BOOK - EQUITY INVESTMENTS Readings and Learning Outcome Statements 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 Self-Test - Equity Investments Formulas lndex 43 106 266 271 276 SCHWESERNOTES™ 2013 CFA LEVEL I BOOK 3: EQUI T Y I N VESTMENTS ©20Publi12shedKaplina20n, 1I2nc.byAlKapll rigahtnsSchwes reserved.er PriISBN:nted978-1in the4Uni277-te4d245-Stat2esIof1-Ameri c a 2774 2456 PPN: 3200-2851 If this book does not have the hologram with the Kaplan Schweser logo o n the back cover, i t 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 violarors of this law is greatly appreciated Required CPA Institute disclaimer: "CPA® and Chartered Financial Analyst® are trademarks owned by CPA Institute CPA Institute (formerly the Association for Investment Management and Research) does not endorse, promote, review, or warrant the accuracy of the products or services offered by Kaplan Schweser." Certain materials contained within this text are the copyrighted properry of CPA Institute The following is the copyright disclosure for �ht, 2012, CPA Institute Reproduced and republished from 2013 Learning Outcome Statements, Level I, II, and these materials: "Copyr III questions from CPA Program Materials, CPA Institute Standards of Professional Conduct, and CPA Institute's Global Investment Performance Standards with permission from CPA 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 CPA 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 CPA Institute in their 2013 CPA Level II Study Guide The information contained in these Notes covers topics contained in the readings referenced by CPA Institute and is believed tO be accurate However, their accuracy cannot be guaranteed nor is any warranry conveyed as to your ultimate exam success The authors of the referenced readings have not endorsed or sponsored these Notes READINGS AND LEARNING OUTCOME STATEMENTS READINGS The following material is a review ofthe Equity Investments principles designed to address the Learning outcome statements setforth by CFA Institute STUDY SESSION 10 Reading Assignments CPA Program Curriculum, Volume 4, Level I (CPA Institute, 2013) uation:s Applications and Processes 31.30 RetEquiutrny ValConcept Reading Assignments CPA Program Curriculum, Volume 4, Level I (CPA Institute, 2013) Five eCompet 33.32 TheDiscount d Dividiendtive ValForcesuatioThatn Shape Strategy Reading Assignments CPA Program Curriculum, Volume 4, Level I (CPA Institute, 2013) Free Cas-BhasFleodwValValuatuatioin:onPrice and Enterprise Value Multiples 35.34.36 Market Income ValValuuatatioionn 37 ResPriviatduale Company Equity, STUDY SESSION 11 pagepage219 Equity, STUDY SESSION 12 page 4361 page Equity, ©20 12 Kaplan, Inc page 151106 page page 227195 page Page Book Equity Investments Readings and Learning Outcome Statements - LEARNING OUTCOME STATEMENTS (LOS) STUDY SESSION 10 The topical coverage corresponds with thefollowing CPA Institute assigned reading: 30 TheEquicandi ty Valduatatie oshn:oulAppld beicatiabloenstoand: Processes a Defimispnriecvaling.uat(pioagen and9) intrinsic value, and explain sources of perceived aiatnitohne valgoiune.g concern assumption and contrast a going concern value to a b Expl l i q ui d ( p age 0) betodefipublnitiiconscompany of value,valanduatijoun.stify(pagewhic1h0)definition ofvalue is most c Descri r e l e vant bbee quesapplitcioatnsionsthatofsequihoultdy valbe addres uation.se(dpagein conduct 10) ing an industry and Descri e.d Descri compet i t i v e anal y s i s ( p age 12) Cont rasmodel t absol.u(tpeageand13)relative valuation models, and describe examples of each t y pe of b4e)sum-of-the-parts valuation, and explain a conglomerate discount g Descri ( p age ain broad(pagecri15)teria for choosing an appropriate approach for valuing a given h Expl company 31 TheReturcandin Concepts ould berealablizeedtohol: ding period return, expected holding period a Diretsutrn,indguiatrequieshshamong r,edandretiunrn,ternalreturatrnefrofomretconvergence of price to intrinsic value, di s c ount rat e u rn ( p age 21) ret an equi.ty(prageisk 23)premium using historical and forward b Callookiculngatese andtimatiniotenrpapproaches the r,equitherFama-Fr ed returneonnchanmodelequi,tythinevesPasttmorent- Stusambaugh ing the capimodeltal ,asset c Espritciminatg emodel macroeconomi cum)mul t(ipfageacto27)r models, and the build-up method (e.g., bond yield pl u s r i s k premi d Expl ain beta iesc tcompani imation efos.r(publ ic32)companies, thinly traded public companies, and nonpubl p age s(epsageof met34)hods used to estimate the required e retDescriurnbone santrengtequihtsyandinvesweaknes t m ent Expl a i n i n t e r n at i o nal cons i d erat i o ns i n r e qui r e d r e t u r n es t i m at i o n ( p age 34) ai35)n and calculate the weighted average cost of capital for a company g Expl ( p age antenesof tshofe casusihngfloawpartto ibeculdiarscrount ate ofedreandturnotashera direslcevantount h Evalrate,ugiatveenthae desappropri c ri p t i o facts (page 35) f The topical coverage corresponds with thefollowing CPA Institute assigned reading: f Page ©2012 Kaplan, Inc Book Equity Investments Readings and Learning Outcome Statements - STUDY SESSION 11 The topical coverage corresponds with thefollowing CPA Institute assigned reading: 32 Thea.TheDiFicandisvteinCompeti dguiateshshamong oultivdebeForthablecesfievetThatocompet : ShapeitiveStrategy f o r c es and expl a i n how t h ey dr i v e longogyruandn (ipnagenovat43)ion, government, b Desandindusccompl ritrbye profiwhyementtianbidusalriyttyrpryinogrductthoewtmedi hs andratuesm,etrevandchnol ices are fleeting factors rather than forces s h api n g i n dus t r y s t r u ct u r e ( p age 46) Identtifypotchanges ipnageindus47)try structure, and forecast their effects on the industry's c profi e nt i a l ( a i n how pos i t i o ni n g a company, expl o i t i n g i n dus t r y change, and s h api n g d Expl industry structure may be used to achieve a competitive advantage (page 48) DiThescounted Di v i d end Val u ati o n candidateedisvhiouldendsd be, fablreeecasto:h flow, and residual income as inputs to discounted a casCompar hsuitablfloew (pmodel s , and i d ent i fy i n ves t m ent s i t u at i o ns f o r whi c h each meas u re i s b diCalsccountulatemodel andagei61)n(tDerDM) pret theforvalsinugle eofanda common sholtockdiusingnperig theods.div(pidageend64) mul t i p l e e valu'es ofunderla common s t o ck us i n g t h e Gor d on gr o wt h model , and c explCalcaulinattehethmodel d grCalowtculhatmodel e and iandnterpretcurretntheysiitnmogckplasipriesdumptcgre.owt(ipoagensh r a(68)tpeageof di67)vidends using the Gordon e Calthe ccomponent ulate and inoftertphreetletadihenpresg prientce-valto-ueearniofngrgsowtrahtioopport urelniatiteesd(PtoVGO) and ( P I E ) PVGO ( p age 69) e and.in(pteagerpre70)t the justified leading and trailing P/Es using the Gordon f grCalowtculhatmodel of noncal blonse fiofxed-theraGorte perpet uoalwtprhefmodel erred ,standock.ju(pstiagefy i72)ts h.g sDesCalelecctculriioabnteetstothrevalengtvaluehusaeandcompany' limitalstaicommon d on gr sehlarectesi.o(npageof the73)two-stage DDM, the Expl a i n the as s u mpt i o ns and j u s t i fy t h e s H-common model,stheharetsh r(epe-agestage74)DDM, or spreadsheet modeling to value a company's Expl ai77)n the growth phase, transitional phase, and maturity phase of a business ( p age ue, and(pageexpl78)ain alternative approaches to determining the k Destermicrinbale valtermiue ninalavalDDM Calthe cH-ulamteodeland, andintertphreetththeree-valstaugee ofDDM common(pagesh79)ares using the two-stage DDM, m Esmodeltimatande a rtehquie H-remd odelretur n(pbasageed84)on any DDM, including the Gordon growth n Expl commonain thshe arusees.of(psagepreads87)heet modeling to forecast dividends and to value Kaplan, The topical coverage corresponds with thefollowing CPA Institute assigned reading: 33 J· ©20 12 Inc Page Book Equity Investments Readings and Learning Outcome Statements - o Caldemonsculatteraandte thine tusereprofet DuPont the sustaanalinablyseisgrtoowteshtimratateeofa company' a company,s suandstainable gr o wt h rat e ( p age 88) Evaluatebaswheted onheraaDDM stock iess toverimatvealofued,valfuaie.rly(pvalageued,90)or undervalued by the p market STUDY SESSION 12 The topical coverage corresponds with the following CFA Institute assigned reading: 34 The candidate should be able to: eapproaches the free castoh valflowuattoiotn.he(pfiagerm (1F08)CFF) and fre cash flow to equity a Compar ( F CFE) aaiinn tthhee owner shiiaptepersadjpuectstmivente ismtplo inetcit iinncome, the FCFEearniapproach (pinageteres109)t and b.c Expl Expl appr o pr n gs befor e t(aExesBIT(EDA)BIT, )and, earcasninhgsflobefor eminoperteresat,titoansxes(,Cdepreci atcalion,culandate FCFF amortiandzatioFCFE n w f r o FO) t o d.e (CalDespagecculri109)abteeapprFCFFoachesand FCFE (caspageting116)FCFF and FCFE (page 120) f o r f o r e Comparain how e thediFCFE model, sharande repurchas dividendesdi, sshcarounte issues,modelands (pchanges age 121)in leverage fg Expl v i d ends h Evalvalmayuatuaatfioeen.ctth(fepuageustuereof121)FCFFnet inandcomeFCFE.and EBI(pageTDA121)as proxies for cash flow in Expl ainmodel the sisn, glande-stsaegelect(sandtableju-gsrtoifywtthh)e, apprtwo-ostprage,iateandmodelthregie-vstenagea FCFF ands FCFE company' ics (pages122)value using the appropriate free cash flow model(s) charEstimactateeriastcompany' (Explpageain125)the use of sensitivity analysis in FCFF and FCFE valuations (page 132) Desmodelcri.b(epapprage 133)oaches for calculating the terminal value in a multistage valuation m Evalfree ucasathe whet h er a s t o ck i s over v al u ed, f a i r l y val u ed, or under v al u ed bas e d on a flow valuation model (page 133) 35 The candidate should be able to: ween tahles asmetapproaches hod of comparabl esprandice multhe mettiplehsodinbasvaleudatonion, and a Diforecasstinguitedshfubetndament t o us i n g erandationalintceesrrpaftorieortnalanda jeusspostforifsieieachdblprie drcapproach eawbacks multiplte(o.page(uspagein151)g 153)alternative price b.c explCalDesccaulriinabteeconomi d mulCal(pagectulip153)aletes andand diinvteidrpendret yialteeldrniatnivalve upriatcioen.mul(ptageiple153)s and dividend yield y i n g earni n gs , expl a i n met h ods of normal i z i n g e Calearnciulngsateperandshiarenter(pErPS)et underl Explain and justify the us, eandof earcalnculinagsteyinoreldm(alEi/P)zed EPS (page (161)page 159) Free Cash Flow Valuation J· k I The topical coverage corresponds with the following CFA Institute assigned reading: Market-Based Valuation: Price and Enterprise Value Multiples f Page ©2012 Kaplan, Inc Book Equity Investments Readings and Learning Outcome Statements - al162)factors that influence alternative price multiples and g diDesvicdriendbe fyiuendament l d ( p age Calculratateioand(PIB)int,eandrpreprit thcee-jtuos-tsiaflieeds ratpriicoe-(tPoI-Se)arnifornagsstroack,tio bas(PIeEd),onprifcoe-recasto ted h book fuCalndament als i(nptageerpr162)et a predicted PIE, given a cross-sectional regression c ul a t e and onmetfhuodolndament a(plsage, and166)explain limitations to the cros -sectional regression o gy Evalundament uate a satlosckin byusinthge tmethe methodhodof comparabl es, eands (pexplagea168)in the importance of f of comparabl k rCalelactiulveatvale anduatiionn.ter(pprageet the170)PIE-to-growth ratio (PEG), and explain its use in Cala mulcultaistteageanddiexplscounted ain thcase usheflofowpri(DceCF)mulmodel tiples in(pdetageermi171)ning terminal value in m Expl amulin alttieprlneats, iandve defidesnciritiboenslimofitcasatihonsflowofusedeach idefin prinicteioandn (pentageerpri172)se value ( E V) n Cal(pagecul174)ate and interpret EV multiples, and evaluate the use of EVIEBITDA urces ofudimfienrences ins andcrostsh-beiorder valin valuatuioatniocompari so176)ns (page 176) DesExplcaariiinnbethesomoment di c at o r r us e n ( p age p.o.q Expl use ofandthethareitmedihmetainc tmean, theribeharmoni cramean, the weiof gahtgreodup of harmoni c mean, o des c t h e cent l t e ndency mul t i p l e s ( p age 177) r compari Evaluateswhet ons ofhermula sttiopckles.is(poveragev168)alued, fairly valued, or undervalued based on 36 The candidate should be able to: ate and(pinageterp195)ret residual income, economic value added, and market a valCaluceuladded usinetsriofnsircesvalidualue ofincome modelsst.ock(pageusin198)g the residual income a common c.b DesCalmodelcculri,abtandeetthehecompar e val u e recogni t i o n i n res i d ual i n come and ot h er pres e nt ueaimodel s (pageal198)determinants of residual income (page 20 1) n f u ndament d.e valExpl Expl a i n t h e r e l a t i o n bet w een res i d ual i n come val u at i o n and t h e j u sti f i e d pri c e tCalo-bcookulateraandtio basinteedrponret ftohreecasinttreindsfiuc ndament aalscommon (page 202)stock using single-stage val u e of rinesiresdualidualincome modelgivsen (ptheagemar202)ket price-to Cal(conscultraaanttteio-thegandrowtimanhpl) iesandedtimgrmulatowte tofihstrtaahgetee requi i n come, g book redjuratstiefyofanreestutrimn atone equiof contry i(npuiageng203) a i n cont i n ui n g res i d ual i n come, and h Expl res(pageidual204)income at the forecast horizon, given company and industry prospects Compars e(presageid209)ual income models to dividend discount and free cash flow model Expl a i n s t r e ngt h s and weaknes s e s of res i d ual i n come model s , and j u sti fy t h e on of a residual income model to value a company's common stock (spelageecti210) Kaplan, J· The topical coverage corresponds with thefollowing CFA Institute assigned reading: Residual Income Valuation f J· ©20 Inc Page Book Equity Investments Readings and Learning Outcome Statements - k EvalDescriuatbeewhet accountheriangstiosckuesis iovern applvalyuied,ng rfeasiridlyualvaliuned,comeor model s.al(upedagebas211)ed on a under v residual income model (page 213) 37 ThePrivatcandie Company Val u ati o n dateepublshoulicdandbe prabliveattoe:company valuation (page 227) a.b Compar Descri bnetousfiesnofanciprailvanalate busystsi.n(espsageval229)uation, and explain applications of greatest concer aeiadn varto idiousf erentdefinesittioimnsatofesvalofuvale, uande (pdemons trate how dif erent definitions c Expl can l age 230) d valExpluataiinonthande income, mar k et , and as s e t b as e d approaches to pr i v at e company foawctoesrtsimrelatevantion istouteshereslealteectdiotonprofiveachate compani approach.es and(pageadj231)ustments a i n cas h fl e Expl rCalequiculreadtetothese tvalimuateeofnorprmivalatiezedcompany earningsus i(npgagefre232)e cash flow, capitalized cash flow,aand/in faorctoexces satearrequininrgse adjmetuhstodsment (pwhen age 23es7)timating the discount rate for rs t h g Expl pr i v at e compani e s ( p age 241) h Compar s usede, thteoCAPM, estimatethteheexpanded required CAPM, rate of reandturnthteobuiprivldat-uepcompany equiapproach) ty (feormodel exampl agee val241)ue of a private company based on market approach methods, Detandedesrmicnrie.b(etphadvant aasgesed andapproach disadvantto pragesivateofcompany each metvalhod.uat(ipoagen (243)page 249) Des c ri b e t h e as s e t b k Expl a i n and eval u at e t h e eff e ct s on pr i v at e company val u at i o ns of di s c ount s and premi ubmse thbase reodleonofcontvaluatroiloandn stamarndarkdetsabiinlivalty.u(ipnageg pr249)ivate companies Descri (page 253) The topical coverage corresponds with the following CFA Institute assigned reading: f )· Page ©2012 Kaplan, Inc The following is a review of the Equity Valuation principles designed to address the learning outcome statements set forth by CFA Institute This topic is also covered in: EQUITY VALUATION: APPLICATIONS AND PROCESSES Study Session 10 EXAM FOCUS ThiManys reofvietwheisconcept simply sanandinttreochniductqiouesn tointthroduced e processareofdevel equitoypedvalumoratioenfandul yitisnapplsubsiecquent ation tinotpiricnrseicvivalewsu.e,Candi dsatt percept es shouliodnbeoffamimislpiarircwiintg,h tgoihenconcept s inverstroduced here, ionnclvaludiune,g anal y g concern u s l i q ui d at i and the dif erence between absolute and relative valuation techniques LOS 30.a: Define valuation and intrinsic value, and explain sources of perceived mispricing CPA ® Program Curriculum, Volume 4, page Valanduesattiiomnatisinthgethproces s of det e rmi n i n g t h e val u e of an as s e t There ar e many appr o aches ecaninputdepend s for acrvaluciuaatl yioonn model canystbe's abiquilitteychalto detlengiermnig.neInthvese valtmuentes of sseucuriccestsi,ehowever , t h e anal s The general steps in the equity valuation process are: 1.2 Forecas Understtacompany nd the busperfinesosrmance 3.4 SelConver ect tht etheapprforoeprcasiattseivalntouaatvalionumodel at i o n Apply the valuation conclusions When term iwhontrinhassic valcomplue (eItVe ),unders we arteandirefenrrig nofg tthoethchare valactuateriiostnicofs ofanthaseset orassesetcurorweiitsyusubyiengtshofiemeone efficient, they mayrmdi Tovergtheefrextomentthethiatntrsitnosckic valpricueses.are not perfectly (informationally) Anal sOneecuriyfstrtaiesmewor sseforekiwhinkgditcohviproduce tdheseirmiesstpiposmricatiinteigvofeperceiriinstkr-ivaneddjsicubysvaltedtuheretedianalufrnseyrssdotfrinosmtoobycurtwtorreysntoinurcesgmarto k:idetthentepriifyce didiff eerence betbetwweeneen tmarhe analket priystc'seesandtimtathee iofntirnintrsiincsvalic uvale u(aectandual actmisupalricinintrg)insandic valthuee rence (valuation error) We can represent this relation as fol ows: -price = price) Kaplan, IVanalyst (IVacrual - + (IVanalyst - IVactual) ©20 Inc Page ... I N VESTMENTS ? ?20 Publi12shedKaplina20n, 1I2nc.byAlKapll rigahtnsSchwes reserved.er PriISBN:nted97 8-1 in the4Uni277-te4d245-Stat2esIof1-Ameri c a 27 74 24 56 PPN: 32 0 0 -2 8 51 If this book does not have... 1 2- Equity Investments: Valuation Models Self-Test - Equity Investments Formulas lndex 43 106 26 6 27 1 27 6 SCHWESERNOTES™ 20 13 CFA LEVEL I BOOK 3: ... IVanalyst (IVacrual - + (IVanalyst - IVacrual) LOS 30 .b LOS 30 .c LOS 30 .d LOS 30 .e Page 16 ? ?20 12 Kaplan, Inc Study Session 10 Cross-Reference to CFA Institute Assigned Reading #30 - Equity Valuation: