Study Session 10 : Valuation Concepts
Quantitative Methods Study Session 10 Valuation Concepts 30. : Applications and Processes 31. Valuation Concepts LOS 30.a Define/Explain CFAI V4 p. 6, Schweser B3 p. 9 Intrinsic Value (IV): True underlying value of the security given complete understanding Estimated Value (VE): Investor estimate of intrinsic value Market Price (P): Current price Two Sources of Perceived Mispricing: VE P = (IV P) + (VE IV) 2 Study Session 10 : Valuation Concepts Quantitative Methods Valuation Concepts 30. : Applications and Processes Valuation Concepts LOS 30.b Explain/Contrast CFAI V4 p. 7, Schweser B3 p. 10 Other Value Concepts Going Concern Value: Typically the relevant intrinsic value for publicly traded companies; assumes assets remain in place and continue to produce cash flow into the future via continuing operations Liquidation Value: The value if the firm ceases to operate, all assets are sold, and the firm is dissolved Orderly Liquidation Value: Assumes adequate time to realize liquidation value 3 2
LOS 30.c Describe/Justify CFAI V4 p. 8, Schweser B3 p. 10 Other Value Concepts Fair Market Value: Price at which an arm s length transaction between a willing and informed buyer and willing and informed seller. Usually, market price is equal to fair market value. Investment Value: Value to a specific buyer including the value of perceived synergies. Useful for valuation in acquisitions. 4 LOS 30.e Describe CFAI V4 p. 12, Schweser B3 p. 12 Porter s Elements of Industry Analysis 1. Intra-industry rivalry 2. New entrants 3. Substitutes 4. Supplier power 5. Buyer power 6 Study Session 10 : Valuation Concepts LOS 30.d Describe CFAI V4 p. 9, Schweser B3 p. 10 Uses of 1. Stock selection our focus 2. Inferring inputs from the market vs. history 3. Projecting worth of company actions 4. Fairness opinions for mergers 5. Planning and consulting maximum s/h value 6. Communication with investors 7. Valuing private business 8. Portfolio management 5 LOS 30.e Describe CFAI V4 p. 12, Schweser B3 p. 12 Porter s Elements of Competitive Strategy 1. Cost leadership lowest cost producer 2. Differentiation unique products or services 3. Focus target segment(s) of industry using either of the above strategies 7 3
LOS 30.e Describe CFAI V4 p. 12, Schweser B3 p. 12 Evaluating the Quality of Financial Statement Information is Important Revenue Recognition and Gains Early revenue recognition Misclassification of non-operating income Expenses and Losses Too little or too much reserves Inappropriate capitalization of expenses Off-Balance-Sheet Financing understate liabilities Operating Cash Flow may be artificially inflated 8 LOS 30.g Describe/Explain CFAI V4 p. 25, Schweser B3 p. 14 Sum-of-the-Parts Valuation Sum-of-the-parts: Value each division separately and add the component values to obtain whole company value. Conglomerate Discount (CD): Sum-of-theparts value market price. Reasons for C.D.: Internal capital inefficiency, endogenous factors, and research measurement errors. 10 Study Session 10 : Valuation Concepts LOS 30.f Contrast/Describe CFAI V4 p. 22, Schweser B3 p. 13 Absolute vs. Relative Valuation Absolute valuation models: Intrinsic i value based on fundamental characteristics EPS, asset turns and leverage, return on equity, growth (g) (e.g., DDM, free cash flow, residual income) Relative valuation models: Value derived from relative comparison to similar assets, based on law of one price P/E, P/B, P/CF, P/S models 9 LOS 30.h Explain CFAI V4 p. 27, Schweser B3 p. 15 Appropriate Valuation Approach Consistent with characteristics of company Understand d the company and how its assets create value Based on quality and availability of data DDM problematic when no dividends P/E problematic with highly volatile earnings Consistent with purpose of analysis Free cash flow vs. dividends for controlling interest 11 4
Wrap Up: Process Model suitability Quality of the inputs financial statement analysis, footnotes Absolute versus relative valuation 12 LOS 31.a Distinguish CFAI V4 p. 45, Schweser B3 p. 21 Seven 1. Holding Period Return (HPR) capital gains plus any cash flow stated as a percentage of the initial investment: HPR = (P 1 P 0 + CF 1 ) / P 0 HPR = Price appreciation + dividend yield You see this equation everywhere in CFA land 2. Realized Return historical return based on observed prices and cash flows Can be calculated as an HPR 14 Study Session 10 : Valuation Concepts Quantitative Methods Valuation Concepts 31. Valuation Concepts LOS 31.a Distinguish CFAI V4 p. 45, Schweser B3 p. 21 Seven 3. Expected Return return based on forecasts of a future price and cash flows Think: forecast return 4. Required Return the minimum return an investor requires given the asset s risk Frequently calculated with the CAPM 5. Return from Convergence return expected/realized as market price converges to intrinsic value 15 5
LOS 31.a Distinguish CFAI V4 p. 45, Schweser B3 p. 21 Seven 6. Discount Rate rate used to determine the present value of an investment 7. Internal Rate of Return (IRR) the rate that equates the discounted cash flows to the current market determined price Again, you see this calculation frequently in CFA land (capital budgeting, YTM, cash flow yield, etc.) 16 LOS 31.b Calculate/Interpret CFAI V4 p. 50, Schweser B3 p. 23 Equity Risk Premium (ERP) Required Return for a Stock The ERP can be used to determine the required return for an individual security given its level of systematic risk Average equity Risk-free rate risk premium R R R R i f M f Beta (systematic risk) 18-3 Study Session 10 : Valuation Concepts LOS 31.b Calculate/Interpret CFAI V4 p. 50, Schweser B3 p. 23 Equity Risk Premium (ERP) Equity Risk Premium additional return above the risk-free rate investors require for holding (risky) equity securities Think: Required return RFR The risk-free rate should be equal to the investor s investment horizon T-Bills for short horizons T-Bonds for longer holding periods 17 LOS 31.b Calculate/Interpret CFAI V4 p. 50, Schweser B3 p. 23 Strengths and Weaknesses of Approaches to Estimating the ERP 1. Historical ERP historical mean difference between broad market equity index and T-bill Strength objective and simple Weaknesses: Assumes stationary of mean and variance of returns over time Upwardly biased due to survivorship bias Which risk-free rate to use? 19 6
LOS 31.b Calculate/Interpret CFAI V4 p. 50, Schweser B3 p. 23 Strengths and Weaknesses of Estimating the ERP 2. Forward-Looking ERP utilizes current market conditions and expectations concerning economic and financial variables Strength does not require stationary Weaknesses: Requires frequent updates Makes lots of assumptions 20 LOS 31.b Calculate/Interpret CFAI V4 p. 50, Schweser B3 p. 23 Forward-Looking ERP Example: Ibbotson-Chen (Macro-economic model) ERP = Y + [(1 + E(I))(1 + g R )(1 + PEG) 1] R f Where: Y = dividend yield E(I) = Expected inflation PEG = PE growth due to market correction g R = Real growth rate 3. Survey consensus of experts Strength easy to obtain Weakness wide disparity between opinions 22 Study Session 10 : Valuation Concepts LOS 31.b Calculate/Interpret CFAI V4 p. 50, Schweser B3 p. 23 Forward-Looking ERP 1. Gordon Growth Model E(R) = D 1 / P 0 + g = Y + g ERP = E(R) R f = Y + g R f 2. Macroeconomic Model use macroeconomic and financial variables such as inflation, earnings growth, and so forth Strength robust results Weakness used only with developed countries 21 LOS 31.c Estimate Capital Asset Pricing Model (CAPM) CAPM: Single Factor Required Return on Equity Model Expected equity Risk-free rate risk premium Single Factor Model R R R R i f M f Beta (systematic risk) Example: Rf = 4%, ERP = 3.9%, = 0.8, then: Req. return = 4 + 0.8(3.9) = 7.12% 23-4 7
LOS 31.c Estimate Multifactor Models of Required Return Multifactor Models: Use multiple factors to explain returns Required return = Rf + RP 1 + RP 2 + + RP n Where RP = Risk premium = (sensitivity) (factor) Factor sensitivity asset s s sensitivity to a factor Think: Beta (the one sensitivity in the CAPM) Factor risk premium return driver Think: ERP (the single factor in the CAPM) 24 LOS 31.c Estimate Various Required Return on Equity Models Fama-French Model Example: Risk-free rate of 3% Small Cap factors and sensitivities (Market index Rf) Factor 5% Sensitivity 1.1 (Small Big) returns 3% 0.4 High B/M Low B/M 2% 0.8 R i = 3% + 1.1(5%) + 0.4(3%) 0.8(2%) = 8.1% 26-2 Study Session 10 : Valuation Concepts LOS 31.c Estimate Two types of models Multifactor Models of Required Return Arbitrage models Fama-French Pastor-Stambaugh Arbitrage Pricing Model (BIRR version) Ad hoc model Build-up (i.e., bond yield + risk prem) 25-1 LOS 31.c Estimate Various Required Return on Equity Models Pastor-Stambaugh Model adds a liquidity factor to the Fama-French Model Factor Sensitivity (Market index Rf) 5% 1.1 (Small Big) returns High B/M Low B/M Liquidity premium R i = 3% + 1.1(5%) + 0.4(3%) 0.8(2%) 0.1(4%) = 7.7% 27 3% 2% 4% 0.4 0.8 0.1-1 8
LOS 31.c Estimate Various Required Return on Equity Models Arbitrage Pricing Model: Competitor to CAPM Factors not specified BIRR version is closest to accepted factors: 1. Investor confidence risk 2. Time horizon risk 3. Inflation risk 4. Business-cycle risk 5. Market-timing risk Do not memorize 28-1 LOS 31.c Estimate Various Required Return on Equity Models Build-Up Method Used with closely held companies Used when beta estimates unobtainable E(r) = Rf + ERP + size premium + company specific premium Inputs will be given Method does not use betas! Notice 30-1 Study Session 10 : Valuation Concepts LOS 31.c Estimate Assume: Various Required Return on Equity Models Risk-free rate of 3% Using three factors and sensitivities Factor Sensitivity Investor confidence risk 2% 1.1 Time horizon risk 4% 1.2 Inflation risk 3% 0.8 R i = 3% + 1.1(2%) + 1.2(4%) + 0.8(3%) = 12.4% 29-1 LOS 31.d Explain CFAI V4 p. 63, Schweser B3 p. 32 Beta Estimation: Public Firms Public company betas: Estimated with regression Regress the company s returns on the returns of the overall market index R company = + (R market ) Index choice: S&P 500 Interval: Five years, monthly data Beta drift: Observed tendency of a computed beta to migrate towards 1.0 31-1 9
LOS 31.d Explain CFAI V4 p. 63, Schweser B3 p. 32 Beta Estimation: Thinly Traded and Nonpublic Firms Four-step procedure (called a pure play) 1. Identify a publicly traded firm with similar industry characteristics 2. Estimate the beta of the publicly traded firm using regression (last slide) B E 3. Unlever the beta B unlevered = [1/(1+(D/E comp.firm ))]B E 4. Relever beta B nonpublic = [1+(D/E nonpublic )]B unlevered D/E ratio of the nonpublic firm 32 LOS 31.f Explain CFAI V4 p. 80, Schweser B3 p. 34 International Considerations in Required Return Calculations Exchange rates compute the required return in the home currency and adjust it by the forecast for the change in the exchange rate Emerging market premium use a developed market benchmark and add an emerging market premium 34 Study Session 10 : Valuation Concepts LOS 31.e Describe CFAI V4 p. 62, Schweser B3 p. 34 Strengths and Weaknesses of the Required Rate of Return Approaches CAPM simple, p, easy to compute, single factor model Simplicity comes with potential loss of explanatory power Multi-factor models higher explanatory power More complex and expensive Build up simple Ad hoc and uses historical values 33 LOS 31.g Explain CFAI V4 p. 81, Schweser B3 p. 35 Weighted-Average Cost of Capital Weighted average of rates of return required by capital suppliers (WACC): Required returns WACC w e r e w d r d 1 t MV weights OR target weights 35-2 10
LOS 31.h Evaluate CFAI V4 p. 82, Schweser B3 p. 35 Pairing of Discount Rate With Cash Flows Firm value = FCFF, discount at WACC Equity value = FCFE, discount at R E Use FCFE when capital structure are not volatile Use FCFF with high debt levels, negative FCFE Equity value = firm value MV of debt Big Point: You must align the discount rate with the cash flows! 36-2 Study Session 10 : Valuation Concepts Keys to the Exam Seven return concepts Estimating the equity risk premium CAPM, Fama-French, and related models Beta estimation WACC 37 11
12 C l a s s D i s c u s s i o n Q u e s t i o n s Use the following information to answer Questions 1 4. MegaCorp, Inc. (MG) CAPM Data and Estimates FFM Data and Estimates Risk-free rate 2.25% 2.25% Market (equity) risk premium 6.00% 6.00% Size premium 2.00% Value premium 4.30% Beta 1.07 1.11 Size beta 0.14 Value beta 0.00 1. The required return on equity for MegaCorp using the capital asset pricing model (CAPM) is closest to: A. B. C. 8.41%. 8.67%. 8.83%. 2. The required return on equity for MegaCorp using the Fama-French model (FFM) is closest to: A. B. C. 8.39%. 8.63%. 9.19%. 3. The most accurate interpretation of MegaCorp s value beta is: A. B. C. the market capitalization factor of MegaCorp is the same as the overall market. MegaCorp stock has neither a value nor growth bias. there will be a significant value risk premium effect on MegaCorp s required return. 4. Based on the data provided, MegaCorp is most likely: A. B. C. experiencing less market risk than the average firm. larger than the average company, as evidenced by its negative size beta. smaller than the average company, as evidenced by its negative size beta. 5. A common stock has the following characteristics: Market beta 1.3 Size beta 0.17 Value beta 0.49 Liquidity beta 0.25 The style of a company with the following stock characteristics is most likely to be: A. large-cap growth. B. small-cap value. C. small-cap growth.
13 C l a s s D i s c u s s i o n S o l u t i o n s 1. B The equation for CAPM is: r i = R F + (β i ) market risk premium r i = 2.25% + 1.07(6.00%) r i = 8.67% A is incorrect. This answer was obtained by multiplying the risk-free rate times the market beta and then adding it to the market risk premium. C is incorrect. This answer was obtained by adding the risk-free rate to the market risk premium and then multiplying this total by the market beta. 2. B The solution using the Fama-French model is: r i = R mkt F + β i RMRF + βi size SMB + βi value HML = 225. % + 1. 11( 600. %)+ ( 0. 14) 200. % + 0 ( 430. % ) = 863. % A is incorrect. This answer was obtained by incorrectly multiplying the market risk premium times the CAPM market beta, not the FFM market beta. C is incorrect. This answer was obtained by incorrectly using a positive, instead of a negative, size beta (0.14 instead of 0.14). 3. B The Fama-French model (FFM) incorporates three risk premiums to determine the required rate of return: r = R + β RMRF + β SMB+ β HML i F i mkt i size i value The value beta is used with the high minus low (HML) factor to estimate the value risk premium. The average returns of low book-to-market portfolios are subtracted from the average returns of high book-to-market portfolios to obtain the HML factor. A value beta greater than zero indicates a high book-to-market value for the company, which means it has a value bias. A value beta less than zero indicates a low book-to-market value, thus a growth bias. A value beta of zero has no growth or value bias. A is incorrect. This answer relates to the FFM s small minus big (SMB) factor, which has to do with the effect of size (market capitalization) on the required rate of return. The value beta is not related to size, but rather to market-to-book value. C is incorrect. Because the value beta is zero, there will not be a value premium effect on MegaCorp s required return; zero is the neutral value for both the size and value betas. This is in contrast to the market beta where 1.0 is the neutral value. A zero value beta means MegaCorp s stock has no growth or value bias.
14 4. B The Fama-French model (FFM) incorporates three risk premiums to determine the required rate of return: r = R + β RMRF + β SMB+ β HML i F i mkt i size i value The size beta is used with the small minus big (SMB) factor to estimate the size risk premium. The average returns of three small-cap portfolios minus the average return on three large-cap portfolios is used to obtain the SMB factor. A size beta less than zero is an indication that the firm is larger than the average firm. This is the case for MegaCorp. A size beta greater than zero indicates a firm is smaller than average. A is incorrect. The firm s market beta is 1.11, which indicates it has above average market risk (not less market risk). C is incorrect. Because the size beta is less than zero, MegaCorp is larger than the average firm. 5. C The stock is most likely that of a small-cap growth company. Positive size beta indicates the firm is smaller than average, making it small-cap. Positive liquidity beta is typical for small-cap stocks as they often trade in less liquid markets; the negative value beta implies a growth orientation. A is incorrect. The positive size beta indicates the firm is smaller than average, making it small-cap. The growth portion is correct because the firm has a negative value beta. B is incorrect. The negative value beta indicates a negative sensitivity to the value factor; this implies a growth orientation.