PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted BooK - EQUITY Readings and Learning Outcome Statements v Study Session 10 - Equity Valuation: Valuation Concepts Study Session 11 - Equity Valuation: Industry and Company Analysis in a Global Context Study Session 12 - Equity Investments: Valuation Models 134 Self-Test - Equity 297 Formulas 302 Index 307 PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted SCHWESERNOTES™ 2016 LEVEL II CFA® BOOK 3: EQUITY ©2015 Kaplan, Inc All rights reserved Published in 2015 by Kaplan, Inc Printed in the United States of America ISBN: 978-1-4754-3531-3 PPN: 3200-6843 If this book does not have the hologram with the Kaplan Schweser logo on the back cover, it was distributed without permission of Kaplan Schweser, a Division of Kaplan , Inc., and is in direct violation of global copyright laws Your assistance in pursuing potential violators of chis law is greatly appreciated Required CFA Institute disclaimer: "CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by Kaplan Schweser CFA ® and Chartered Financial Analyst® are trademarks owned by CFA Institute." Certain materials contained within this text are the copyrighted property of CFA Institute The following is the copyright disclosure for these materials: "Copyright, 2015, CFA Institute Reproduced and republished from 2016 Learning Outcome Statements, Level I, II, and III questions from CFA ® Program Materials, CFA Institute Standards of Professional Conduct, and CFA lnstitute's Global Investment Performance Standards with permission from CFA Institute All Rights Reserved." These materials may not be copied without written permission from the author The unauthorized duplication of these notes is a violation of global copyright laws and the CFA Institute Code of Ethics Your assistance in pursuing potential violators of this law is greatly appreciated Disclaimer: The Schweser Notes should be used in conjunction with the original readings as set forth by CFA Institute in their 2016 Level II CFA Study Guide The information contained in these Notes covers topics contained in the readings referenced by CFA Institute and is believed to be accurate However, their accuracy cannot be guaranteed nor is any warranty conveyed as to your ultimate exam success The authors of the referenced readings have not endorsed or sponsored these Notes Page iv ©2015 Kaplan, Inc PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted READINGS AND LEARNING OUTCOME STATEMENTS READINGS The following material is a review of the Equity principles designed to address the learning outcome statements set forth by CFA Institute STUDY SESSION 10 Reading Assignments Equity, CFA Program Curriculum, Volume 4, Level II (CFA Institute, 2015) 29 Equity Valuation: Applications and Processes 30 Return Concepts page page 13 STUDY SESSION 11 Reading Assignments Equity, CFA Program Curriculum, Volume 4, Level II (CFA Institute, 2015) 31 32 33 34 The Five Competitive Forces That Shape Strategy Your Strategy Needs a Strategy Industry and Company Analysis Discounted Dividend Valuation page page page page 35 53 62 89 STUDY SESSION 12 Reading Assignments Equity, CFA Program Curriculum, Volume 4, Level II (CFA Institute, 2015) 35 36 37 38 Free Cash Flow Valuation Market-Based Valuation: Price and Enterprise Value Multiples Residual Income Valuation Private Company Valuation ©2015 Kaplan, Inc page page page page 134 180 226 258 Page v PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Equity Readings and Learning Outcome Statements LEARNING OUTCOME STATEMENTS (LOS) STUDY SESSION 10 The topical coverage corresponds with the following CFA Institute assigned reading: 29 Equity Valuation: Applications and Processes The candidate should be able to: a define valuation and intrinsic value and explain sources of perceived mispricing (page 1) b explain the going concern assumption and contrast a going concern value to a liquidation value (page 2) c describe definitions of value and justify which definition of value is most relevant to public company valuation (page 2) d describe applications of equity valuation (page 2) e describe questions that should be addressed in conducting an industry and competitive analysis (page 4) f contrast absolute and relative valuation models and describe examples of each type of model (page 5) g describe sum-of-the-parts valuation and conglomerate discounts (page 6) h explain broad criteria for choosing an appropriate approach for valuing a given company (page 7) The topical coverage corresponds with the following CFA Institute assigned reading: 30 Return Concepts The candidate should be able to: a distinguish among realized holding period return, expected holding period return, required return, return from convergence of price to intrinsic value, discount rate, and internal rate of return (page 13) b calculate and interpret an equity risk premium using historical and forwardlooking estimation approaches (page 15) c estimate the required return on an equity investment using the capital asset pricing model, the Fama-French model, the Pastor-Stambaugh model, macroeconomic multifactor models, and the build-up method (e.g., bond yield plus risk premium) (page 19) d explain beta estimation for public companies, thinly traded public companies, and nonpublic companies (page 24) e describe strengths and weaknesses of methods used to estimate the required return on an equity investment (page 26) f explain international considerations in required return estimation (page 26) g explain and calculate the weighted average cost of capital for a company (page 27) h evaluate the appropriateness of using a particular rate of return as a discount rate, given a description of the cash Row to be discounted and other relevant facts (page 27) Page vi ©2015 Kaplan, Inc PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Equity Readings and Learning Outcome Statements STUDY SESSION 11 The topical coverage corresponds with the following CFA Institute assigned reading: 31 The Five Competitive Forces That Shape Strategy The candidate should be able to: a distinguish among the five competitive forces and explain how they drive industry profitability in the medium and long run (page 35) b describe why industry growth rate, technology and innovation, government, and complementary products and services are fleeting factors rather than forces shaping industry structure (page 38) c identify changes in industry structure and forecast their effects on the industry's profit potential (page 39) d explain how positioning a company, exploiting industry change, and shaping industry structure may be used to achieve a competitive advantage (page 40) The topical coverage corresponds with the following CFA Institute assigned reading: 32 Your Strategy Needs a Strategy The candidate should be able to: a describe predictability and malleability as factors in assessing an industry (page 53) b describe how an industry's predictability and malleability are expected to affect the choice of an appropriate corporate strategy (classical, adaptive, visionary, or shaping) (page 54) c evaluate the predictability and malleability of an industry and select an appropriate strategy (page 5) The topical coverage corresponds with the following CFA Institute assigned reading: 33 Industry and Company Analysis The candidate should be able to: a compare top-down, bottom-up, and hybrid approaches for developing inputs to equity valuation models (page 62) b compare "growth relative to GDP growth" and "market growth and market share" approaches to forecasting revenue (page 62) c evaluate whether economies of scale are present in an industry by analyzing operating margins and sales levels (page 63) d forecast the following costs: cost of goods sold, selling general and administrative costs, financing costs, and income taxes (page 63) e describe approaches to balance sheet modeling (page 66) f describe the relationship between return on invested capital and competitive advantage (page 67) g explain how competitive factors affect prices and costs (page 67) h judge the competitive position of a company based on a Porter's five forces analysis (page 67) explain how to forecast industry and company sales and costs when they are subject to price inflation or deflation (page 68) j evaluate the effects of technological developments on demand, selling prices, costs, and margins (page 70) k explain considerations in the choice of an explicit forecast horizon (page 71) l explain an analyst's choices in developing projections beyond the short-term forecast horizon (page 72) m demonstrate the development of a sales-based pro forma company model (page 73) ©2015 Kaplan, Inc Page vii PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Equity Readings and Learning Outcome Statements The topical coverage corresponds with the following CFA Institute assigned reading: 34 Discounted Dividend Valuation The candidate should be able to: a compare dividends, free cash flow, and residual income as inputs to discounted cash flow models and identify investment situations for which each measure is suitable (page 89) b calculate and interpret the value of a common stock using the dividend discount model (DOM) for single and multiple holding periods (page 92) c calculate the value of a common stock using the Gordon growth model and explain the model's underlying assumptions (page 95) d calculate and interpret the implied growth rate of dividends using the Gordon growth model and current stock price (page 96) e calculate and interpret the present value of growth opportunities (PVGO) and the component of the leading price-to-earnings ratio (P/E) related to PVGO (page 97) f calculate and interpret the justified leading and trailing P/Es using the Gordon growth model (page 98) g calculate the value of noncallable fixed-rate perpetual preferred stock (page 100) h describe strengths and limitations of the Gordon growth model and justify its selection to value a company's common shares (page 101) explain the assumptions and justify the selection of the two-stage DOM, the H-model, the three-stage DDM, or spreadsheet modeling to value a company's common shares (page 102) j explain the growth phase, transitional phase, and maturity phase of a business (page 105) k describe terminal value and explain alternative approaches to determining the terminal value in a DDM (page 106) calculate and interpret the value of common shares using the two-stage DOM, the H-model, and the three-stage DDM (page 107) m estimate a required return based on any DDM, including the Gordon growth model and the H-model (page 112) n explain the use of spreadsheet modeling to forecast dividends and to value common shares (page 115) o calculate and interpret the sustainable growth rate of a company and demonstrate the use of DuPont analysis to estimate a company's sustainable growth rate (page 116) p evaluate whether a stock is overvalued, fairly valued, or undervalued by the market based on a DDM estimate of value (page 118) Page viii ©2015 Kaplan, Inc PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Equity Readings and Learning Outcome Statements STUDY SESSION 12 The topical coverage corresponds with the following CFA Institute assigned reading: 35 Free Cash Flow Valuation The candidate should be able to: a compare the free cash flow to the firm (FCFF) and free cash flow to equity (FCFE) approaches to valuation (page 136) b explain the ownership perspective implicit in the FCFE approach (page 137) c explain the appropriate adjustments to net income, earnings before interest and taxes (EBIT), earnings before interest, taxes, depreciation, and amortization (EBITDA), and cash flow from operations (CFO) to calculate FCFF and FCFE (page 137) d calculate FCFF and FCFE (page 144) e describe approaches for forecasting FCFF and FCFE (page 148) f compare the FCFE model and dividend discount models (page 149) g explain how dividends, share repurchases, share issues, and changes in leverage may affect future FCFF and FCFE (page 149) h evaluate the use of net income and EBITDA as proxies for cash flow in valuation (page 149) explain the single-stage (stable-growth), two-stage, and three-stage FCFF and FCFE models and select and justify the appropriate model given a company's characteristics (page 150) j estimate a company's value using the appropriate free cash flow model(s) (page 153) k explain the use of sensitivity analysis in FCFF and FCFE valuations (page 160) l describe approaches for calculating the terminal value in a multistage valuation model (page 161) m evaluate whether a stock is overvalued, fairly valued, or undervalued based on a free cash flow valuation model (page 161) The topical coverage corresponds with the following CFA Institute assigned reading: 36 Market-Based Valuation: Price and Enterprise Value Multiples The candidate should be able to: a distinguish between the method of comparables and the method based on forecasted fundamentals as approaches to using price multiples in valuation, and explain economic rationales for each approach (page 180) b calculate and interpret a justified price multiple (page 182) c describe rationales for and possible drawbacks to using alternative price multiples and dividend yield in valuation (page 182) d calculate and interpret alternative price multiples and dividend yield (page 182) e calculate and interpret underlying earnings, explain methods of normalizing earnings per share (EPS), and calculate normalized EPS (page 188) f explain and justify the use of earnings yield (EIP) (page 190) g describe fundamental factors that influence alternative price multiples and dividend yield (page 191) h calculate and interpret the justified price-to-earnings ratio (PIE), price-tobook ratio (PIB), and price-to-sales ratio (PIS) for a stock, based on forecasted fundamentals (page 191) calculate and interpret a predicted PIE, given a cross-sectional regression on fundamentals, and explain limitations to the cross-sectional regression methodology (page 195) ©2015 Kaplan, Inc Page ix PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Equity Readings and Learning Outcome Statements j evaluate a stock by the method of comparables and explain the importance of fundamentals in using the method of comparables (page 197) k calculate and interpret the PIE-to-growth ratio (PEG) and explain its use in relative valuation (page 200) I calculate and explain the use of price multiples in determining terminal value in a multistage discounted cash flow (DCF) model (page 201) m explain alternative definitions of cash flow used in price and enterprise value (EV) multiples and describe limitations of each definition (page 202) n calculate and interpret EV multiples and evaluate the use of EV/EBITDA (page 204) o explain sources of differences in cross-border valuation comparisons (page 205) p describe momentum indicators and their use in valuation (page 206) q explain the use of the arithmetic mean, the harmonic mean, the weighted harmonic mean, and the median to describe the central tendency of a group of multiples (page 207) r evaluate whether a stock is overvalued, fairly valued, or undervalued based on comparisons of multiples (page 197) The topical coverage corresponds with the following CFA Institute assigned reading: 37 Residual Income Valuation The candidate should be able to: a calculate and interpret residual income, economic value added, and market value added (page 226) b describe the uses of residual income models (page 229) c calculate the intrinsic value of a common stock using the residual income model and compare value recognition in residual income and other present value models (page 229) d explain fundamental determinants of residual income (page 232) e explain the relation between residual income valuation and the justified price-tobook ratio based on forecasted fundamentals (page 233) f calculate and interpret the intrinsic value of a common stock using single-stage (constant-growth) and multistage residual income models (page 233) g calculate the implied growth rate in residual income, given the market price-tobook ratio and an estimate of the required rate of return on equity (page 234) h explain continuing residual income and justify an estimate of continuing residual income at the forecast horizon, given company and industry prospects (page 235) compare residual income models to dividend discount and free cash flow models (page 240) j explain strengths and weaknesses of residual income models and justify the selection of a residual income model to value a company's common stock (page 241) k describe accounting issues in applying residual income models (page 242) I evaluate whether a stock is overvalued, fairly valued, or undervalued based on a residual income model (page 244) Page x ©2015 Kaplan, Inc PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Equity Readings and Learning Outcome Statements The topical coverage corresponds with the following CFA Institute assigned reading: 38 Private Company Valuation The candidate should be able to: a compare public and private company valuation (page 258) b describe uses of private business valuation and explain applications of greatest concern to financial analysts (page 260) c explain various definitions of value and demonstrate how different definitions can lead to different estimates of value (page 261) d explain the income, market, and asset-based approaches to private company valuation and factors relevant to the selection of each approach (page 262) e explain cash flow estimation issues related to private companies and adjustments required to estimate normalized earnings (page 263) f calculate the value of a private company using free cash flow, capitalized cash flow, and/or excess earnings methods (page 268) g explain factors that require adjustment when estimating the discount rate for private companies (page 272) h compare models used to estimate the required rate of return to private company equity (for example, the CAPM, the expanded CAPM, and the build-up approach) (page 272) calculate the value of a private company based on market approach methods and describe advantages and disadvantages of each method (page 274) j describe the asset-based approach to private company valuation (page 280) k explain and evaluate the effects on private company valuations of discounts and premiums based on control and marketability (page 280) describe the role of valuation standards in valuing private companies (page 284) ©2015 Kaplan, Inc Page xi PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Study Session 12 Cross-Reference to CFA Institute Assigned Reading #38 - Private Company Valuation The resulting calculations are as follows Using the build-up method: the risk-free rate, the equity risk premium, the small stock premium, a company-specific risk premium, and an industry risk premium are added together: 4.8% + 5.5% + 3.8% + 2.5% + 2.0% = 18.6% The WACC using the optimal capital structure factors in the debt to total cap, the cost of debt, the tax rate, and the given cost of equity: [15% x 10% x (1 - 35%)] + [(1- 15%) x 18.6%] = 16.8% 13 B The adjustment to the MVIC/EBITDA multiple for the higher risk of the private firm is: 9.0 x (1 - 0.30) = 6.3 The adjusted multiple is applied against the normalized EBITDA: 6.3 x $27, 100,000 = $170,730,000 Subtracting out the debt results in the equity value: $170,730,000 - $2,600,000 = $168, 130,000 Since the buyer is a strategic buyer, a control premium of 25% is added: 168,130,000(1.25) = $210,162,500 14 C It is difficult to find comparable data for individual intangible assets, so the asset-based approach would not be used Natural resource firms and finance firms where their asset values can be determined by examining market prices would be easier to value using the asset-based approach 15 C An IPO would increase liquidity and decrease the DLOM Lower asset risk would result in less value uncertainty and a lower DLOM A longer asset duration (later, lower payments) would result in reduced liquidity and a higher DLOM 16 A The discount for lack of control (DLOC) can be backed out of the control premium: DLOC= 1- [ l + control premium l DLOC = l - [ ] = 15.25% l + 0.18 The total discount also uses the discount for lack of marketability (DLOM): total discount= - [(l - DLOC)(l - DLOM)] total discount= - [(l - 0.1525)(1 - 0.22)] = 33.9% 17 A Page 296 Although various organizations provide technical guidance on the use of their valuation standards, it is limited due to the heterogeneity of valuations It is very difficult for the organizations to ensure compliance to the standards because most valuations are confidential There is no single mandated valuation standard ©2015 Kaplan, Inc PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted SELF-TEST: EQUITY Use the following information to answer Questions 1-6 VisionLink is a U.S.-based producer of flat-panel televisions The company is known for its low cost products, which are primarily sold through retail electronics stores and discount super stores While the design work is handled in house, production is outsourced to a Taiwanese electronics manufacturer, ElectroTech, which manufactures televisions for several other major television brands Electro Tech is just one of three companies that actually manufacture televisions The major brands primarily handle design, marketing, and product distribution and leave manufacturing and assembly to ElectroTech and its competitors VisionLink's CFO, David Lewis, is concerned about VisionLink's position in the consumer television industry and the profitability of the industry in general Lewis consults with Roger Diltz, the director ofVisionLink's marketing department, regarding his concerns and requests that Diltz identify the major factors that will affect the longterm profitability of the consumer television industry Since VisionLink has positioned itself as a low cost provider of televisions, Lewis is concerned about the potential for rampant price-cutting by the other competitors, which will erode VisionLink's profits and market share Lewis asks Diltz to identify the factors that would contribute to rivalry among existing competitors VisionLink is interested in the development and incorporation of 3D technologies into consumer televisions and has been discussing internally the possible entry into the 3D television market Jonathan Levy, head of research for VisionLink, has done some initial research on what it would take to develop a line of 3D televisions and writes an email to VisionLink's CFO, David Lewis In his e-mail, Levy notes that while some initial R&D will be required to enter into the 3D market, the costs are minimal, and VisionLink will not be required to pay any royalties or fees to patent holders Levy also believes that as new content is developed specifically for 3D viewing, the demand for 3D televisions will continue to grow VisionLink is looking at different options on how it might expand into the 3D market Right now, there are few competitors, and one of the strategies being reviewed is an acquisition of one of the leading brand names of 3D televisions There is currently internal debate within VisionLink regarding the short-term versus long-term benefits of such an expansion strategy Lewis is also concerned about the threat of substitutes to consumer televisions Specifically, Lewis believes that computers will be used more frequently for viewing television content over the internet as will portable devices such as tablets and mobile phones While discussing the threat of substitutes with Lewis, Levy suggests that VisionLink could respond by increasing functionality in its televisions to include web surfing and viewing of internet videos Levy also suggests that VisionLink could offer a line of computer monitors that provides a superior viewing experience to customers that decide to use computers as substitutes to televisions Given the structure of the television industry, the bargaining power of suppliers is: to higher long-term profitability for VisionLink B low, leading to higher long-term profitability for VisionLink C high, leading to lower long-term profitability for VisionLink A high, leading ©2015 Kaplan, Inc Page 297 PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Self-Test: Equity Which of the following would Diltz be most likely to identify as a determinant of long-term profitability for the consumer television industry? A Industry structure B Supply and demand C Eliminating competitors through an acquisition or merger Which of the following is most likely to increase rivalry and price competition among existing competitors in the consumer television market? A High brand identity within the industry B High degree of operating or financial leverage C Threat of forward integration Based on Levy's analysis, the innovation and development of 30 televisions will most likely cause profits in the consumer television industry to: A permanently increase B temporarily increase C remain at current levels If VisionLink goes forward and acquires a leading manufacturer of 30 televisions, how would this strategy be best characterized? A The strategy is risky because it may attract more competitors B The strategy is preferred because changes to industry structure will improve the company's competitive position C The strategy is preferred, since it will reduce competition longer term Levy's suggested ideas regarding the threat of substitutes would best be described as: A altering the firm's existing position B creating changes in the industry structure C capitalizing on changes in the industry Use the following information to answer Questions through 12 Charles Porter, a Level II CFA candidate, is a junior analyst for ValueSegment, an independent provider of equity analysis and valuations Porter has been tasked with valuing four different firms and has questions regarding the valuation models and techniques to apply to each The firms that he has been assigned to value are described in the following: Firm is a publicly traded retail fashion store that has been in operation for more than 70 years The firm has a consistent dividend policy with a target dividend growth rate of 3.5% per year Additionally, its earnings are projected to steadily increase in the near future A ValueSegment customer who is looking to become the majority shareholder of the firm requested the independent valuation of this firm Firm 2, a software manufacturer, has a consistent track record of paying dividends that is related to its earnings The firm is projected to have a growth rate of 25% for the next five years and has an estimated required rate of return of 14% The valuation of Firm will be included in a ValueSegment research report targeted toward common investors Firm is a steel manufacturer that has been in business for more than 50 years The firm has a stable dividend history with a historical growth rate of7.5% over the last 10 years The most recent dividend per share was $2.25 Porter has estimated that the required rate of return (r) for Firm is 12% Page 298 ©2015 Kaplan, Inc PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Self-Test: Equity Firm is an upstart internet retailer that is growing at an extremely fast rate The firm's guidance suggests that the dividend growth rate will be high during the next year, and then gradually decline over the next five years to a lower, more sustainable rate The most recent earnings per share (EPS) was $3.25, and Porter estimates that EPS next year will be $3.90 The estimated required rate of return is 10.25% After collecting information on his assigned firms, Porter believes that he will need to use the Gordon growth model (GGM) to value at least one of the firms Since he is concerned about using the model, he decides to consult a coworker, Albert Huang, about the strengths and weaknesses of the GGM Huang makes the following statements to Porter regarding the GGM: • • Statement 1: The Gordon growth model is simple to use and discuss and can be applied to stable, dividend-paying firms Statement 2: The Gordon growth model is sensitive to estimates of the required rate of return but is insensitive to estimates of the dividend growth rate The type of valuation model that is most appropriate for Porter to use to value Firm is a: A dividend discount model B free-cash flow model C residual income model Would it be appropriate for Porter to use a dividend discount model (DOM) to value Firm 2? A Yes B No, the DOM should only be used when an investor takes the perspective of a majority shareholder C No, the dividend growth rate is higher than the required rate of return If the current stock price of Firm is $34.50, the growth rate implied by the Gordon growth model would be: A 5.86% B 5.14% C 7.50% 10 The valuation model that would be most appropriate to value Firm would be the: A two-stage DOM B three-stage DOM C H-model 11 If Firm 4's shares trade at $45, then the present value of growth opportunities (PVGO) for Firm is closest to: A $13.29 B $31.71 C $6.95 12 Are Huang's statements to Porter regarding the Gordon growth model accurate? A No, one of the statements is inaccurate B No, both statements are inaccurate C Yes, both statements are accurate ©2015 Kaplan, Inc Page 299 PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Self-Test: Equity SELF-TEST ANSWERS: EQUITY Page 300 C Since there are a limited number of suppliers (three) that actually manufacture and assemble televisions, there is a high concentration of suppliers, meaning that the suppliers have higher bargaining power Since the major brands team with manufacturers to produce all of their televisions, there would be a high cost to switch their line to another manufacturer Additionally, there is a high threat of forward integration as a manufacturer like Electro Tech could develop their own line of televisions to sell direct to consumers A Supply and demand is a determinant of short-term rather than long-term profitability Long-term profitability is determined by industry structure, which is determined by Porter's five forces: threat of new entrants in the industry, threat of substitutes, bargaining power of buyers, bargaining power of suppliers, and rivalry among existing competitors While it is tempting to eliminate rivals through a merger or acquisition, the resulting increase in profits may be short-term, since increased profits could attract more competitors, including online competitors, which would serve to reduce profitability in the long-run B This relates to Porter's Force Five-the degree of rivalry among existing competitors A high degree of operating/financial leverage increases the likelihood that participants in this market space will price cut in order to defend their market share and attempt to cover their fixed costs Brand identity within an industry is associated with product differences Product differences make it more difficult to compete directly on price, therefore reducing the strength of this force The threat of forward integration relates to the bargaining power of suppliers B Innovation and technology may affect an industry on a temporary basis but not determine long-term profitability unless the change in technology affects one of Porter's five forces In this case, the barriers to entering the new 3D market segment are low, indicating that television producers that adopt the technology early, may initially be able to charge higher prices and earn higher profits The higher profits will cause the other competitors to adopt the technology, resulting in profitability returning to normal levels A While eliminating a major competitor may appear to be an attractive proposition at first, the increased profits will only be temporary as the profits will entice new competitors to enter the market C Lewis is projecting changes in the threat of substitutes, while Levy is suggesting ways to exploit these changes This is best described as capitalizing on changes in the industry B Because the valuation is being done on the customer's behalf, Porter will need to use a model that accounts for the perspective of a majority shareholder The free cash flow model is the best choice because it can be used to value a firm when the perspective is that of a controlling shareholder ©2015 Kaplan, Inc PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Self-Test: Equity A The dividend discount model (DDM) is an appropriate valuation methodology to use when: The company has a history of dividend payments The dividend policy is clear and related to the earnings of the firm The perspective is that of a minority shareholder Based on the information provided, the firm meets the requirements of a dividend discount model The fact that the current growth rate is higher than the required rate of return means that the single-stage Gordon growth model could not be applied, but a multiple stage dividend discount model may be appropriate B We start with the standard Gordon growth model (GGM) and input the known D (1+ g) vanables: P0 = r-g $2.25 (1+ g) 0.12-g $34.50 Then, we rearrange the terms and solve for g as follows: $2.25 + $2.25g = $34.50 x 0.12 -$34.50g $1.89 = $36.75g g = 0.0514 = 5.14% 10 C The dividends for Firm start out high and then linearly decrease over time to a constant future rate The two-stage and three-stage DDM models are inappropriate because they assume that dividend growth remains constant during a phase and then immediately changes at the start of the next phase The H-model, on the other hand, assumes that dividends start out at a high rate and then gradually decline to a lower, constant rate 11 C The present value of growth opportunities can be calculated as follows: E1 V0 = - r + PVGO => PVGO = PVGO = $45 - 12 A V0 E1 - - r 39 $ = $6.95 10.25% Statement is correct The Gordon growth model is easily communicated and explained, and it is applicable to stable, mature, dividend-paying firms Statement is inaccurate The Gordon growth model is sensitive to estimates of both the growth rate and the required rate of return ©2015 Kaplan, Inc Page 301 PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted FORMULAS 10, 11, STUDY SESSIONS Holding period return: r = & 12: EQUITY P1 - P0 + CI) P + CI) = -' -'- Po Po Gordon growth model equity risk premium: ~GM eq~ity nsk premmm [ estimate l[ = Blume adjusted beta = l?ear fore.casted d1v1dend yield on market index l l[ l [consensus ~ong-term long-term earnmgs - government growth rate bond yield + (2/3 x regression beta) + (1/3 x 1.0) Weighted-average cost of capital: WACC = market val of debt (l ) market val of equity x q x - tax rate + x re market val of debt & equity market val of debt & equity Gordon growth stock valuation model: V0 Two-stage stock valuation model: V0 = D x (l + g) r- g ~D (1 + = D r-g f (l + rr t= l Value of perpetual preferred shares: V g5 DP P = -r p E1 Present value of growth opportunities: Vo = - + PVGO r Page 302 ©2015 Kaplan, Inc D = + D x (l + g )° x (l+gL) (l + rf x (r - gL) PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Equity Formulas H-model: Vo = Do x (1 + gL) r - gL Sustainable growth rate: + Do x H x (gs - gL) r - gL l l g = [ net in com~ - dividends x ( net income) x [ sales x[ total ass~ts net mcome sales total assets stockholders equity l Value with free cash How models: firm value = FCFF discounted at the WACC equity value = FCFE discounted at the required return on equity Free cash How to the firm and free cash How to equity: FCFF =NI+ NCC+ [Int x (1 - tax rate)] - FCinv - WCinv FCFF = [EBIT x (1 - tax rate)] + Dep - FCinv - WCinv FCFF = [EBITDA x (1 - tax rate)] + (Dep x tax rate) - FCinv - WCinv FCFF =CFO+ [Int x (1 - tax rate)] - FCinv FCFE = FCFF - [Int x (1 - tax rate)] + net borrowing FCFE =NI+ NCC - FCinv -WCinv + net borrowing FCFE = CFO - FCinv + net borrowing FCFE = NI - [(I - DR) x (FCinv - Dep)] - [(I - DR) x WCinv] Weighted average cost of capital: WACC = (we x r) + [wd x rd x (1 - tax rate)] FCFI) Single-stage FCFF model: value of the firm = - - ~ WACC - g FCFF0 x (1 + g) WACC - g FCFE x (1 + g) FCFE Single-stage FCFE model: value of equity = - - -1 = - - -0~ - ~ r- g ©2015 Kaplan, Inc r- g Page 303 PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Equity Formulas Price multiples: market price per share trailing PIE = = = EPS over previous 12 months market price per share leading PIE= - - - - ~ ~ ~ - - - - forecasted EPS over next 12 months market value of equity PIB ratio= - - - - - - - = - - - ' book value of equity market price per share book value per share market value of equity market price per share - ~~~~-Pis ratio= total sales sales per share market value of equity market price per share - ~~~~-PI CF ratio cash flow cash flow per share where: cash flow= CF, adjusted CFO, FCFE, or EBITDA EVIEBITDA ratio= enterprise value EBITDA x most recent quarterly dividend trailing DIP= -= -' -market price per share Iead mg DIP = forecasted dividends over next four quarters market price per share Justified PIE multiples: D0 x(1+% justified trailing PIE= Po = Eo E0 (1-b)x(l+g) r-g DYE justified leading PIE= Po = _§_ = l - b E1 r-g r-g Justified PIB multiple: 'fi1ed PIB ratio= ROE - g r-g JUStl Page 304 ©2015 Kaplan, Inc r-g PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Equity Formulas Justified PIS multiple: justified Po = (Eo / So) x (l - b) x (l + g) S0 r- g Justified PICF multiple: FCFE x (1 + g) Vo = - - -0- - ~ r- g Justified dividend yield: 00 P0 r- g l+ g PEG ratio: PIE ratio PEG rauo = - - g Weighted harmonic mean: weighted harmonic mean Residual income: (ROE -r) x B0 Vo = Bo+ [- - - - r - g g = r -[ Bo x (ROE- r)l Vo - Bo ©2015 Kaplan, Inc Page 305 PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Equity Formulas Economic value added: EVA= NOPAT - $WACC NOPAT = EBIT x (1 - t) = (sales - COGS - SGA- dep) x (1 - t) $WACC = WACC x total capital total capital = = Page 306 net working capital + net property, plant, and equipment long-term debt + stockholders' equity ©2015 Kaplan, Inc PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted INDEX dividend discount model (DOM) 89, 231, 240 three-stage DOM 104 two-stage DOM 103 dividend yield (D/P) 187 DuPont analysis 116 A absolute valuation models adaptive corporate strategy 54 adjusted beta 24 adjusted CFO 202 aggressive accounting practices 243 arithmetic mean 207 asset-based approach 262, 280 E B balance sheet adjustments 243 balance sheet modeling 66 bargaining power of buyers 35 bargaining power of customers 68 bargaining power of suppliers 35, 67 beta 24 Blume method 24 bond-yield plus risk premium method 23 bottom-up analysis 62 breakup value build-up method 22, 273 Burmeister, Roll, and Ross model 22 c cannibalization factor 71 capital asset pricing model (CAPM) 19, 272 capitalized cash flow method of valuation 269 cash flow from operations (CFO) 142, 202 classical corporate strategy 54 clean surplus relationship 242 company-specific factors 258 competitive advantage 35, 67 competitive forces 35 compliance-related valuations 260 conglomerate discount continuing residual income 235 cost of goods sold (COGS) 63 country risk rating model 26 country spread model 26 cumulative translation adjustment (CTA) 242 currency translation gains and losses 241 D discount for lack of control (DLOC) 281 discount rate 27, 272 discounts for lack of marketability (DLOM) 282 earnings before interest, taxes, depreciation, and amortization (EBITDA) 203 earnings-plus-noncash-charges 202 earnings retention ratio 116 earnings surprise 206 earnings yield (E/P) 190 EBIT 142 EBITDA 142, 149 economic profit 226 economic value added (EVA) 227 economies of scale 63 elements of industry structure enterprise value (EV) 204 equity risk premium 15 excess earnings method of valuation 270 expanded CAPM 273 expected return 14, 112 F fairly valued 118 fair market value 2, 261 fairness opinions Fama-French model 20 Fed model 199 financing cost 64 five competitive forces 4, 35 fixed capital investment 138 forecast horizon 71 free cash flow 89 free cash flow method of valuation 269 free cash flow to equity (FCFE) 134, 187, 203, 231 forecasting 148 from CFO 143 from FCFF 143 from net income 143 free cash flow to equity (FCFE) models 150, 240 free cash flow to the firm (FCFF) 134 forecasting 148 from CFO 142 ©2015 Kaplan, Inc Page 307 PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Equity Index M from EBIT 142 from EBITDA 142 from net income 138 models 153 G going concern assumption Gordon growth model 16, 95, 101 growth phase of a business 105 guideline public company method (GPCM) 275 guideline transactions method (GTM) 278 H harmonic mean 207 H-model 103 holding period return 13 hybrid analysis 62 macroeconomic models 17 malleability 53, 55 market approach ro private company valuation 262 market growth and market share approach 63 market value added (MVA) 228 market value of invested capital (MVIC) 275 maturity phase of a business 105 median 207 method of average return on equity 189 method of comparables 180, 196 method of forecasted fundamentals 180 method of hisrorical average EPS 189 Molodovsky effect 189 momentum indicators 206 multicollinearity 195 multifactor models 19 mutability 53 I implied growth rate of dividends 96 implied rate of return 112 income approach ro private company valuation 262 income tax expense 65 industry analysis 41 industry attractiveness 35 intensity of industry rivalry 67 internal rate of return (IRR) 15 international accounting differences 205, 244 cultures 205 growth opportunities 205 risk 205 intrinsic value l, 262 investment value 2, 262 J justified dividend yield 19 EVIEBITDA multiple 195 PIE multiple 191 price to cash flow 194 justified price multiples 182 justified price-ro-book (PIB) ratio 193, 233 L Law of One Price 180 leading PIE 182 liquidation value litigation-related valuations 261 Page 308 N net income 138, 149 nonrecurring items 243 nonstrategic buyers 265 NOPAT 227 normalized earnings 72, 189, 263 overvalued 118 ownership perspective 137 p Pasror-Stambaugh model 21 PIB ratio 183 PICF ratio 187 PIE benchmarks 197 justified 98 leading 98 predicted 195 ratio 182 trailing 99, 182 persistence factor 23 PIE-ro-growth (PEG) ratio 200 Porter's five forces Porter's five forces 67 PRAT model 116 predictability 53, 55 premiums for control and marketability 280 present value of growth opportunities (PVGO) 97 price convergence 14 price multiples 180 ©2015 Kaplan, Inc PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Equity Index T price-to-book ratio (PIB) 183, 184, 234 price-to-cash flow ratio (PICF) 187 price-to-earnings (PIE) 182 price-to-sales ratio (PIS) 185 prior transaction method (PTM) 279 private company valuation 258 private market value pro forma financial statements 73 PIS ratio 185 Q technological developments 70 terminal value 106, 161 terminal value estimation 201 threat of new entrants 35, 68 threat of substitutes 35, 67 top-down analysis 62 traditional accounting income 226 transaction-related valuations 260 transitional phase of a business 105 quality of financial statement information u R underlying earnings 188 undervalued 118 unexpected earnings 206 R&D expenditures 243 realized return 14 relative valuation models required rate of return 14, 272 reserves and allowances 243 residual income 89, 226, 229 retention ratio 193 return on capital employed 67 return on equity (ROE) 116 return on invested capital (ROIC) 67 rivalry among existing competitors 35 v visionary corporate strategy 55 w Wal-Mart 42 weaknesses of residual income models 241 weighted average cost of capital (WACC) 27, 136,227 weighted harmonic mean 207 working capital investment 140 s selling general and administrative costs (SG&A) 64 sensitivity analysis 160 shaping corporate strategy 54 special purpose entities (SPEs) 243 spreadsheet modeling 104, 115 standardized unexpected earnings (SUE) 206 stock-specific factors 259 strategic buyers 265 sum-of-the-parts value survival corporate strategy 55 survivorship bias 16 sustainable growth rate (SGR) 116 y Yardeni model 199 ©2015 Kaplan, Inc Page 309 PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Notes ... SCHWESERNOTES 2016 LEVEL II CFA BOOK 3: EQUITY â2015 Kaplan, Inc All rights reserved Published in 2015 by Kaplan, Inc Printed in the United States of America ISBN: 978-1-4754 -35 31 -3 PPN: 32 00-68 43 If... Equity Valuation: Applications and Processes 30 Return Concepts page page 13 STUDY SESSION 11 Reading Assignments Equity, CFA Program Curriculum, Volume 4, Level II (CFA Institute, 2015) 31 32 ... page 35 53 62 89 STUDY SESSION 12 Reading Assignments Equity, CFA Program Curriculum, Volume 4, Level II (CFA Institute, 2015) 35 36 37 38 Free Cash Flow Valuation Market-Based Valuation: Price