5 Equity Valuation

2023CFA二级科目equity valuation，其中用FCFF与FCFE估值为本章难点，复习过程中需要重点理解FCF的计算

Equity Valuation

• Applications and processes
  • Different kinds of value
    • 类型
      • Intrinsic value (IV)
      • Fair market value (MV)
      • Investment value: the value of a stock to a particular buyer that depends on the buyer's specific needs and expectations, and perceived synergies with existing buyer assets
      • Liquidation value; the estimate of what the assets of the firm would bring if sold separately, net of the company's liabilities
    • 大小关系
      • Liquadation value最小，Investment value最大，其他两个在中间
      • 根据内在价值和市场价值之间的关系，可以判断市场有效性并指导投资决策
  • Planning: Valuation on individual security is not apply to Indexing strategy but active management
  • Quantitative and qualitative factors in valuation
    • Quantitative factors: Key source from company's accounting information and financial disclosures.Including B/S, I/S, CF/S, as well as the footnotes
    • Qualitative factors: measure industry performance, such as legal and regulatory environment
      • Quality of the firm's management team
      • The transparency of its performance
      • The analyst's confidence in the firm's
      • Industry's accounting practices
  • Abnormal return (α)
    • Ex ante alpha=expected holding period return-required return
    • Ex post alpha=actual holding period return-contemporaneous required return
  • Going concern assumption
    • Going concern: a company will continue to operate as a business, and the valuation models we will cover are all based on this assumption
    • Non-going-concern: a company will finish operating and all assets will be sold out, which is used to calculate liquadation value
  • Sum-of-the-parts valuation and conglomerate discount
    • Sum-of-the-parts value: the value an analyst obtained from individual parts of the firm and add them up to determine the value for the company as a whole. The value is sometimes called breakup value or private market value
    • Conglomerate discount: the value of a whole company is lower than the sum of its parts
    • Explanations for conglomerate discounts
      • Internal capital inefficiency: The company's allocation of capital to different divisions may not have been based on sound decisions
      • Endogenous (internal) factors: For example, the company may have pursued unrelated business acquisitions to hide poor operating performance
      • Research measurement errors: Some hypothesize that conglomerate discounts do not exist
• Discounted Dividend Valuation
  • The Gordon Growth model
    • Assumptions
      • The firm expects to pay a dividend, D1, in one year
      • Dividends grow indefinitely at a constant rate, g (which may be less than zero)
      • 3. The growth rate, g, is less than the required return,r
    • 公式
    • The value of a firm's equity has two components
      • The present value of a perpetual cash flow of equity
      • The present value of its present value of growth opportunities(PVGO)
        • 假设：公式将全部净利润用于发放股利
    • Justified P/E (b=1-dividend payout ratio)
      • Leading
      • Trailing
  • Discount cash flow model
    • Valuing perferred stock
  • Multistage dividend discount model
    • Two-stage DDM
    • Three-stage DDM
    • H-model
      • 特点:The growth rate starts out high, and then declines linearly until it reach the long-term growth rate
      • 公式
    • Spreadsheet modeling
      • 方法：用Excel等软件计算股利变化不规律时的情况
      • 优点
        • Flexibility
        • Computational accuracy
  • Three phases
    • 模型选择
    • Decline: not valuation; just short
  • Equity analysis
    • The sustainable growth rate (SGR)
      • 定义: the rate at which earnings (and dividends) can continue to grow indefinitely
      • 公式: SGR=b*ROE=(1-Dividend payout ratio)*ROE
    • Expansion (PRAT model)
    • DuPont model (five-step ROE)
• Free Cash Flow Valuation
  • Introduction
    • The reasons for using FCF (FCFF/FCFE)
      • Some companies do not pay dividends
      • The dividends paid differ significantly from the company's capacity to pay dividends
      • Free cash flows align with profitability within a reasonable forecast period with which the analyst is comfortable
      • FCF valuation takes a "control" perspective, while DDM takes a "minority" perspective
    • The relationship between FCFF and FCFE
    • FCF 选择的问题 （FCFF or FCFE）
      • FCFE is easier and more straightforward
      • If a company has negative FCFE, we use FCFF, which is usually positive
      • Equity value = Firm value - Market value of debt
      • Different values
        • The value of the firm
          • Firm value = FCFF discounted at the WACC
          • FCFFt= FCFFt-1× (1+g)
        • The value of equity
          • Equity value=FCFE discounted at the required return on equity(r)
          • The methods to estimate return
            • CAPM
            • Multifactor model
            • Build up method
          • Constant Growth Valuation Model
  • FCF公式
    • FCFF
      • From EBIT (核心公式)
      • From NI
      • From EBITDA
      • From CFO
    • FCFE
      • 核心公式
      • From NI
        • 注：这里计算NI时用的FCFE公式中的Int(1-t)实际上是债券利息支付，等于票面利率*面值，而FCFF中的Int(1-t)是利息费用，等于实际负债*市场利率，只有当债券账面价值与市场价值相等，即平价发行，二者相等，公式才成立，因此题目中通常会做出该假设
      • From EBIT
      • From EBITDA
      • From CFO
      • From target debt ratio (DR)
  • 计算公式中的项目
    • NCC(Non-cash charges) adjustments
    • WCInv
      • WC=CA (exclude cash) - CL (exclude debt, e.g., notes payable)
    • FCInv
      • 核心公式: FCInv = capital expenditures − proceeds from sales of long-term assets
      • 不同情况计算
        • If no long-term assets were sold during the year
          • 基于GV
          • 基于BV
        • If long-term assets were sold during the year
          • 基于GV
          • 基于BV
    • Net borrowing (NB)
      • net borrowing=debt1- debt0
      • 注: debt包含long and short-term(note payable)
    • 特殊情况： Free Cash Flow With Preferred Stock
      • FCFF=NI(total) + Int * (1-T) + NCC – WCInv- FCInv
      • FCFE=NI(common stock) + NCC – WCINV– FCINV +NB
      • NI(total)=NI(common stock)+preferred dividends
  • 根据财务报表计算FCF
  • 用FCF折现（模型与DDM中相同）
    • Single-stage
    • Two-stage: The value is the present value of the first stage's FCF plus the present value of the terminal value of the FCF
    • Three-stage: The value is the present value of the high-growth and transitional period's FCF plus the present value of the terminal value of the FCF
  • Sensitivity analysis: Some variables have a greater impact on valuation results than others. The importance of various forecasting errors can be assessed through this approach
• Market-Based Valuation: Price And Enterprise Value Multiples
  • Introduction
    • The method of comparables values a stock based on the average price multiple of the stock of similar companies
    • The economic rationale: Law of One Price
  • Price multiple
    • P/E
      • Advantages
        • Earnings power (EPS) is the primary determinant of investment value
        • The P/E ratio is popular in the investment community
      • Disadvantages
        • Earnings can be negative, which produces a meaningless P/E ratio
        • The volatile, transitory portion of earnings makes the interpretation of P/Es difficult for analysts
        • Management discretion within allowed accounting practices can distort reported earnings, and thereby lessen the comparability of P/Es across firms
      • 计算
      • Methods of normalizing EPS
        • Historical average EPS
          • The normalized EPS is estimated as the average EPS over some recent period,
          • The method ignores size effects
        • Average return on equity
          • Normalized EPS is estimated as the average return on equity (ROE) multiplied by the current book value per share (BVPS)
          • The reliance on BVPS reflects the effect of firm size changes
        • average EPS and ROE are often measured over the most recent business cycle
      • P/E-to-growth ratio (PEG)
        • 公式
        • The implied valuation rule is that stocks with lower PEGs are more attractive than stocks with higher PEGs
        • Disadvantages
          • The relationship between P/E and g is not linear, which makes comparisons difficult
          • The PEG ratio doesn't reflect the duration of the high-growth period for a multistage valuation model, especially if the analyst uses a short-term high growth forecast
    • P/B
      • 计算
        • 定义: P/B=P/BVPS
        • The computation of BVPS
          • Common shareholders' equity = shareholders' equity - prefer shareholders' equity
          • BVPS= common shareholders' equity / number of common stock shares
        • 计算式
          • P/B0=(ROE-g) / (r-g)
          • The P/B increases as
            • ROE increases
            • as the spread between ROE and r increases
      • Rationales for using P/B ratio in valuation
        • Book value is a cumulative amount that is usually positive, even when the firm reports a loss and EPS is negative. Thus, a P/B can typically be used when P/E cannot
        • Book value is more stable than EPS and it is an appropriate measure of net asset value for firms that primarily hold liquid assets
      • Disadvantages
        • P/Bs can mislead when there are significant size differences
        • Different accounting conventions can obscure the true investment in the firm made by shareholders
        • Inflation and technological change can cause the book and market value of assets to differ significantly
        • P/Bs do not recognize the value of nonphysical assets
    • P/S
      • Rationales for using price-to-sales (P/S) ratio
        • P/S is meaningful even for distressed firms
        • Sales revenue is not as easy to manipulate or distort as EPS and book value
        • P/S ratios are not as volatile as P/E multiples
        • P/S ratios are particularly appropriate for valuing stocks in mature or cyclical industries and start-up companies with no record of earnings
      • Disadvantages
        • Higher sales do not necessarily indicate higher operating profits
        • P/S ratios do not capture differences in cost structures across companies
        • Revenue recognition practices can still distort sales forecasts
      • P/S calculation
        • 变形
    • P/CF
      • Advantages
        • Cash flow is harder for managers to manipulate than earnings
        • Price to cash flow is more stable than price to earnings
        • Reliance on cash flow rather than earnings handles the problem of differences in the quality of reported earnings
      • Disadvantages
        • Items affecting actual cash flow from operations are ignored when the EPS plus noncash charges estimate is used
        • From a theoretical perspective, free cash flow to equity (FCFE) is preferable to operating cash flow. However, FCFE is more volatile than operating cash flow, so it is not necessarily more informative
    • EV/EBITDA
      • 公式
        • Enterprise value (EV) = market value of common stock + market value of preferred equity +market value of debt + minority interest – cash and investments
        • EBITDA = recurring earnings from continuing operations + interest + taxes + depreciation + amortization
      • Situations when EV/EBITDA is useful
        • Comparing firms with different degrees of financial leverage
        • Value capital-intensive businesses with high levels of depreciation and amortization
        • EBITDA is usually positive even when EPS is not
    • Dividend yield
    • Compare price multiple with benchmark
      • For P/E P/B P/S P/CF EV/EBITDA
        • If multiples < benchmark: the stock is undervalued
        • If multiples > benchmark, the stock is overvalued
      • For dividend yield
        • If multiples < benchmark, the stock is overvalued
        • If multiples > benchmark, the stock is undervalued
  • 技术分析
    • Momentum valuation indicators
      • Unexpected earnings (earnings surprise) = reported EPS − expected EPS
      • 存在问题：只考虑收益（EPS），没有考虑风险（标准差）
        • 解决: standardized unexpected earnings (SUE)
    • Relative strength indicator (RSTR): compare a stock's price or return performance during a given time period with benchmark
      • Its own historical performance
      • Some group of peer stocks
    • 计算 portfolio P/E
• Residual Income Valuation
  • Concept and calculation of residual income
    • 定义
      • Resisual income (RI) = NI – Equity capital * cost of equity
      • Economic value added (EVA) = NOPAT* (WACC- cost of capital)=EBIT*(1-t)-WACC
      • Market value added (MVA)= market value of equity + market value of debt − total capital
    • 计算
      • RI = Equity0* (ROE - re)
      • RI 的递推计算公式 （基于 clean surplus relation）
  • Residual income valuation model
    • Introduction
      • The two elements of residual income valuation model
        • Current book value of equity
        • Present value of expected future residual income
        • b0=current book value of equity
      • Difference with DDM & FCFE: a large portion of the estimated intrinsic value comes from the present value of the expected terminal value
    • Single-stage
      • 公式
      • The relation with justified price-to-book ratio
        • ROE > r
          • The present value of residual income >0
            • Market value > book value
              • The justified P/B ratio > 1
    • Continuing residual income (Two-stage model)
      • Three components: V0= B0+ (PV of interim high-growth RI) + (PV of continuing residual income)
      • Steps
        • Calculate the current book value per share
        • Calculate residual income in each year 1 to T − 1 during the interim high-growth period and discount them back to today at the required return on equity
        • Calculate continuing residual income that begins at the end of the high-growth period starting in year T, and then calculate the present value of continuing residual income as of the end of year T − 1
      • Assumptions
        • Assumption #1: Residual Income Persists at the Current Level Forever
        • Assumption #2: Residual Income Drops Immediately to Zero
        • Assumption #3: Residual Income Declines Over Time to Zero (market price=book value)
          • persistence factor(ω): The projected rate at which residual income is expected to fade over the life cycle of the firm, which is between zero and one
        • Assumption #4: Residual Income Declines to Long-Run Level in Mature Industry
    • Issues in applying residual income models
      • Clean Surplus Violations
        • Foreign currency translation gains and losses that flow directly to retained earnings under the current rate method
        • Certain pension adjustments
        • Gains/losses on certain hedging instruments
        • Changes in revaluation surplus (IFRS only) for long-lived assets
        • Changes in the value of certain liabilities due to changes in the liability's credit risk (IFRS only)
        • Changes in the market value of debt and equity securities classified as available-for-sale
      • Variations from Fair Value
        • Operating leases
        • Special purpose entities (SPEs)
        • Inventory
        • Deferred tax liabilities
• Private Company Valuation
  • Compare public and private company
    • Company-Specific Factors
      • Stage of lifecycle: Private companies are typically less mature than public firms
      • Size: Private firms typically have less capital, fewer assets and employees and can be riskier
      • Quality and depth of management: Smaller private firms may not be able to attract as many qualified applicants as public firms
      • Management/shareholder overlap: In most private firms, management has a substantial ownership position
      • Short-term investors : management may take a shorter-term view compared to private firms where managers are long-term holders of significant equity interests
      • Quality of financial and other information: A potential creditor or equity investor in a private firm will have less information and reduces private firm valuations
      • Taxes: Private firms may be more concerned with taxes than public firms due to the impact of taxes on private equity owners/managers
    • Stock-Specific Factors
      • Liquidity: Private company equity typically has fewer potential owners and is less liquid
      • Restrictions on marketability: Private companies often have agreements that prevent shareholders from selling
      • Concentration of control: The control of private firms is usually concentrated in the hands of a few shareholders
  • Definitions of Value
    • Fair market value
    • Fair value for financial reporting
    • Fair value for litigation
    • Market value:
    • Investment value
    • Intrinsic value
    • Liquidation value
  • Valuation process
    • Issues for financial statement adjustments
      • Estimating Normalized Earnings
        • Exclude nonrecurring and unusual items
        • Artificially low earnings may also be the result of excessively high owner compensation or of personal expenses charged to the firm
        • Any real estate owned by the firm may merit treatment separate from that of firm operations
      • Strategic and Nonstrategic Buyers
        • In a strategic transaction, valuation of the firm is based in part on the perceived synergies with the acquirer's other assets
        • A financial transaction assumes no synergies, as when one firm buys another in a dissimilar industry
      • Estimating Cash Flow
        • FCFF is usually more appropriate when the significant changes in the firm's capital structure are anticipated
        • the FCFF valuation is less sensitive to the degree of financial leverage assumed in the analysis than the FCFE valuation
      • Factors that require adjustment (when estimating the discount rate for private companies)
        • Size premiums: Size premiums are often added to the discount rates for small private companies
        • Availability and cost of debt
        • Projection risk: Because of the lower availability of information from private firms and managers who are inexperienced at forecasting
        • Lifecycle stage
        • Acquirer versus target: When acquiring a private firm, some acquirers will incorrectly use their own (lower) cost of capital, rather than the higher rate appropriate for the target, and arrive at a value for the target company that is too high
    • Valuation approaches
      • Income approach
        • Free Cash Flow Method (a two-stage model)
        • Capitalized Cash Flow Method (single-stage model): capitalization rate = required rate of return - growth rate
        • Excess Earnings Method
          • Excess earnings = firm earnings - the earnings required to provide the required rate of return on working capital -earnings of fixed assets
            • excess earnings=value of intangible assets
      • Market-based valuation
        • Market multiple
          • Large private firm: is usually based on EBIT or EBITDA multiples
          • Small private companies with limited assets: net income multiples
        • The three methods
          • guideline public company method (GPCM): 要考虑 control premium
          • The guideline transactions method (GTM)：不考虑 control premium
          • The prior transaction method (PTM)
        • Valuation discounts
          • Discount for Lack of Control (DLOC)
            • 公式
            • Premiums (discounts) for controlling interest
          • Discount for Lack of Marketability(Liquidity) (DLOM)
      • Asset-based approach
        • 计算: value of firm equity = fair value of assets - fair value of liabilities
        • The approach might be appropriate in these circumstances
          • Firms with minimal profits and little hope for better prospects
          • Finance firms where their asset and liability values can be based on market prices and factors
          • Investment companies where the underlying assets values are determined using the market or income approaches
          • Small companies or early stage companies with few intangible assets
          • Natural resource firms where assets can be valued using comparables sales
    • Three models used to estimate the required rate of return
      • CAPM
      • Expanded CAPM: includes additional premiums for size and firm-specific (unsystematic) risk
      • Build-up method: When it is not possible to find comparable public firms for beta estimation