor's required rate of return (r). Multi Period DDM  If you anticipate holding the stock for several years and then selling it, the valuation estimate is more difficult.  You must forecast several future dividend payments and estimate the sale price of the stock several years in the future. Study Session 10, Reading 33
  • 34. Value of a Common Stock Using the Dividend Discount Model (DDM) • Terminal Value in DDM  The terminal value can be estimated by liquidation of the firm’s assets in the terminal year and estimate what others would pay for the assets that the firm has accumulated at that point.  Multiples to earnings, revenues or book value can also be used to estimate the value in the terminal year.  Another method is to assume a stable growth rate and then the terminal value can be estimated using a perpetual growth model. Study Session 10, Reading 33
  • 35. Calculating the Value of Common Shares Using H Model The H-Model is a modification of the Two Stage DDM. Unlike other two-stage models where the growth rate is assumed to be a constant, the H-Model assumes that the growth starts at a higher rate, and then gradually declines until it becomes normal stable growth rate.  “H” represents half-life of the high growth period. Study Session 10, Reading 33
  • 36. Estimating Required Returns Based on the DDM Assuming that markets are efficient, DDM models can be used for the calculation of the expected rate of return on a stock. Other models such as the general two-stage DDM, threestage DDM and more complicated spreadsheet models can be solved for the effective rate of return only by iteration. > Change the discount rate until the present value of dividends and the terminal value is equal to the market price. > If we believe that the market price differs from the intrinsic value of a stock, we need to adjust the expected required rate of return accordingly. > This is the same approach that is used for the calculation of IRR in corporate finance. Study Session 10, Reading 33
  • 37. Evaluating a Stock Based on a DDM Estimate of the Value If the market price of a company's stock does not equal its intrinsic value, the expected holding-period return will differ from the required rate of return. This difference is called alpha or expected abnormal return.  Investors look for positive alphas (expected holding period return minus required rate of return), since these investments earn more than other assets with similar risk. Spreadsheet Modeling in Forecasting Dividends and Valuing Common Shares Estimating future dividends can be done through spreadsheet modelling. Two period or multiple period DDMs can be more easily facilitated through the use of spreadsheets. 10, Reading 33 Study Session
  • 38. Assumptions of GGM The future dividend stream will grow at a constant rate (g) for an infinite period. Required rate of return on equity is greater than growth rate of future dividends Valuation using GGM  To determine the value of the stock using the GGM, use the following formula:  The formula does not work for companies with dividend growth in excess of the required rate of return.  For such "growth companies", analysts employ two-stage or three-stage models. Usually companies eligible for evaluation using the GGM grow at a rate close to the expected long-term growth of gross domestic product (which consists of real growth and expected inflation). Study Session 10, Reading 33
  • 39. Present Value of Growth Opportunities (PVGO) • The PVGO allows analysts to calculate how much growth opportunities contribute to a company’s current share price: As a company generates positive earnings and retains these earnings, its book value of equity increases. However, in order for the positive retained earnings to create wealth for investors, the company’s return on equity must exceed its cost of equity. Percentage of a leading P/E related to PVGO = (PVGO/E1)/Leading P/E = (PVGO/E1)/(P0/E1) Study Session 10, Reading 33
  • 40. Justified Leading and Trailing P/E There are two types of price-to-earnings ratios:  A stock's trailing P/E (current P/E) is its current market price divided by the most recent four quarters' EPS.  The P/E published in financial newspapers' stock listings is the trailing P/E. The leading P/E (forward P/E or prospective P/E) is a stock's current price divided by next year's expected earnings. The Gordon Growth Model allows analysts to estimate the fundamentals-based value of the P/E ratio. The trailing ratio is calculated as: Study Session 10, Reading 33
  • 41. Value of Non-callable Fixed-Rate Perpetual Preferred Stock Fixed-rate perpetual preferred stock is a senior claim on a company's assets compared to its current stock. It entitles stockholders for a level stream of dividends into perpetuity. Payments of fixed-rate perpetual preferred dividends are made only after the firm pays its bond interest. Study Session 10, Reading 33
  • 42. Strengths of the Gordon Growth Model The GGM very clearly and simplistically defines the relationships among value and growth, required rate of return and the payout ratio. It allows us to more easily perform valuation of stable-growth, dividend-paying companies. It can be used for valuation of broad-based equity market indexes. It is useful for estimation of a terminal value in multiple-stage models. Study Session 10, Reading 33
  • 43. Limitations of the Gordon Growth Model GGM is highly sensitive to growth rate and required rate of return inputs. Very small variations in estimation of these inputs can lead to significantly different estimates of intrinsic value. It cannot be used to value non-dividend paying stocks. It cannot be used to value companies with unstable growth rates. Study Session 10, Reading 33
  • 44. Maturity Phases of a Business Growth Phase  During the growth phrase, companies enjoy supernormal growth which cannot be sustained in the long run.  Free cash flows are often negative because companies invest heavily in expanding operations.  Very low or zero dividend payments may occur when a majority of earnings are retained to finance growth. Study Session 10, Reading 33
  • 45. Maturity Phases of a Business Transitional Phase  Sales growth, prices and profit margins are declining as a result of intensifying competition in the industry. Earnings growth rates may be still above average but declining towards the growth rate for the overall economy.  Capital requirements typically decline often resulting in positive free cash flows and increasing dividend payout ratios. Study Session 10, Reading 33
  • 46. Maturity Phases of a Business Mature Phase  Profit margins have fallen to the average profitability of the economy.  Companies invest in projects that earn the cost of capital.  Growth is commensurate with the general economic growth. It is called the mature growth rate.  Dividend payout is significant. Study Session 10, Reading 33
  • 47. Estimating the Sustainable Growth Rate using DuPoint Analysis • Sustainable Growth rate  A growth rate is sustainable in the long run. A company can grow at this rate indefinitely in the future without changing the capital structure.  The sustainable growth rate can be estimated using the following formula: • Du Pont Model  A system of analysis has been developed that focuses the attention on all three critical elements of the financial condition of a company: the operating management, management of assets and the capital structure. This analysis technique is called the "DuPont Formula".  The ROE can be estimated using the Du Pont formula which is: Study Session 10, Reading 33
  • 48. Two Measures of Cash Flows • Free Cash Flow to Firm  Measures the cash produced for the debt and equity holders of the firm.  It starts with CFO.  Interest payments for the year are added back as they are available to the firm’s stakeholders.  Net capital expenditures are taken away as cash spent on them is not available to the firm’s stakeholders. Study Session 10, Reading 34
  • 49. Two Measures of Cash Flows • Free Cash Flow to Equity  Measures the cash which remains for stockholders.  It also starts with CFO, but doesn’t add in the interest payments as they are paid only to debtholders, and are thus not available to stockholders.  If the firm has to use cash to pay back debtholders it is money the stockholders don’t have.  Equally if the firm issues new debt, then the stockholders have in theory more cash. Study Session 10, Reading 34
  • 50. FCFE Approach vs Dividend Discount Approach FCFE assumes a control perspective. That is, all the cash flows are available to the stock owners. The Dividend Discount Model assumes that the valuation is done from a minority shareholders perspective. It assumes that only the dividends are available to the stock owners.  The Dividend Discount Model assumes that a relatively large component of the present value would be realized later in the future (which means that terminal value will be a large component of the total present value). Study Session 10, Reading 33
  • 51. Approaches for Forecasting FCFF and FCFE The simplest method is to assume a constant growth rate that is based on historical trends. To get a more precise forecast, analysts need to forecast the components of free cash flow by evaluating and capturing the complex relationships among the components of free cash flow.  Often, analysts start with the sales forecast. After that they analyze historical operating profit margin and two ratios: o Net investment in new fixed assets / sales increase, and o Investment in working capital / sales increase. Study Session 10, Reading 33
  • 52. Effect of Dividends, Share Repurchases and Issues, and Leverage on FCFF and FCFE  Dividends, share repurchases and share issues have no effect on FCFF and FCFE.  This is because these transactions are uses of free cash flows, but FCFF and FCFE are the cash flows available to investors or shareholders.  When calculating FCFF and FCFE we only consider how these cash flows are generated, and not how they are used. Transactions between the company and its shareholders (through dividends, share repurchases, and share issuances) do not affect free cash flow.  Changes in leverage have both a short-term and long-term effect on FCFE.  In the year of change, net borrowing increases FCFE.  In the long-run, assuming more debt means higher interest payments, partly compensated by an increase in the interest tax shield. Therefore, the long-run effect of higher leverage is the decrease in FCFE. o Study Session 10, Reading 33
  • 53. Net Income (NI) as a Proxy for Cash Flow Net Income (NI) includes non-cash charges like depreciation. These charges should be added back to arrive at FCFE. NI ignores investments in working capital and fixed assets. They should be subtracted to arrive at FCFE. NI ignores net borrowing which is a part of cash flow available to shareholders, but not a part of NI. Study Session 10, Reading 33
  • 54. Using EBITDA as a Proxy for Cash Flow EBITDA is a before-tax measure and doesn't reflect taxes paid. The discount rate applied to EBITDA would need to be a beforetax rate. The WACC used to discount FCFF is an after-tax rate.  EBITDA is a measure of operating activities only. It ignores investments a company makes in working capital and fixed assets.  Depreciation tax shield (the depreciation charge times the tax rate) is ignored by the EBITDA measure. Study Session 10, Reading 33
  • 55. Single-Stage, Two-Stage and Three-Stage FCFF and FCFE Models Single stage FCF models are similar to single stage Gordon Growth Models. In multi stage models (two or three stage) we have the option of forecasting either the growth rate of either FCFF (or FCFE) or specific components of FCFF (or FCFE). Company Valuation using Free Cash flow Models If a stocks model price is lower than the market price, the stock is considered undervalued in the market. Study Session 10, Reading 33