Category: Essential Concepts for Level II

04-12-19 Essential Concept 41: Target Company Valuation

Discounted cash flow analysis: In this method, we discount the company’s expected future free cash flows to the present in order to estimate the value of the company. A two-stage model is used. The first stage includes only those years where an analyst can provide reasonably accurate estimates of the company’s free cash flows. These are discounted to their present value, using an appropriate discount rate. The second stage incorporates value derived from years beyond the first stage. This is called the terminal value of the company. The terminal value is then discounted back to the present. The sum of… Read More

101 concepts level II

04-12-19 Essential Concept 42: Intrinsic Value and Sources of Perceived Mispricing

Intrinsic value is the true or real value given a hypothetically complete understanding of the asset’s investment characteristics. Intrinsic value might be different from the current (market) price of an asset. Perceived mispricing is the difference between the estimated intrinsic value and the market price of an asset. It can be expressed as: VE – P = (V – P) + (VE – V) Interpretation: The first component is (V-P) is the true mispricing or market error. It is the difference between the unobservable intrinsic value V, and the observed market price An analyst exploits the mispricing if it arises from the first term as it contributes to the… Read More

101 concepts level II

04-12-19 Essential Concept 43: Return Concepts

Holding period return is the return earned from investing in an asset over a specified period of time. Realized return is the holding period return earned in the past. Expected return is the expected holding-period return for a stock in the future based on expected dividend yield and the expected price appreciation return. Required return is the minimum level of expected return that an investor requires over a specified period of time, given the asset’s riskiness. Asset’s expected alpha or expected abnormal return is the difference between the expected return and the required rate of return on an asset. It… Read More

101 concepts level II

05-12-19 Essential Concept 44: Equity Risk Premium

The equity risk premium is the incremental return above the risk-free rate that investors expect from holding equities. It can be used to calculate the required return for a particular stock. Required return on a stock = current expected risk-free return + βi * equity risk premium Historical equity risk premium is the mean value of the difference between a broad-based equity market index returns and government debt return over some selected period Generally, longer time period is better, but if the selected is too long then there is a risk that ERP has permanently shifted to a different level…. Read More

101 concepts level II

05-12-19 Essential Concept 45: Estimating Required Return on Equities

The CAPM is the widely used for estimating required return. Required return: The Fama–French model (FFM) is a three-factor model; it adds two premiums in addition to the equity risk: a size factor, and a value factor. The Pastor-Stambaugh model is an extension to the FFM; it adds a fourth factor for liquidity. Build up models are similar to risk premium approaches, however they do not use betas to adjust for exposures to factors. An example is the bond yield plus risk premium approach, which is used to value the equity of companies with publicly traded debt…. Read More

101 concepts level II

05-12-19 Essential Concept 46: Top-down and Bottom-up Approaches

Top-down approach begins at the economy level, then the industry and finally to the company level. There are two top-down approaches: Growth relative to GDP growth: In this approach, we: Forecast nominal GDP growth rate (can forecast real GDP growth and inflation separately) Forecast revenue growth relative to GDP depending on the company’s position in the lifecycle and/or business cycle sensitivity. The forecasted revenue is expressed in two ways: As percentage point discounts or premiums. For instance, Pfizer’s revenue is projected to grow at 100 bps above nominal GDP growth rate. In relative terms: GDP is forecasted to grow at… Read More

101 concepts level II

05-12-19 Essential Concept 47: Impact of Competitive Factors in Prices and Costs

The forecasting process must consider the competitive environment of a company/industry. Porter’s “five forces” framework is commonly used to analyze the impact of competition on future prices and costs. Force Comment Threat of substitutes If numerous substitutes exist and switching costs are low, companies have limited pricing power. If few substitutes exist and/or switching costs are high, companies have greater pricing power. Internal rivalry Pricing power is limited in industries that are fragmented, have limited growth, high exit barriers, high fixed costs, and have more or less identical product offerings. Supplier power Companies (and overall industries) whose suppliers have greater… Read More

101 concepts level II

05-12-19 Essential Concept 48: Dividend Discount Model (DDM)

The value of a stock using DDM for a single-holding period is: The value of a stock using DDM for multiple finite holding periods is: The value of a stock for infinite holding periods is: There are two approaches to forecast dividends. One is to assume that they follow a stylized growth pattern (constant growth, two-stages of growth, or three stages of growth). The other alternative is to forecast dividends for a finite period, then forecast the remaining dividends based on a pattern or by calculating the terminal stock price.

101 concepts level II

05-12-19 Essential Concept 49: Gordon Growth Model

The Gordon growth model assumes that: Dividends grow at a constant growth rate g. Discount rate r is constant and is greater than g. Dividends bear and understandable and consistent relationship with profits. The value of a stock using the Gordon growth model is: If prices are efficient (price equals value), the price is expected to grow at a rate of g, known as the rate of price appreciation. In this case, the stock’s expected rate of return is: If an estimate of the next-period dividend and the stock’s required rate of return are given, then the Gordon growth model… Read More

101 concepts level II

05-12-19 Essential Concept 50: Multistage Dividend Discount Models

Companies with varying growth prospects must be valued using multistage DCF models such as the two-stage DDM, H-model, three-stage DDM or spreadsheet modeling. The assumptions of these models are: Two-stage DDM: this model assumes different growth rates in stage 1 and stage 2. A supernormal growth in stage 1 is followed by a lower, sustainable growth rate in second stage. H-model: the dividend growth rate declines linearly from a high supernormal rate to the normal growth rate in stage 1, and becomes constant and normal in stage 2. Three-stage DDM: There are two variations of this model. In one version,… Read More

101 concepts level II