WORKBOOK. Second Edition ISBN In this chapter, we have discussed the scope of equity valuation, outlined the valuation process. ISBN (hardback). 1. Investment analysis. 2. Securities— Valuation. 3. Investments—Valuation. I. Pinto, Jerald E. II. Equity asset valuation. ISBN: October Pages Equity Asset Valuation Workbook, Third Edition was designed as a companion to Equity Asset Valuation, .

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Equity Asset Valuation Workbook 2nd Edition. by Workbook. ISBN ISBN Why is ISBN important? ISBN. This bar- code. Equity Asset Valuation Workbook (Cfa Institute Investment) · Read more Business Valuation Body of Knowledge Workbook, 2nd Edition · Read more. Your complete guide to equity assets valuation Equity Asset Valuation Workbook, Third Edition was designed as a companion to Equity Asset Valuation, Third.

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Early Transcendentals, 2nd. Volume 3. Year 6. The Value Line Investment Survey. Define normal EPS. Price Multiples 2. Neither business has been profitable to date, and neither is anticipated to have positive EPS over the next year. On the basis of the above information, answer the following questions. State how the analyst might make a relative valuation in this case.

Which stock should the analyst recommend? RUF has 30 million shares outstanding and options outstanding for an additional 3,, shares. You are researching the valuation of the stock of a company in the food processing industry. You calculate Give two reasons why your conclusion that the stock is undervalued may be in error.

What additional information about the stock and the peer group would support your original conclusion? Suppose an analyst uses an equity index as a comparison asset in valuing a stock. Which price multiple s would cause concern about the impact of potential overvaluation of the equity index on a decision to recommend download of an individual stock? Tables and provide financial statements and other information for Sundanci. Price Multiples 41 i. The risk beta of Sundanci increases substantially.

The market risk premium increases. A change in a fundamental factor is assumed to happen in isolation; interactive effects between factors are ignored.

Every other item of the company is unchanged. The computations supporting his analysis follow. Growth will increase as indicated above and ROE will be steady. Tom Smithfield is valuing the stock of a food processing business. Compute terminal value based on comparables. Contrast your answer in Part A to an estimate of terminal value using the Gordon growth model. Avtech is a multinational distributor of semiconductor chips and related products to businesses. Its leading competitor around the world is Target Electronics.

Based on the information given, answer the following questions: Peninsular has a client who has inquired about the valuation method best suited for comparison of companies in an industry with the following characteristics: Jones recommends that the client consider the following valuation ratios: Support your answer with one reason that makes that ratio superior to either of the other two ratios in this case.

The return on equity is The Treasury bond rate is 4.

Price Multiples A. Assume that the dividend and earnings growth rates are 9 percent. Given that the assumptions and constant growth model are appropriate, state whether GE appears to be fairly valued, overvalued, or undervalued based on fundamentals. He has gathered relevant information on the companies in the following table. Justify your selection. Define the major alternative cash flow concepts, and state one limitation of each. Data for two hypothetical companies in the pharmaceutical industry, DriveMed and MAT Technology, are given in the table below.

For both companies, expenditures in fixed capital and working capital during the previous year reflected anticipated average expenditures over the foreseeable horizon. Justify your conclusion. Your value-oriented investment management company recently hired a new analyst, Bob Westard, because of his expertise in the life sciences and biotechnology areas.

He bases his recommendation to the Investment Committee on two considerations. Explain the difference between price multiples and relative strength approaches. Kirstin Kruse, a portfolio manager, has an important client who wants to alter the composition of her equity portfolio, which is currently a diversified portfolio of 60 global common stocks. The client wants a portfolio that meets the following criteria: The table below shows how many stocks satisfied each screen, which was run in November Critique the construction of the screen.

Do these screens identify an appropriate replacement portfolio for the client? Describe alternative measures of residual earnings, such as economic value added.

Discuss the uses of residual income models. Calculate future values of residual income given current book value, earnings growth estimates, and an assumed dividend payout ratio. Calculate the intrinsic value of a share of common stock using the residual income model.

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Contrast the recognition of value in the residual income model to value recognition in other present value models. Discuss the strengths and weaknesses of the residual income model.

Justify the selection of the residual income model for equity valuation, given characteristics of the company being valued. Identify and discuss the fundamental determinants or drivers of residual income. Explain the relationship between the justified price-to-book ratio and residual income. Explain the relationship of the residual income model to the dividend discount and free cash flow to equity models. Discuss the major accounting issues in applying residual income models.

Calculate an implied growth rate in residual income given the market price-to-book ratio and an estimate of the required rate of return on equity. Define continuing residual income and list the common assumptions regarding continuing residual income. Justify an estimate of continuing residual income at the earnings forecast horizon given company and industry prospects.

Calculate the intrinsic value of a share of common stock using a multistage residual income model, given the required rate of return, forecasted earnings per share over a finite horizon, and forecasted continuing residual earnings. Residual income is an appealing economic concept because it attempts to measure economic profit: The deduction is called the equity charge, and is equal to equity capital multiplied by the required rate of return on equity the cost of equity capital in percent.

Alternatively, we can forecast per-share residual income as beginning book value per share multiplied by the difference between forecasted ROE and the required rate of return on equity. The residual income model is most appropriate in the following cases: The fundamental determinants or drivers of residual income are book value of equity and return on equity. When fully consistent assumptions are used to forecast earnings, cash flow, dividends, book value, and residual income through a full set of pro forma projected financial statements, and the same required rate of return on equity is used as the discount rate, the same estimate of value should result from a residual income, dividend discount, or free cash flow valuation.

In practice, however, analysts may find one model much easier to apply and possibly arrive at different valuations using the different models. In other terms, the ending book value of equity equals the beginning book value plus earnings less dividends, apart from ownership transactions. Continuing residual income is residual income after the forecast horizon. Frequently, one of the following assumptions concerning continuing residual income is made: Based on the following information, determine whether Vertically Integrated Manufacturing VIM earned any residual income for its shareholders in Palmetto Steel, Inc.

PSI , maintains a dividend payout ratio of 80 percent because of its limited opportunities for expansion. Its return on equity is 15 percent. The required rate of return on PSI equity is 12 percent, and its long-term growth rate is 3 percent. Its cost of debt is 8 percent before taxes, and its cost of equity capital is 12 percent. Half of its assets were financed with debt with a pretax cost of 9 percent.

Its cost of equity capital is 12 percent, and its tax rate is 40 percent. Did SWI achieve a positive residual income? Calculate the economic value added EVA or residual income, as requested, for each of the following: Martin uses the fiscal information below for his analysis.

Calculate the following for Sundanci. EVA for fiscal B. MVA as of fiscal year-end c05a. Calculate the value of the stock using the following: Dividend discount model B. Residual income model 9. Notable Books NB is a family-controlled company that dominates the retail book market.

Its required return on equity is Place a value on the stock of NB using the following: Residual income model The last dividend includes the liquidating payment to shareholders at the end of Year 3 when the trust terminates. What is the current value per share of SITI according to the dividend discount model? Foodsco Incorporated FI , a leading distributor of food products and materials to restaurants and other institutions, has a remarkably steady track record in terms of both return on equity and growth.

For the foreseeable future, you expect the company to achieve an ROE of 15 percent on trailing book value and to pay out one-third of its earnings in dividends. Your required return is 12 percent. Lendex Electronics LE has had a great deal of turnover of top management for several years and was not followed by analysts during this period of turmoil.

Kent decides LE merits further analysis. Simms expects long-term ROE to be 18 percent, long-term c05a. What conclusion would you expect Simms to arrive at if he uses a single-stage residual income model to value these shares? Both favorable demographics and the likelihood of slow, steady increases in market share should enable DMH to maintain its ROE of 15 percent and growth rate of 10 percent over time.

Compute the value of its equity using the single-stage residual income model. Use the following inputs and the finite horizon form of the residual income model to compute the value of Southern Trust Bank STB shares as of December 31, Refer to Equation in the text. Having completed the revised analysis, which gives TSM greater credit for its patented technology, the analyst realizes that the changes warrant an additional adjustment.

Recall she is now using a persistence parameter of 0. Kobayashi has made the following assumptions: Prepare a table showing the beginning and ending book values, net income, and cash dividends annually for the eight-year period.

Estimate the residual income and the present value of residual income for the eight years. Estimate the value per share of UPS stock using the residual income model. Estimate the value per share of UPS stock using the dividend discount model. How does this value compare with the estimate from the residual income model? Assume that the single-stage growth model is appropriate for valuing BA. A satisfactory answer includes any four of the following uses of valuation models: A corporate officer would be most directly concerned with using valuation concepts and models to evaluate corporate events, evaluate business strategies and models, and communicate with analysts and shareholders.

In any present value model, present value is inversely related to the discount rate applied to expected future cash flows. As part of the planning step after specification of investment objectives , the investor will generally elaborate on his approach to investment analysis and security selection.

In the execution step, investment strategies are integrated with expectations to select a portfolio. In selecting a portfolio, the investor is continually put to the test to make accurate valuations of securities. Therefore, skill in valuation plays a key role in this step of the portfolio management process.

An investor trying to replicate a stock index does not need to make valuation judgments about securities. In contrast, active investors attempt to identify mispriced securities—in particular, securities expected to earn a positive excess riskadjusted return. The ex ante alpha is the expected return minus the required return for a stock. Because the analysts feel their stocks are undervalued, the expected returns should exceed the required rates of return and the ex ante alphas should be positive greater than zero.

The ex post alpha is the actual return minus the contemporaneous required return. For KMG, the ex post alphas are An asset with a positive negative expected alpha is undervalued overvalued. According to Part B, Security 2 and Security 3 offer positive expected alphas.

We might thus decide to invest in Security 2 and Security 3. The risks in such a decision include the following: We may not have accounted for all sources of risk reflected in the prices of the securities. It is also possible to enumerate other risks. For example, Chapter 2 discusses the uncertainty associated with estimating beta, the measure of risk in the CAPM.

The analyst collects, organizes, analyzes, and communicates corporate information to investors and then recommends appropriate investment actions based on his analysis.

When an analyst does his work well, clients are helped in reaching their investment objectives.

When well executed, the work of analysts promotes informed download and sell decisions. Such informed decisions make asset prices better reflections of underlying value, with the result that capital flows to its highest-valued uses. We need to know 1 the time horizon for the price target and 2 the required rate of return on MBFG.

Without a time frame, we cannot evaluate how attractive that rate is. Suppose that the time horizon is one year. To further interpret a 20 percent expected one-year rate of return, we need to adjust it for risk. This number would allow us to conclude whether the stock was fairly valued. By pushing down pre-acquisition EPS to an artificially low number, XMI can show unusual post-acquisition earnings growth rates.

Based on both expensing and revenue-recognition policies, earnings clearly do not accurately reflect underlying economics.

Equity Asset Valuation Workbook, 3rd Edition

As noted in Part A, XMI attempts to manipulate the expensing policy of acquisitions to benefit its own earnings growth rate. In summary, the quality of XMI earnings is poor. The underlying model is a relative valuation model or the method of comparables. Risk factors might include: When beta is negative, an asset has a CAPM required rate of return that is below the risk-free rate.

The value of each stock using the Gordon growth model is 0. All three stocks are selling at a premium above their DDM estimated values. Compounded for eight years, 0. The expected rate of return is D1 1. Then we multiply this sales per share figure by the number of outstanding shares to get the total sales figure. An analyst extending the dividend target would compute the value as follows: The table below calculates the first five dividends and also finds their present values discounted at 12 percent.

Equity Asset Valuation Workbook (Cfa Institute Investment)

D6 is found by growing the D1 dividend at 50 percent for two years, at 20 percent for two more years, and at 5 percent for one year: EB Systems dividends are expected to grow in two stages, and the two-stage dividend discount model DDM is used to value the stock.

Because the dividend is growing more rapidly during Years 1 through 5, the rate of return will exceed In the table below, we illustrate using trial and error to find the discount rate. The second column shows the dividends for Years 1 through 5. The following columns calculate the present value of these five dividends discounted at 11 percent, The present value of V5 is calculated and added to the present value of the first five dividends in the bottom row of the table.

Further trial and error reveals the discount rate to be Slightly different and acceptable values would be obtained if balance sheet averages were used for assets and equity or if the beginning value for equity were used. The sustainable growth rate of If the problem were temporary, management could simply accumulate resources in anticipation of future growth.

Assuming this trend continues for the longer term as the question states , however, management has at least two alternative courses of action when actual growth is below sustainable growth: Return on equity is the product of three components: If the company maintains the current capital structure and a stable dividend payout rate, the sustainable rate of growth is defined by the product of ROE, which was calculated above, and the retention rate 1 minus the dividend payout rate , which can be determined from Table An increase in the dividend payout rate lowers the retention rate and thus decreases the sustainable growth rate.

Bond issue Increase Financial leverage or equity multiplier. An increase in the debt ratio raises financial leverage or the equity multiplier and thus increases sustainable growth.

Stock split No effect None. A stock split affects none of the components and thus does not affect the sustainable growth rate. Proposal C. Justification QuickBrush should have an expected return above its required rate of return, whereas SmileWhite should have an expected return below its required return. The DDM is extremely sensitive to the estimated growth rate, g. As a result, a company such as QuickBrush can be evaluated in light of an anticipated change in sustainable growth.

Industries have distinct life cycles in which they typically move from a period of rapid growth to a period of normal growth and then to declining growth.

The two-stage model has many of the same problems as the constant-growth model, but it is probably a more realistic approach than assuming a constant growth rate for all time. Weaknesses inherent in all DDMs: All dividend discount models are extremely sensitive to input values. These inputs are difficult to estimate and may be based on unrealistic assumptions.

Property, plant, and equipment D. Interest expense E. Cash dividends paid 0 0 K. Shares issued 0 0 L. Share redownloads 0 0 2. Management discretion concerning dividends is limited by investor expectations that dividends will be maintained. Common stock dividends are not subtracted from FCFF, because doing so represents a distribution of the cash available to investors.

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If a company pays preferred dividends, they are added back in Equation to include them in FCFF if they had previously been taken out when calculating net income available to common stock dividends.

If preferred dividends had been subtracted to obtain net income in CFO , they would also have to be added back in. FCFE equals net income less the investments financed with equity: Taiwan Semiconductor Manufacturing Co.

The total value of equity is the FCFE discounted at the required rate of return of equity: Alternative values of beta, the equity risk premium, or the initial FCFE value also have a large impact on the value of the stock, although the impacts of these variables are smaller than that of the growth rate.

The following table shows net income, which grows at 20 percent annually for Years 1, 2, and 3, and then at 8 percent for Year 4. Debt financing is 40 percent of this investment. In Year 4, the investment in operating assets is 30 percent of net income, and debt financing is 40 percent of this investment.

For the first three years, Alcan has a small FCFE because of the large investments it is making during the high-growth phase. In the normal-growth phase, FCFE is much larger because the investments required are much smaller. The planner did not do this. So, EBITDA overstates the funds available to stockholders if reinvestment needs exceed depreciation charges, which is the case for growing companies such as Alcan. Dividing by a fixed rate also assumes erroneously that the cash flow stream is a fixed perpetuity.

EBITDA cannot be a perpetual stream because, if it were distributed, the stream would eventually decline to zero lacking capital investments. Alcan is actually a growing company, so assuming it to be a nongrowing perpetuity is a mistake. The table below develops the information to calculate FCFE.

The net capital expenditures each year were specified by the analyst. The increase in working capital per share is equal to 25 percent of net capital expenditures.

Debt financing for through is found in the same way. FCFE equals net income minus net capital expenditures minus investment in working capital plus new debt financing. Notice that FCFE is initially negative in because of large capital investments and investments in working capital. As these investments decline relative to net income, FCFE becomes very substantial and positive. The present values of FCFE from through are given in the bottom row of the table.

Because the FCFE from onward will grow at a constant 6 percent, the constant-growth model can be used to value these cash flows. FCFE is defined as the cash flow remaining after the company meets all financial obligations, including debt payment, and covers all capital expenditure and working capital needs. FCFE measures how much a company can afford to pay out as dividends, but in a given year, FCFE may be more or less than the amount actually paid out. The FCFE model requires forecasts of FCFE for the high-growth years and plus a forecast for the first year of stable growth to allow for an estimate of the terminal value in based on perpetual growth.

Alternatively, the components of FCFE can be projected and aggregated for each year. Capital expenditures 38 0. Increase in net working capital 41 0. FCFE 24 0. The DDM uses a strict definition of cash flows to equity—that is, the expected dividends on the common stock. The FCFE model expands the definition of cash flows to include the balance of residual cash flows after all financial obligations and investment needs have been met.

In instances of a change of corporate control, and thus the possibility of changing dividend policy, the FCFE model provides a better estimate of value. These two-stage models share the same limitations with respect to the growth assumptions. First, there is the difficulty of defining the duration of the extraordinary growth period.

For example, a longer period of high growth will lead to a higher valuation, and analysts may be tempted to assume an unrealistically long period of extraordinary growth. Second, an assumption of a sudden shift from high growth to lower, stable growth is unrealistic. The transformation more likely will occur gradually over a period of time. Third, because value is quite sensitive to the steady-state growth assumption, overestimating or underestimating this rate can lead to large errors in value.

The two models share other limitations as well, notably difficulties in accurately estimating required rates of return. Using a two-stage dividend discount model, the value of a share of Mackinac is calculated as follows: The FCFE model is best for valuing firms for takeovers or in situations that have a reasonable chance for a change in corporate control.

Because controlling stockholders can change the dividend policy, they are interested in estimating the maximum residual cash flow after meeting all financial obligations and investment needs. The dividend discount model is based on the premise that the only cash flows received by stockholders are dividends. FCFE uses a more expansive definition to measure what a company can afford to pay out as dividends. The real required rate of return for SK Telecom Co. The real growth rate of FCFE is expected to be the same as the country rate of 3.

The estimated future values of FCFE are given in the following table. Year t Variable Calculation 0. These calculated values for FCFE are shown in the table. The present values of the FCFE for the first four years discounted at the required rate of return are given in the last column of the table.

Normal EPS is the level of earnings per share that the company could currently achieve under midcyclical conditions. Averaging ROE over the — period, we find that 0. According to the method of average ROE, we have 0.

Neither business, however, has a history of profitability. The difference in earnings yield cannot be explained by differences in sales growth forecasts. In fact, Hand has a higher expected sales growth rate than Somersault. Therefore, the analyst should recommend Hand. But a specific reason to use leading 78 c04b.

For HS: Your conclusion may be in error because of the following: The following evidence supports the original conclusion: If the stock market is overvalued, an asset that appears to be comparably valued may also be overvalued. An increased market risk premium would increase the required rate of return, lowering the price of a stock relative to its earnings.

The argument concerning a change in dividend payout is incorrect. Any of the following arguments may be made: The company can also issue new stock. The sustainable growth rate formula cannot realistically serve as a basis to predict a cut in dividends. Investors look to the underlying cash flow of the business in valuation.

Because Yu is correct, CSG should be added to the focus list. Given the required rate of return of 0. In this case, the Gordon growth model estimate of terminal value is higher than the estimate based on multiples. The two estimates may differ c04b. Price Multiples for a number of reasons, including the sensitivity of the Gordon growth model to the values of inputs. Although the measurement of book value has a number of widely recognized shortcomings, it can still be applied fruitfully in several categories of circumstances: When a company is likely to be liquidated so that ongoing earnings and cash flow are not relevant the value of its assets less its liabilities is of utmost importance.

Naturally, the analyst must establish the fair value of these assets. Although companies are able to make a number of legitimate business and accounting decisions that affect earnings, their discretion over reported sales revenue recognition is more limited.

Hormel Using the CAPM, the required rate of return is 4. Zaldys should select RGI as relatively undervalued. The major cash flow concepts are: Ignores changes in working capital and noncash revenue. Not a free cash flow concept. Not a free cash flow concept, so not directly linked to theory. Often more variable and more frequently negative than other cash flow concepts. Relative strength is based strictly on price movement a technical indicator. In contrast, the price-multiple approaches are based on the relationship of current price not to past prices, but to some measure of value such as EPS, book value, sales, or cash flow.

The most restrictive criterion as judged by the number of stocks meeting it is the dividend yield criterion, which results in only 10 eligible investments. The screen strongly emphasizes dividend yield as a valuation indicator.

The screen may be too narrowly focused on dividend yield. It did not include variables related to expected growth, required rate of return or risk, or financial strength.

The screen results in a very concentrated portfolio. Except for Eastman Kodak, the companies are all utilities, which typically pay high dividends.

They belong to a very small segment of the investment universe and would constitute a narrowly focused and nondiversified portfolio. Yes, VIM earned a positive residual income: According to the residual income model, intrinsic value for a share of common stock equals book value per share plus the present value of expected future per-share residual income.

For SWI: Specifically, residual income equals 0. In the absence of information that would be required to calculate the weighted average cost of debt and equity, and given that Sundanci has no long-term debt, the only capital cost used is the required rate of return on equity of 14 percent. Because the dividend is a perpetuity, the no-growth form of the DDM is applied as follows: The book values and residual incomes for the next three years are: Year c05b.

Because the residual incomes for each year are necessarily the same in Parts B and C, the results for stock valuation are identical. Net income and residual income will grow by 10 percent annually. When items such as changes in the value of available-for-sale securities bypass the income statement, they are generally assumed to be nonoperating items that will fluctuate from year to year, although averaging to zero over a period of years.

The evidence suggests, however, that changes in the value of available-for-sale securities are not averaging to zero but are persistently negative.

Furthermore, these losses are bypassing the income statement. It appears that the company is either making an inaccurate assumption or misleading investors in one way or another. ROE would then decline commensurately. The value of TSM for the forecast period would be c05b. The table below shows calculations for book values, net income, and dividends.

Dividends are 30 percent of net income. The ending book value is the beginning book value plus net income minus dividends. The final column of the table gives the present value of the calculated residual income, discounted at 8. We need to estimate the final term, the present value of the excess of the terminal stock price over the terminal book value.

The present value of this amount discounted at 8. Discounting them at 8. The stock values estimated with the residual income model and the dividend discount model are identical. Because they are based on similar financial assumptions, this equivalency is expected. Even though the recognition of income differs between the two models, their final results are the same.

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If an investor pays the current GBP price for the stock, what will be the rate of return? Not a free cash flow concept. The Search for Power and Economic Justice.

The Treasury bill rate is 4. Pinto [PDF].

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