The general steps in the equity valuation process are:
- Understand the business
- Forecast company performance
- Select the appropriate valuation model
- Convert the forecasts into a valuation
- Apply the valuation conclusions
going concern assumption = a company will continue to operate as a business, as opposed to going out of business.
- Threat of new entrants in the industry
- Threat of substitutes
- Bargaining power of buyers
- Bargaining power of suppliers
- Rivalry among existing competitors
holding period return = r =
- realized holding period return
- expected holding period return
equity risk premium = required return on equity index - risk-free rate
required return for stock j = risk-free return +
- Historical estimates: survivorship bias
- forward-looking estimates
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Gordon growth model
$$(D_1 / P) + \hat{g} - r_{LT, 0}$$ -
Supply-side estimates (Macroeconomic models)
equity risk premium =
$(1+i)\times(1+r_{EPS})\times(1+g_{P/E}) - 1 + Y - r_f$ where:
i = expected inflation
r_{EPS} = expected real growth in EPS
g_{P/E} = expected changes in the P/E ratio
Y = the expected yield on the index
r_f = the expected risk-free rate
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survey estimates
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CAPM
required return on stock j = risk-free rate + (equity risk premium * beta of j)
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multifactor models
required return = RF + (risk premium)_1 + (risk premium)_2 + ... + (risk premium)_n
(risk premium)_i = (factor sensitivity)_i * (factor risk premium)_i
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Fama-French model
required return of stock j =
$RF + \beta_{mkt, j} \times (R_{mkt} - RF) + \beta_{SMB, j} \times (R_{small} - R_{big}) + \beta_{HML, j} \times (R_{HBM} - R_{LBM})$ where:
(R_{mkt} - RF) = return on a value-weighted market index minus the risk-free rate
$(R_{small} - R_{big})$ = a small-cap return premium$(R_{HBM} - R_{LBM})$ = a value return premium -
Pastor-Stambaugh model = Fama-French model + liquidity factor
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Macroeconomic multifactor models
- confidence risk
- time horizon risk
- inflation risk
- business cycle risk
- market timing risk
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Build-up method required return = RF + equity risk premium + size premium +specific-company premium
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Bond-yield plus risk premium method
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adjusted beta = (2/3 * regression beta) + (1/3 * 1.0)
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identify a benchmark company, XYZ, which is publicly traded and similar to ABC in its operations
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unlever the beta for XYZ:
unlevered beta for XYZ = (beta of XYZ) / (1 + D/E of XYZ)
-
lever up the unlevered beta for XYZ to get an estimate of ABC's beta
estimate of beta for ABC = (unlevered beta of XYZ) * (1 + D/E of ABC)
- bottom-up: starts with analysis of an individual company
- top-down: begins with expectations about a macroeconomic vairbale, ofthen the growth rate of nominal GDP.
- hybrid
forecast COGS = (1 - gross margin)(estimate of future revenue)
- statutory rate
- effective tax rate
- cash tax rate
The fundamental value represents not only the present value of the future dividends (on a non-growth basis) but also the present value of the growth opportunites (PVGO):
justified leading P/E =
justified trailing P/E =
where:
b = earning retention rate = 1 - divident payout rate
g = ((net income - dividends) / net income) * (net income / sales) * (sales / total assets) * (total assets / equity) = R * P * A * T
FCFF = Cash revenue - WCInv -FCInv - Cash operating expense
FCFE = FCFF - Interest payment + net borrowing
firm value = FCFF discounted at the WACC
equtiy value = FCFE discounted at the required return on equity
equity value = firm value - market value of debt
FCFF = NI + NCC + [Int * (1 - tax rate)] - FCInv - WCInv
where:
NCC = noncash charges
FCInv = capital expenditures - proceeds from sales of long-term assets
(Almost) FCFF = (NI + NCC - WCInv) - FCInv = CFO - FCInv
(Actual) FCFF = (NI + NCC - WCInv) + Int(1 - tax rate) - FCInv = CFO Int(1 - tax rate) - FCInv
FCFF = EBIT(1 - tax rate) + Dep - FCINv - WCInv
FCFF = EBITDA(1 - tax rate) + tax rate * Dep - FCInv - WCInv
FCFE = NI + NCC - FCInv - WCInv + net borrowing
For forecasting FCFE, use:
FCFE = NI [(1 - DR) * (FCInv - Dep)] - [(1 - DR) * WCInv]
value of the firm =
value of equity =
PEG ratio =
EV = market value of common stock + market value of preferred equity + market value of debt + minority interest - cash and investments
earings surprise = reported EPS - expected EPS
SUE = earnings surprise / standard deviation of earings surprise
EVA (Economic value added) = NOPAT - (WACC * capital) = EBIT(1 - t) - $WACC
MVA (Market value added) = market value - total capital
DLOC = 1 - 1 / (1 + control premium)
total discount = 1 - [(1 - DLOC)(1 - DLOM)]
where:
DLOM = discount for lack of mmarketability
NAV = Value of operating real estate + value of other tangible assets - value of liabilities
FFO = net earnings + depreciation + deferred tax charges +/- Losses/gains from sales of property and debt restructuring
AFFO = FFO - non cash rent - maintenance-type capital expenditutrd and leasing costs