Study Session 1091acf2223c449e9aca09-573931475ab0c8bec3ec5b55f4da0a6c.r12.cf1.… · Intra-industry rivalry Equity Va luation LOS ... company value. ... Study Session 10 Equity Valuation:

Study Session 10Equity Valuation: Valuation Concepts

CFA_L2V2_Class_Lecture_Notes.indb 1 11/29/2012 4:36:29 PM

2St

udy

Sess

ion

10

Equi

ty V

alua

tion:

Val

uatio

n C

once

pts

Qua

ntita

tive

Met

hods

Stud

ySe

ssio

n10

Stud

ySe

ssio

n10

Valu

atio

n C

once

pts

30.E

quity

Val

uatio

n: A

pplic

atio

ns a

nd

Pro

cess

es

Valu

atio

n C

once

pts

31.R

etur

n C

once

pts

Qua

ntita

tive

Met

hods

Vl

tiC

t30

. Equ

ity V

alua

tion:

A

pplic

atio

ns a

nd P

roce

sses

Valu

atio

nC

once

pts

Valu

atio

n C

once

pts

pp

Mic

roec

onom

ic A

naly

sis

Equi

ty V

alua

tion

Intr

insi

c Va

lue

(IV):

True

und

erly

ing

valu

e of

th

ese

curit

ygi

ven

com

plet

eun

ders

tand

ing

Equi

ty V

alua

tion

LOS

30.a

Def

ine/

Expl

ain

CFA

I V4

p. 6

, Sch

wes

er B

3 p.

9

the

secu

rity

give

n co

mpl

ete

unde

rsta

ndin

gEs

timat

ed V

alue

(VE)

: Inv

esto

r est

imat

e of

in

trins

ic v

alue

Mar

ket P

rice

(P):

Cur

rent

pric

e

Two

Sour

ces

ofPe

rcei

ved

Mis

pric

ing:

© K

apla

n, In

c.

Two

Sour

ces

ofPe

rcei

ved

Mis

pric

ing:

VE

–P

= (IV

–P)

+ (V

E –

IV)

2

Mic

roec

onom

ic A

naly

sis

Oth

er V

alue

Con

cept

s�

Goi

ng C

once

rn V

alue

: Typ

ical

ly th

e re

leva

nt

intri

nsic

valu

efo

rpub

licly

trade

dco

mpa

nies

;

Equi

ty V

alua

tion

LOS

30.b

Exp

lain

/Con

tras

tC

FAI V

4 p.

7, S

chw

eser

B3

p. 1

0

intri

nsic

val

ue fo

r pub

licly

trad

ed c

ompa

nies

; as

sum

es a

sset

s re

mai

n in

pla

ce a

nd c

ontin

ue

to p

rodu

ce c

ash

flow

into

the

futu

re v

ia

cont

inui

ng o

pera

tions

�Li

quid

atio

n Va

lue:

The

val

ue if

the

firm

ce

ases

toop

erat

eal

lass

ets

are

sold

and

© K

apla

n, In

c.ceas

es to

ope

rate

, all

asse

ts a

re s

old,

and

th

e fir

m is

dis

solv

ed�

Ord

erly

Liq

uida

tion

Valu

e:A

ssum

es

adeq

uate

tim

e to

real

ize

liqui

datio

n va

lue

3


3St

udy

Sess

ion

10

Equi

ty V

alua

tion:

Val

uatio

n C

once

pts

Mic

roec

onom

ic A

naly

sis

Oth

er V

alue

Con

cept

s�

Fair

Mar

ket V

alue

: Pric

e at

whi

ch a

n ar

m’s

le

ngth

trans

actio

nbe

twee

na

willi

ngan

d

Equi

ty V

alua

tion

LOS

30.c

Des

crib

e/Ju

stify

CFA

I V4

p. 8

, Sch

wes

er B

3 p.

10

leng

th tr

ansa

ctio

n be

twee

n a

willi

ng a

nd

info

rmed

buy

er a

nd w

illing

and

info

rmed

se

ller.

Usu

ally

, mar

ket p

rice

is e

qual

to fa

ir m

arke

t val

ue.

�In

vest

men

t Val

ue: V

alue

to a

spe

cific

buy

er

incl

udin

gth

eva

lue

ofpe

rcei

ved

syne

rgie

s

© K

apla

n, In

c.incl

udin

g th

e va

lue

of p

erce

ived

syn

ergi

es.

Use

ful f

or v

alua

tion

in a

cqui

sitio

ns.

4

Mic

roec

onom

ic A

naly

sis

Use

s of

Equ

ity V

alua

tion

1. S

tock

sel

ectio

n—ou

r foc

us2

Infe

rrin

gin

puts

from

the

mar

ketv

shi

stor

y

Equi

ty V

alua

tion

LOS

30.d

Des

crib

eC

FAI V

4 p.

9, S

chw

eser

B3

p. 1

0

2. I

nfer

ring

inpu

ts fr

om th

e m

arke

t vs.

his

tory

3. P

roje

ctin

g w

orth

of c

ompa

ny a

ctio

ns4.

Fai

rnes

s op

inio

ns fo

r mer

gers

5. P

lann

ing

and

cons

ultin

g—m

axim

um s

/h

valu

e6

Com

mun

icat

ion

with

inve

stor

s

© K

apla

n, In

c.

6. C

omm

unic

atio

n w

ith in

vest

ors

7. V

alui

ng p

rivat

e bu

sine

ss8.

Por

tfolio

man

agem

ent

5

Mic

roec

onom

ic A

naly

sis

Port

er’s

Ele

men

ts o

f Ind

ustr

y A

naly

sis

1.In

tra-in

dust

ry ri

valry

Equi

ty V

alua

tion

LOS

30.e

Des

crib

eC

FAI V

4 p.

12,

Sch

wes

er B

3 p.

12

2.N

ew e

ntra

nts

3.S

ubst

itute

s

S

© K

apla

n, In

c.

4.S

uppl

ier p

ower

5.B

uyer

pow

er

6

Mic

roec

onom

ic A

naly

sis

Port

er’s

Ele

men

ts o

f Com

petit

ive

Stra

tegy

1.C

ost l

eade

rshi

p –

low

est c

ost p

rodu

cer

Equi

ty V

alua

tion

LOS

30.e

Des

crib

eC

FAI V

4 p.

12,

Sch

wes

er B

3 p.

12

pp

2.D

iffer

entia

tion

–un

ique

pro

duct

s or

se

rvic

es

3Fo

cus

–ta

rget

segm

ent(s

)ofi

ndus

try

© K

apla

n, In

c.

3.Fo

cus

–ta

rget

seg

men

t(s) o

f ind

ustry

us

ing

eith

er o

f the

abo

ve s

trate

gies

7


4St

udy

Sess

ion

10

Equi

ty V

alua

tion:

Val

uatio

n C

once

pts

Mic

roec

onom

ic A

naly

sis

Eval

uatin

g th

e Q

ualit

y of

Fin

anci

al

St

atem

ent I

nfor

mat

ion

is Im

port

ant

Rev

enue

Rec

ogni

tion

and

Gai

ns

Equi

ty V

alua

tion

LOS

30.e

Des

crib

eC

FAI V

4 p.

12,

Sch

wes

er B

3 p.

12

g�

Ear

ly re

venu

e re

cogn

ition

�M

iscl

assi

ficat

ion

of n

on-o

pera

ting

inco

me

Expe

nses

and

Los

ses

�To

o lit

tle o

r too

muc

h re

serv

es

© K

apla

n, In

c.

�In

appr

opria

te c

apita

lizat

ion

of e

xpen

ses

Off-

Bal

ance

-She

et F

inan

cing

–un

ders

tate

liab

ilitie

s

Ope

ratin

g C

ash

Flow

–m

ay b

ear

tific

ially

infla

ted

8

Mic

roec

onom

ic A

naly

sis

Abs

olut

e vs

. Rel

ativ

e Va

luat

ion

Abs

olut

eva

luat

ion

mod

els:

Iti

il

bd

fd

tlEq

uity

Val

uatio

nLO

S 30

.f C

ontr

ast/D

escr

ibe

CFA

I V4

p. 2

2, S

chw

eser

B3

p. 1

3

�In

trins

ic v

alue

base

d on

fund

amen

tal

char

acte

ristic

s—E

PS

, ass

et tu

rns

and

leve

rage

, ret

urn

on e

quity

, gro

wth

(g)

�(e

.g.,

DD

M, f

ree

cash

flow

, res

idua

l inc

ome)

Rel

ativ

eva

luat

ion

mod

els:

© K

apla

n, In

c.

�V

alue

der

ived

from

rela

tive

com

paris

on to

si

mila

r ass

ets,

bas

ed o

n la

w o

f one

pric

e�

P/E

, P/B

, P/C

F, P

/S m

odel

s

9

Mic

roec

onom

ic A

naly

sis

Sum

-of-t

he-P

arts

Val

uatio

n�

Sum

-of-t

he-p

arts

: Val

ue e

ach

divi

sion

se

para

tely

and

add

the

com

pone

ntva

lues

to

Equi

ty V

alua

tion

LOS

30.g

Des

crib

e/Ex

plai

nC

FAI V

4 p.

25,

Sch

wes

er B

3 p.

14

sepa

rate

ly a

nd a

dd th

e co

mpo

nent

val

ues

to

obta

in w

hole

com

pany

val

ue.

�C

ongl

omer

ate

Dis

coun

t (C

D):

Sum

-of-t

he-

parts

val

ue –

mar

ket p

rice.

�R

easo

ns fo

r C.D

.:In

tern

al c

a pita

l

© K

apla

n, In

c.

pin

effic

ienc

y, e

ndog

enou

s fa

ctor

s, a

nd

rese

arch

mea

sure

men

t err

ors.

10

Mic

roec

onom

ic A

naly

sis

App

ropr

iate

Val

uatio

n A

ppro

ach

Con

sist

ent w

ith c

hara

cter

istic

s of

com

pany

Ud

td

thd

hit

t

Equi

ty V

alua

tion

LOS

30.h

Exp

lain

CFA

I V4

p. 2

7, S

chw

eser

B3

p. 1

5

�U

nder

stan

d th

e co

mpa

ny a

nd h

ow it

s as

sets

cr

eate

val

ueB

ased

on

qual

ity a

nd a

vaila

bilit

y of

dat

a�

DD

M p

robl

emat

ic w

hen

no d

ivid

ends

�P

/E p

robl

emat

ic w

ith h

ighl

y vo

latil

e ea

rnin

gs

© K

apla

n, In

c.

pg

yg

Con

sist

ent w

ith p

urpo

se o

f ana

lysi

s�

Free

cas

h flo

w v

s. d

ivid

ends

for c

ontro

lling

inte

rest

11


5St

udy

Sess

ion

10

Equi

ty V

alua

tion:

Val

uatio

n C

once

pts

Mic

roec

onom

ic A

naly

sis

Wra

p U

p: E

quity

Val

uatio

n Pr

oces

s�

Mod

el s

uita

bilit

y

Equi

ty V

alua

tion

�Q

ualit

y of

the

inpu

ts—

finan

cial

sta

tem

ent

anal

ysis

, foo

tnot

es�

Abso

lute

ver

sus

rela

tive

valu

atio

n

© K

apla

n, In

c.12

Qua

ntita

tive

Met

hods

Valu

atio

n C

once

pts

31R

etur

nC

once

pts

Valu

atio

n C

once

pts

31.R

etur

nC

once

pts

Mic

roec

onom

ic A

naly

sis

Ret

urn

Con

cept

s

Seve

n R

etur

n C

once

pts

1.H

oldi

ng P

erio

d R

etur

n (H

PR)—

capi

tal g

ains

pl

usan

yca

shflo

wst

ated

asa

perc

enta

geof

LOS

31.a

Dis

tingu

ish

CFA

I V4

p. 4

5, S

chw

eser

B3

p. 2

1

plus

any

cas

h flo

w s

tate

d as

a p

erce

ntag

e of

th

e in

itial

inve

stm

ent:

�H

PR

= (P

1–

P 0+

CF 1

) / P

0

�H

PR

= P

rice

appr

ecia

tion

+ di

vide

nd y

ield

�Yo

u se

e th

is e

quat

ion

ever

ywhe

re in

C

FAl

d

© K

apla

n, In

c.14

CFA

land

2.R

ealiz

ed R

etur

n—hi

stor

ical

retu

rn b

ased

on

obse

rved

pric

es a

nd c

ash

flow

s

�C

an b

e ca

lcul

ated

as

an H

PR

Mic

roec

onom

ic A

naly

sis

Ret

urn

Con

cept

s

Seve

n R

etur

n C

once

pts

3.Ex

pect

ed R

etur

n—re

turn

bas

ed o

n fo

reca

sts

ofa

futu

repr

ice

and

cash

flow

s

LOS

31.a

Dis

tingu

ish

CFA

I V4

p. 4

5, S

chw

eser

B3

p. 2

1

fore

cast

s of

a fu

ture

pric

e an

d ca

sh fl

ows

�Th

ink:

fore

cast

retu

rn4.

Req

uire

d R

etur

n—th

e m

inim

um re

turn

an

inve

stor

requ

ires

give

n th

e as

set’s

risk

�Fr

eque

ntly

cal

cula

ted

with

the

CA

PM

© K

apla

n, In

c.15

5.R

etur

n fr

om C

onve

rgen

ce—

retu

rn

expe

cted

/real

ized

as

mar

ket p

rice

conv

erge

s to

intri

nsic

val

ue


6St

udy

Sess

ion

10

Equi

ty V

alua

tion:

Val

uatio

n C

once

pts

Mic

roec

onom

ic A

naly

sis

Ret

urn

Con

cept

s

6.D

isco

unt R

ate—

rate

use

d to

det

erm

ine

the

pres

entv

alue

ofan

inve

stm

ent

Seve

n R

etur

n C

once

pts

LOS

31.a

Dis

tingu

ish

CFA

I V4

p. 4

5, S

chw

eser

B3

p. 2

1

pres

ent v

alue

of a

n in

vest

men

t7.

Inte

rnal

Rat

e of

Ret

urn

(IRR

)—th

e ra

te th

at

equa

tes

the

disc

ount

ed c

ash

flow

s to

the

curr

ent m

arke

t det

erm

ined

pric

e�

Aga

in, y

ou s

ee th

is c

alcu

latio

n fr

eque

ntly

inC

FAla

nd(c

apita

lbud

getin

g

© K

apla

n, In

c.16

freq

uent

lyin

CFA

land

(cap

ital b

udge

ting,

Y

TM, c

ash

flow

yie

ld, e

tc.)

Mic

roec

onom

ic A

naly

sis

Ret

urn

Con

cept

s

Equi

ty R

isk

Prem

ium

(ER

P)�

Equi

ty R

isk

Prem

ium

—ad

ditio

nal r

etur

n ab

ove

the

risk-

free

rate

inve

stor

sre

quire

for

LOS

31.b

Cal

cula

te/In

terp

ret

CFA

I V4

p. 5

0, S

chw

eser

B3

p. 2

3

abov

e th

e ris

k-fre

e ra

te in

vest

ors

requ

ire fo

r ho

ldin

g (ri

sky)

equ

ity s

ecur

ities

�Th

ink:

Req

uire

d re

turn

–R

FR�

The

risk-

free

rate

sho

uld

be e

qual

to th

e in

vest

or’s

inve

stm

enth

oriz

onT

Bill

fh

thi

© K

apla

n, In

c.17

�T-

Bills

for s

hort

horiz

ons

�T-

Bon

ds fo

r lon

ger h

oldi

ng p

erio

ds

Mic

roec

onom

ic A

naly

sis

Ret

urn

Con

cept

s

�R

equi

red

Ret

urn

for a

Sto

ck�

The

ERP

can

beus

edto

dete

rmin

eth

e

Equi

ty R

isk

Prem

ium

(ER

P)

LOS

31.b

Cal

cula

te/In

terp

ret

CFA

I V4

p. 5

0, S

chw

eser

B3

p. 2

3

�Th

e ER

P ca

n be

use

d to

det

erm

ine

the

requ

ired

retu

rn fo

r an

indi

vidu

al s

ecur

ity

give

n its

leve

l of s

yste

mat

ic ri

skAv

erag

e eq

uity

ris

k pr

emiu

mR

isk-

free

rate

© K

apla

n, In

c.18

��

if

Mf

RR

RR

��

��

Bet

a (s

yste

mat

ic ri

sk)

-3

Mic

roec

onom

ic A

naly

sis

Ret

urn

Con

cept

s

Stre

ngth

s an

d W

eakn

esse

s of

A

ppro

ache

s to

Est

imat

ing

the

ERP

1.H

isto

rical

ERP—

hist

oric

alm

ean

diffe

renc

e

LOS

31.b

Cal

cula

te/In

terp

ret

CFA

I V4

p. 5

0, S

chw

eser

B3

p. 2

3

1.H

isto

rical

ERP

hist

oric

al m

ean

diffe

renc

e be

twee

n br

oad

mar

ket e

quity

inde

x an

d T-

bill

�

Stre

ngth

—ob

ject

ive

and

sim

ple

�W

eakn

esse

s:�

Ass

umes

sta

tiona

ryof

mea

n an

d va

rianc

e of

re

turn

sov

ertim

e

© K

apla

n, In

c.19

retu

rns

over

tim

e �

Upw

ardl

y bi

ased

due

to s

urvi

vors

hip

bias

�

Whi

ch ri

sk-fr

ee ra

teto

use

?


7St

udy

Sess

ion

10

Equi

ty V

alua

tion:

Val

uatio

n C

once

pts

Mic

roec

onom

ic A

naly

sis

Ret

urn

Con

cept

s

Stre

ngth

s an

d W

eakn

esse

s of

Es

timat

ing

the

ERP

2Fo

rwar

d-Lo

okin

gER

P—ut

ilizes

curre

nt

LOS

31.b

Cal

cula

te/In

terp

ret

CFA

I V4

p. 5

0, S

chw

eser

B3

p. 2

3

2.Fo

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wes

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apla

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c.23

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a (s

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ple:

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: R

eq. r

etur

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-4


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10

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c.27

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9St

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c.28

2. T

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c.29

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10

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c.32

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poe

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c.34

pem

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-2


11

Stud

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ssio

n 10

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uatio

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alua

tion

Con

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Mic

roec

onom

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naly

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82,

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wes

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35

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atile

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ativ

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FE

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apla

n, In

c.36

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WAC

C

© K

apla

n, In

c.37


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 EstimatesRisk-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 1.11Size beta — –0.14Value beta — 0.00

The required return on equity for MegaCorp using the capital asset pricing model (CAPM) is 1. closest to:

8.41%.A. 8.67%.B. 8.83%.C.

The required return on equity for MegaCorp using the Fama-French model (FFM) is 2. closest to:

8.39%.A. 8.63%.B. 9.19%.C.

The 3. most accurate interpretation of MegaCorp’s value beta is:

the market capitalization factor of MegaCorp is the same as the overall market.A. MegaCorp stock has neither a value nor growth bias.B. there will be a significant value risk premium effect on MegaCorp’s required return.C.

Based on the data provided, MegaCorp is 4. most likely:

experiencing less market risk than the average firm.A. larger than the average company, as evidenced by its negative size beta.B. smaller than the average company, as evidenced by its negative size beta.C.

A common stock has the following characteristics:5.

Market beta 1.3Size beta 0.17Value beta –0.49Liquidity beta 0.25

The style of a company with the following stock characteristics is most likely to be:large-cap growth.A. small-cap value.B. small-cap growth.C.


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

B1. The equation for CAPM is:

ri = R

F + (β

i) market risk premium

ri = 2.25% + 1.07(6.00%)

ri = 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.

B2. The solution using the Fama-French model is:

ri RF imktRMRF i

sizeSMB ivalueHML= + + +

= + ( )+β β β

. % . . %2 25 1 11 6 00 0 .. . % . %

. %14 2 00 0 4 30

8 63( ) + ( )

=

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).

B3. The Fama-French model (FFM) incorporates three risk premiums to determine the required rate of return:

r R RMRF SMB HMLi F imkt

isize

ivalue= + + +β β β

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.


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B4. The Fama-French model (FFM) incorporates three risk premiums to determine the required rate of return:

r R RMRF SMB HMLi F imkt

isize

ivalue= + + +β β β

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.

C5. 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.


Study Session 1091acf2223c449e9aca09-573931475ab0c8bec3ec5b55f4da0a6c.r12.cf1.… · Intra-industry rivalry Equity Va luation LOS ... company value. ... Study Session 10 Equity Valuation:

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