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Concepts
Valuation

Description
Equity Valuation : Application and Process
Definition : Process of determining the value of an assets, by :
(1) using model, based on variables that influence the findamental value of the asset
(2) compare with other observable market value of similar assets
General steps in equity valuation process :
1
...
Forecast the company performance
3
...
Convert forecast into valuation
5
...
Fair market value : price that a willing, informed and able seller would trade an asset to a willing, informed and able buyer
2
...
Stock selection : purchase / hold / sale of stocks, by comparing (1) intrinsic value with its market price ; or (2) comparing its price with comparable stocks' price
2
...
Projecting value of corporate actions : determine the value of proposed corporate mergers, acquisitions, divestitures, management buyouts, recapitalisations
4
...
Planning and consulting : evaluate the effects of proposed corporate strategies on firm's stock price, to pursue those that have greatest value to shareholders
6
...
Valuation of private business
8
...
Industry analysis - Porter's 5 forces :
- Threat of new entrants
- Threat of substitutes
- Bargaining power of buyers
- Bargaining power of suppliers
- Rivalry amongst existing competitors
2
...
Performance analysis : based on the info from fim's reports and releases
...
Issues related to
earning quality includes:
- Accelerating or premature recognition of income (e
...
: record sales before shipment / acceptance ; bill and hold)
- Reclassifying gain and non-operating income → distort the financial result of con nuance opera ons, hiding underperformance/decline in sales
- Expense recognition and losses (delaying recognition of expenses, capitalising expenses, classifying operating expenses as non-operating expenses)
- Amortisation, depreciation and discount rates (pension plan obligation)
- Off-BS issues

Absolute valuation model / Relative 1
...
Relative valuation mdel : estmiate value on an asset in relation to values of other similar assets, e
...
:
- P/E ratio : Firm's P/E > Comparable companies P/E → overvalued rela ve to other firms
Sum-of-ther-parts valuation /
Conglomerate discount

1
...
Conglomerate discount : Markdown to the value of a company operating in multiple unrelated industries (compared to other single-industry peers)
...
g
...
Whether the model fits the characteristics of the company (does it pay dividends? Is earnings growth estimatable? Does it have significant intangible assets?)
2
...
Whether the model suitable, given the purpose of the analysis
(*) Using multiple models and examining the differences in valuation could reveal the impact of assumptions and the perspective of the analysis on the estimated value

Concepts

Description
Return concepts

Holding period return

𝐻𝑜𝑙𝑑𝑖𝑛𝑔 𝑝𝑒𝑟𝑖𝑜𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 =

𝑃 + 𝐶𝐹 − 𝑃
𝑃

Realised return /
Expected return

Realised return : historical return, based on past observed prices and CFs
Expected return : return based on forecasts of future prices and CFs

Required return

Minimum return required by an investor, given the asset's risks
Riskier assets → Higher required return

Price convergence

Price convergence : If expected return ≠ required return → addi onal return from convergence of price to intrinsic value
𝑉 −𝑃
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 = 𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 + 𝑃𝑟𝑖𝑐𝑒 𝑐𝑜𝑛𝑣𝑒𝑟𝑔𝑒𝑛𝑐𝑒 𝑡𝑜 𝑖𝑛𝑡𝑟𝑖𝑛𝑠𝑖𝑐 𝑣𝑎𝑙𝑢𝑒 = 𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 +
𝑃

Discount rate

Rate used to find the PV of investment
...
Definition : return in excess of risk-free rate that investors requires for holding equity securities
Equity risk premium = Required return on equity indes - Risk-free rate
2
...
g
...
risk-free rate over time

- Use current info and expectations concerning economics and financial
variables

Strength :

- Objective
- Simple
- If investors are rational → historical es mates is unbiased

- Does not rely on assumption of stationarity
- Less subject to survivorship bias

Weakness :

- Assumption of constant mean and variance over time
- Subject to survivorship bias, if only surviving form are included in the sample
→ upward bias

Example:

Gordon growth model

- Gordon growth model
- Supply-side model
- Estimates from surveys
GGM equity-risk premium = (1-year forecasted dividend yield on market index) + (LT earning growth rate) - (LT government bond yield)
Weakness:
- estimates change over time → need to be updated
...
In case of mul ple growth stage, required rate of returm = IRR from this equa on :
Equity index price = PV-rapid + PV-transition + PV-mature

Supply-side estimates

1
...
Strength : Use proven and current info
3
...
Definiton : use the opinion from a sasmple of people
...
Strength : easy to obtain
3
...
E
...
:
1
...
Time horizon risk : unexpected change in the difference between return of LT G-bonds and T-bills
3
...
Business cycle risk : unexpected change in the level of real business activity
5
...
Country spread model
Required return on emerging market = Corresponding required return in developed market + premium for emerging market
Premium for emerging market = Bonds yield in emerging market - Corresponding bonds yield in developed market

Appropriateness of rate of return
used as discount rate

2
...
Bottom up :
equity valuation models
- Start with analysis of individual company / reported segments
- Revenue projection : based on historical revenue growth ; or company’s new product introductions over the forecast horizon
2
...
Hybrid = Bottom p + Top down
...
Growth relative to GDP growth : Relationship between GDP and company sales (e
...
: Revenue growth = GDP growth + x% ; or Revenue growth = GDP × (1 + x%)
2
...
COGS is closely related to revenue
Forecast COGS = (Historical COGS / Revenue) × Estimated future revenue; or
Forecast COGS = (1 - Gross margin) × Estimated future revenue
2
...
Should examine the gross margin of competitors to check the reasonableness of future gross margin estimates
...
Should examine the volume and price of firm's input → improve the quality of forecastd COGS
5
...
SGA are less sensitive to changes in sales volume, tend to growth gradually as firm grows
- R&D : set by management → uncorrelated to revenue
- Expenses for HQ, management salaries, IT operation : fixed cost
2
...
Gross interest expenses = Gross debt × Market interest rates
2
...
Net interest expenses = Gross interest expenses - Interest income on Cash and ST debt securities

Forecasting Income tax expenses

1
...
Effective tax rate = Income tax expenses / Pretax income
3
...
Forecasted inventory = Forecasted annual COGS / Inventory turnover
2
...
PPE is determined by depreciationadn CAPEX
- Approach 1 : PPE is assumed to grow @ same rate as revenue
- Approach 2 : Project future capital neds by understanding copany's operations and future plans
- Approach 3 : Separate CAPEX for maintenance and CAPEX for growth
...
Threat of substitute products
(Porter's 5 forces) on the prices and
costs
2
...
Bargaining power of suppliers

- ↑ bargaining power of suppliers → ↓ prospect of earning growth

4
...
Threat of new entrants

- Low threat of new entrants → ↑ pricing power and prospect earning growth

Forecast sales and costs when
1
...
No hedging
- Monitor production costs by product category / geographic location
- Focus on factors that affect input price (weather, gov regulation, tax, tariff, characteristics of input markets)
- Must make assumptions about the company pricing strategy, and the effect of price increase on unit sales
+ Temporary increase input costs → cut other costs
- Effect of increase selling price depend on demand elasticity of the product
+Elastic demand → % reduc on in sales > % increase in price → Total revenue decrease
+ Demand elasticity : most affected by the availability of substitute products
+ Firm quick to increase price → Decline sales volumes ; Firm slow to increase price → decline in gross margin

Effect of technological
developments on demand, selling
prices, costs and margins

1
...
Some advances in technology ↑ subs tutes or create a wholy new products
3
...
Buy side analyst : appropriate forecast horizon = expected holding period for a stock
2
...
In case of recent impactful events (M&A, restructuring) :
- These events should be considered as temporary
- Forecast horizon should be long enough that the perceived benefits of those events could be realised (or not)
4
...
Approach 1 : assume continuance of previous cycle revenue growth rate → pro forma financial results
2
...
Approach 3 : DCF
- Key inputs : CF / Earnings measure ; and expected future growth rate
- Expected CF / Earnings should be normalised to a mid-cycle value, not affected by temporary initiatives and events
- Recognised inflection point - point when the future will not be like the past, due to change in competitive environment of the company or industry, or change in overall economy
...
Estimate revenue growth and future expected revenue
2
...
Estimate SGA
4
...
Estimate income tax expense and cash taxes, take into account changes in DTA / DTL
6
...
Use historical depreciation and CAPEX to estimate future CAPEX and net PPE for BS
8
...
investment = PV of future
CF = PV of future dividend
- Less volatile than other measures

Disadvantage

- Difficult to apply to firm that do not currently
pay dividend
- Take perspective of a minority stakeholder

- Can be applied to many firms

- Company has history of dividend payments
- Clear dividend policy, related to firm's earnings
- Perspective of minority shareholders

Most appropriate when

DDM for single / multiple periods

One-period DDM

𝑉 =

𝐷 +𝑃
1+𝑟

𝑉 =

𝐷
𝐷 +𝑃
+
1+𝑟
1+𝑟

Two-period DDM

Multiple-period DDM

𝑉 =

𝐷
1+𝑟

+

𝐷
1+𝑟

+⋯+

- Could be applied to negative FCF / non-dividend
firms
- Significant capital requirement → nega ve FCF
for many years (due to tech revolution,
- Difficult to apply, require in-depth analysis
competitive, rapid expansion) → complicated and - Difficult to be accurate when FR is not
less reliable
transaprent or poor quality earnings
- Firms with no history of dividend payment /
payment history is not clear and not related to
earnings
- FCF that related with the profitability
- Perspective of controlling shareholders

𝐷 +𝑃
1+𝑟

(*) use CF and NPV in the calculator for easier calculate
Gordon growth model

𝑉 =

𝐷 × (1 + 𝑔)
𝐷
=
𝑟−𝑔
𝑟−𝑔

Assumption:
- Firm expected to pay dividend D1 in 1 year
- Dividend growth at constant rate g
-gPresent value of growth
opportunities

Definition : Firm's return > required rate of return → benefit from inves ng in growth opprtuni es rather than paying dividend
→ Fundamental value = PV of future dividend + PVGO
𝐸
𝑉 =
+ 𝑃𝑉𝐺𝑂
𝑟
Equity value include 2 components :
- Value of assets in place = PV of perpetual CF of E
- PV of future investment opportunities (PVGO)

Justified leading / trailing P/E

Justified P/E : based on firm's fundamentals
Leading P/E : Based on earning forecast for the next period

𝐿𝑒𝑎𝑑𝑖𝑛𝑔 𝑃𝐸 =

𝑃
𝐷 × (1 + 𝑔) 𝐷
1
1 − 𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒
=
=
×
=
𝐸
𝐸 × 𝑟−𝑔
𝐸
𝑟−𝑔
𝑟−𝑔

Trailing P/E : based on earning forecast for the previous period

𝑇𝑟𝑎𝑖𝑙𝑖𝑛𝑔 𝑃𝐸 =
Value of perpetual preferred shares

Strengths / Limitations of GGM

𝑃 =

𝑃
𝐷 × (1 + 𝑔) (1 − 𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒) × (1 + 𝑔)
=
=
𝐸
𝐸 × (𝑟 − 𝑔)
𝑟−𝑔

𝐷
𝑟

1
...
Limitations :
- Sensitive to growth rate and required rate of return (difficult to precisely estimate)
- Cannot be easily applied to non-dividend paying firm
- Unpredictable growth of firm → difficult to apply + unreliable results

- Firms with no dividend history
- Firms with negative FCF in foreseeable future
- Transparent FR + high quality earnings

Assumptions and reasons for
Overall assumptions :
selection of 2-stage DDM, H-model
- Forecast dividends into the future, and discount back to PV to find intrinsic value
and 3-stage DDM
- Over the LT, growth rates tends to revert to LT rate ≈ LT GDP growth rate + LT inflation rate (from 2% to 5%)
1
...

2
...
3-stage DDM : for firms that are expected to have 3 distinct stage of earnings growth
Compare between growth phase /
transition phase and maturity
phase
Earning growth

Initial growth phase

Transition phase

Maturity phase

Very high

Above average, but declining

Stable at LT level

Capital investment

Significant requirements

Declining

Stable at LT level

Profit margin

High

Above average, but declining

Stable at LT level

FCFE

Negative

Maybe positive, but increasing

Stable at LT level

ROE vs
...
GGM
2
...
Project cash dividend on the basis of these estimates
Step 3 : Estimate the normalised level of growth at the end of supernormal growth rate to estimate terminal value
Step 4 : Discount to PV

Sustainable growth rate

1
...
From NI

FCFF = NI + NCC + i × (1-t) - FCInv - WCInv

2
...
From EBIT

FCFF = EBIT × (1-t) + NCC - FCInv - WCInv

4
...
Approach 1 : Calculate historical FCF, and applied growth rate
/ FCFE
2
...
Single stage model
value
2
...
Method of comparables : value a stock based von avg price multiples of similar companies's stock
...
g
...
Method of forecasted fundamentals : value stock based on ratio of its value from DCF model to some fundamental variable (E
...
: PV of DCF/EPS)
Justified price multiple / Actual
multiple

P/E ratio

Justified price multiple : what the multiple should be if stock is fairly valued
Actual multiple = Current multiple
- Actual multiple > Justified multiple → Overvalued
- Actual multiple < Justified multiple → Undervalued
- Actual multiple = Justified multiple → Fairly valued

𝑇𝑟𝑎𝑖𝑙𝑖𝑛𝑔 𝑃𝐸 =

𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
𝑃
𝐷 × (1 + 𝑔) 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑎𝑦𝑜𝑢𝑡 𝑟𝑎𝑡𝑖𝑜 × (1 + 𝑔)
=
=
=
𝐸𝑃𝑆 𝑝𝑣𝑒𝑟 𝑝𝑟𝑒𝑣𝑖𝑜𝑢𝑠 12 𝑚𝑜𝑛𝑡ℎ𝑠 𝐸
𝐸 × (𝑘 − 𝑔)
𝑘−𝑔

𝐿𝑒𝑎𝑑𝑖𝑛𝑔 𝑃𝐸 =

𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
𝑃
𝐷
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑎𝑦𝑜𝑢𝑡 𝑟𝑎𝑡𝑖𝑜
=
=
=
𝐹𝑜𝑟𝑒𝑐𝑎𝑠𝑡𝑒𝑑 𝐸𝑃𝑆 𝑜𝑣𝑒𝑟 𝑛𝑒𝑥𝑡 12 𝑚𝑜𝑛𝑡ℎ𝑠 𝐸
𝐸 × (𝑘 − 𝑔)
𝑘−𝑔

1
...
Disadvantages
- Volatile, transitory portion of eanings → difficult to apply P/E
- Management discretion of accounting practices → distort reported earnings → reduce comparability of P/E
3
...
Advantages
- Book value is usually positive → could be used even when P/E could not
- BV is more stable than EPS → could ued when EPS is too high / too low / vola le
- Apropriate measure of net asset value for firms that primarily hold liquid assets (finance, investment, insurance, banking)
- Useful for firm that expected to go out of business
- P/B helps explain difference in LT avg stock returns
2
...
g
...
g
...
Common adjustments
- Tangible BV = BV of equity - Intangibe assets
- Significant off-BS items
- Adjust to ensure compatibility (e
...
: FIFO vs
...
Impact of fundamental variables
- Positively related to ROE
- Larger spread between ROE and k → Higher P/B ra o

P/S ratio

𝑃𝑆 𝑟𝑎𝑡𝑖𝑜 =

𝑀𝑉 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 𝐸
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑎𝑦𝑜𝑢𝑡 𝑟𝑎𝑡𝑖𝑜 × (1 + 𝑔)
1−𝑔
=
=
×
= 𝑃𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 × 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑎𝑦𝑜𝑢𝑡 𝑟𝑎𝑡𝑖𝑜 ×
𝑇𝑜𝑡𝑎𝑙 𝑠𝑎𝑙𝑒𝑠
𝑆𝑎𝑙𝑒𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
𝑆
𝑘−𝑔
𝑘−𝑔

1
...
Disavantages
- High sales growth does not always indicate hight operating profits
- Do not capture differences in cost structure
- Revenue recognition practices (e
...
: bill and hold) could distort revenue
3
...
Advantages
- CF is harder to manage than earnings
- P/CF is more stable than P/E
- No impact from he differences in quality of reported earnings
- Difference in P/CF are significantly related to differences in LT avg stocks returns
2
...
g
...
Impacts of fundamntal variables
- Decrease required return → Increase P/CF
- Increase growth rate → Increasse P/CF

Dividend yield

𝑇𝑟𝑎𝑖𝑙𝑖𝑛𝑔 𝐷/𝑃 =

4 × 𝑚𝑜𝑠𝑡 𝑟𝑒𝑐𝑒𝑛𝑡 𝑞𝑢𝑎𝑟𝑡𝑒𝑟𝑙𝑦 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑
𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

𝐿𝑒𝑎𝑑𝑖𝑛𝑔 𝐷/𝑃 =

𝐹𝑜𝑟𝑒𝑐𝑎𝑠𝑡𝑒𝑑 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑜𝑣𝑒𝑟 𝑛𝑒𝑥𝑡 4 𝑞𝑢𝑎𝑟𝑡𝑒𝑟𝑠
𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

𝐽𝑢𝑠𝑡𝑖𝑓𝑖𝑒𝑑 𝐷𝑃 =

𝑟−𝑔
1+𝑔

1
...
Disadvantages
- Ignore capital appreciation
- Dividend paid displace future earnings → trade off between current and future CF
3
...
Advantages
- More useful than P/E when comparing firms with different degrees of financial leverage
- Use in valuing capital-intensive businesses, with high level of depreciation and amortisation
- EBITDA usually > 0, while EPS is not
2
...
EBITDA is adequate if CAPEX = deprecia on
3
...
k
...
persistent / contining / core earnings) : earnings excluding non-recurring components (e
...
: gain/loss from selling assets, assets write down, provision for future
losses, changes in accounting estimates

Normalised earnigs

Normalised EPS : estimated EPS in the middle of the business cycle
2 methods for normalising earnings:
1
...
Method of avg ROE: Normalised EPS = Avg ROE × Current BVPS

Earnings yield (E/P)

1
...
P/E ratio : P/E < benchmark
- Stock is undervalued
- Stock is properly valued, but stock's growth rate < benchmark's growth rate
- Stock is properly valued, but stock's required return > benchmark's required return
2
...
Approach 1 : based on fundamentals

𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 = 𝐽𝑢𝑠𝑡𝑖𝑓𝑙𝑒𝑑 𝑙𝑒𝑎𝑑𝑖𝑛𝑔 𝑃/𝐸 × 𝐹𝑜𝑟𝑒𝑐𝑎𝑠𝑡𝑒𝑑 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠
𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 = 𝐽𝑢𝑠𝑡𝑖𝑓𝑖𝑒𝑑 𝑡𝑟𝑎𝑖𝑙𝑖𝑛𝑔 𝑃/𝐸 × 𝐹𝑜𝑟𝑒𝑐𝑎𝑠𝑡𝑒𝑑 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠
2
...
Earnings + NCC (often ignores items that affect CF, e
...
: non-cash revenue, changes in net WC)
2
...
FCFE (more volatile)
4
...
Differences in accounting methods (goodwill, DTA/DTL, FX adjustments, R&D, pension expense, tangible assets revaluation)
2
...
Differences in risks
4
...
g
...
Measure the manageria effectiveness and executive compensation
2
...
Measure goodwill impairment

Intrinsic value of common stock
under residual income model

𝑅𝐼 = 𝐸 − 𝑟 × 𝐵
𝑉 =𝐵 +

𝑅𝐼
1+𝑟

= 𝑅𝑂𝐸 × 𝐵

−𝑟×𝐵

= 𝑅𝑂𝐸 − 𝑟 × 𝐵

= 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 + 𝑇𝑜𝑡𝑎𝑙 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑅𝑒𝑠𝑖𝑑𝑢𝑎𝑙 𝐼𝑛𝑐𝑜𝑚𝑒

Advantage : Current book value is usually a substantive % of estimated intrinsic value → less sensi ve to terminal value es mes
Single stage residual income valuation model

Two stage residual income
valuation model

𝑅𝑂𝐸 − 𝑟 × 𝐵
𝑅𝑂𝐸 − 𝑟 × 𝐵
𝑅𝑂𝐸 − 𝑟 × 𝐵
→𝑟−𝑔=
→𝑔 =𝑟−
𝑟−𝑔
𝑉 −𝐵
𝑉 −𝐵
𝑉 = 𝐵 + 𝑃𝑉 𝑜𝑓 𝑖𝑛𝑡𝑒𝑟𝑖𝑚 ℎ𝑖𝑔ℎ 𝑔𝑟𝑜𝑤𝑡ℎ 𝑅𝐼 + 𝑃𝑉 𝑜𝑓 𝑐𝑜𝑛𝑡𝑖𝑛𝑢𝑖𝑛𝑔 𝑅𝐼
𝑉 =𝐵 +

Step 1 : Calculate current BV per share
Step 2 : Calculate RI in each year during the interim high-growth period (from year 1 to year t-1) and discount to PV @ required return on equity
Step 3 : Calculate continuing RI begin at the end of high-growth period and discount back to PV, using the following formula :

𝑃𝑉 𝑜𝑓 𝑐𝑜𝑛𝑡𝑖𝑛𝑢𝑖𝑛𝑔 𝑅𝐼

𝑅𝐼
1+𝑟−𝜔

=

In which:
𝜔 = 𝑝𝑒𝑟𝑠𝑖𝑠𝑡𝑒𝑛𝑐𝑒 𝑓𝑎𝑐𝑡𝑜𝑟 ; 0 ≤ 𝜔 ≤ 1
Two stage residual income
valuation model - assumptions

Assumption # 1 : RI persist @ current level forever→ ω = 1

𝑃𝑉 𝑜𝑓 𝑐𝑜𝑛𝑡𝑖𝑛𝑢𝑖𝑛𝑔 𝑅𝐼

=

𝑅𝐼
𝑅𝐼
𝑅𝐼
=
=
1+𝑟−𝜔 1+𝑟−1
𝑟

Assumption # 2 : RI drops immediately to 0 → ω = 0

𝑃𝑉 𝑜𝑓 𝑐𝑜𝑛𝑡𝑖𝑛𝑢𝑖𝑛𝑔 𝑅𝐼

=

𝑅𝐼
𝑅𝐼
𝑅𝐼
=
=
1+𝑟−𝜔 1+𝑟−0 1+𝑟

Assumption # 3 : RI declines over time to 0

𝑃𝑉 𝑜𝑓 𝑐𝑜𝑛𝑡𝑖𝑛𝑢𝑖𝑛𝑔 𝑅𝐼

=

𝑅𝐼
1+𝑟−𝜔

Assmption # 4 : RI declines to long-run level in mature industry

𝑃𝑉 𝑜𝑓 𝑐𝑜𝑛𝑡𝑖𝑛𝑢𝑖𝑛𝑔 𝑅𝐼

=

𝑃 − 𝐵 + 𝑅𝐼
𝐵 × 𝐹𝑜𝑟𝑒𝑐𝑎𝑠𝑡𝑒𝑑 𝑃/𝐵 − 𝐵 + 𝑅𝐼
=
1+𝑟
1+𝑟

(*) High persistence factors due to:
- Low dividend payouts
- Historically high RI persistence in the industry
(*) Low persistence factors due to :
- High ROE
- Significant level of non-reccuring items
- High accounting accruals
Strengths / Weaknesses of RI
model

Strengths :
- Terminal value does not dominate the intrinsic value estimate
- RI model uses accounting data → easy to find
- Applicable to firms that do not pay dividend / do not have positive expected FCF in short-run
- Applicable even when CF are volatile
- Focus on economic profitability rather than accounting profitability
Weaknesses :
- Accounting data could be manipulated by management
- Require significant adjustments
- Assume clean surplus relation holds / failure to hold has been taken into account

Appropriate / Inappropriate
circumstances of RI models

Appropriate circumstances
- Firm does not pay dividends / stream of payment is too volatile
- Negative expected FCF dor the foreseeable future
- Highly uncertain terminal value forecast → DDM / FCF are less useful
Inappropriate circumstances
- Clean surplus accounting relation is violate significantly
- Significant uncertainty about the estimates of BV and ROE

Accounting isses in applying RI
model

1
...
Variations from FV
- Operating leases → treat similar to finance lease
- Special purpose entities whose assets / liabilities are not reflected in FS of parent company → consolidated
- Reserves and allowances should be adjusted to reflect expected loss experience
- Inventory : LIFO should be adjusted to FIFO (adding LIFO reserve to inventory an equity)
- Pension asset / liability → adjusted to reflect the funded status of the plan (= FV of plan assets - Projected benefit obliga on)
- DTL / DTA : eliminated id not expected to reverse
3
...
Non-recurring items and other agressive accounting practices
- Non-recurring items (discontinued operations, accounting changes, unusual items, extraordinary items, restructuring changes) → not included in RI
- Aggressive accounting practies that overstatee BV and earnings (accelerate revenues to current period / deferring expenses to later period) → may be adopted
5
...
Matters to be considered:
- How reliable are earnings forecasts?
- Are there systematic violations of the clean surplus relation?
- Do poor quality accounting rules result in FS that bear no resemblance to economic reality of the business?

Concepts
Private company factors

Description
Private Company Valuation
1
...
Stock-specific factors
- Liquidity : Fewer potential owners, less liquid than public firm → liquidity discount
- Restriction on marketability : Often have agreements that prevent selling → reducing marketability
- Concentration of control : Control is focused in few shareholders → higher benefits for owners/managers at the expense of minority shareholders

Uses of private business valuation

1
...
Valuation is performed by both buyer and seller
- Bankruptcy proceedings : to determine whether the firm should be liquidated or reorganised
- Performance-based managerial compensation
2
...
Litigation-related valuations : Required for shareholder suit, damage claims, lost profit claims, divorce settlements

Different definitions of value

1
...
Fair value for FR : current price paid to purchase an asset / transfer a liability
- Arm's length transaction
- Well-informed buyer and seller
3
...
Market value : frequently used for appraisals of real estate and other real assets, characterised by:
- Willing seller and buyer
- Arm's length transaction
- An asset that has been marketed
- Well-inform and prudent buyer and seller
5
...
Intrinsic value

Approaches for private company
valuation

1
...
Most appropriate for firm in high growth phase
...
Market approach : price multiples, based on recent transactions of comparable assets
...
Asset- based approach : firm value = MV of assets - MV of liabilities
...
Capitalised CF method : single-stage FCF model

FCF method

𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑖𝑟𝑚 =

𝐹𝐶𝐹𝐹
𝑊𝐴𝐶𝐶 − 𝑔

𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 =

𝐹𝐶𝐹𝐸
𝑟−𝑔

2
...
Size premium : Added to discount rate for small private companies
2
...
Acquirer vs
...
Projection risk : Less availability of information + Managers's inexperience at forecasting → higher discount rate applied
5
...
Guideline public company method : use price multiples from trade data for public companies + adjustments for differences between the firm and comparables
- Control premium = Pro rata value of controlling interest - Pro rata value of non-controlling interest
- Issues to be considered when estimating control premium :
+ Transaction type : Strategic transaction vs
...
stock consideration
+ Reasonableness
- Methods to incorporate control premium
+ Method 1 : Acquisition price = Control premium + Equity value = Control premium + (Firm value - MV of debt)
+ Method 2 : Adjusted control premium on firm = Control premium on equity × (1 - Debt to asset ratio)
2
...
Financial transaction
+ Contingent consideration : reflect on the acquisition price any contingent on the achievement of specific company performance targets (receive FDA approval for a drug)
+ Type of consideration : Stock vs
...
Prior transaction method : Use the transactions data from the stock of actual subject company → most appropriate for non-controlling interest

Valuation - asset based approach

Value of firm equity = FV of assets - FV of liabilities
- Not use for going concern
- Lowest valuation result
- Appropriate situations :
+ Firms with minimal profits, little hope for better prospect → Liquida on value > Going concern value, due to assets could be put to be er use
+ Finance firms (banks), where assets and liabilities values can be based on market price and factors
+ Investment companies (REITs , closed-end investment companies), where underlying assets values are determined usin market or income approaches
+ Small companies or early-stage companies, with few intangible FA
+ Natural resource firms, where assets could be valued using comparables sales

Discount / Premium based on
control and marketability

1
...
Estimated discounts varied due to :
- Data used to estimate the discount, and analyst's interpretation of the discount
- Perceived importance of the invested position
- Allocation of sales, result control effect
- Relationship between various parties
- Protection to minority shareholders by state laws
- Likelihood of IPO or sale
- Payment of dividends
3
...
Discount for lack of marketability : arised when an interest in a firm could not be sold easily
2
...
Methods to estimate DLOM
- Method 1 : Compare restricted shares vs
...
Uniform Standards of Professional Appraisal Practice (USPAC) :
- Create by Appraisal Foundation
- Cover real estate, fixed income and private business valuation
- Not require to follow
2
...
Challenges in implementation of appraisal standards :
- Most buyers are unaware of the standards → Compliance is at discre on of the appraiser
- Most valuation reports are private → difficult for the organisa ons to ensure compliance to the standards
- Limited technical guidance on the use of standards, due to heterogeneity of the valuation



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Title: CFA Level 2 - Equity Investments
Description: I create this summary of knowledge related to CFA level 2 for my 2018 June exam. I got into the top 10% with this. Hope this can help you. Please note that this does not guarantee for your pass, which requires dedication, hardwork and consistency. In case having trouble with any part, please refer to CFA notebook/Schwesser. I also understand that there were several changes in curriculum since then. At this moment, I did not update the note accordingly. Please be aware of that.

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