Reading 47: Free Cash Flow Valuation

I finished doing this Reading from Schweser and the Curriculum combined. Schweser has actually done a good job on this one. I am yet to work out the Chapter End Problems though. I'll do that tomorrow.

Some useful concepts:

1. FCFF and FCFE are the cash flows available to all of the investors in the company and to common stock holders, respectively.

2. Analysts like to use free cash flow as return (either FCFF or FCFE) when-

• the company is not dividend paying
• the company is dividend paying, but the dividend stream differs a lot from the company's dividend paying capacity
• if FCFs align with profitability within a reasonable forecast period with which the analyst is comfortable; or
• if the investor takes a control perspective (as in the case of mergers and acquisitions).

3. FCFF is preferred if the company is unstable or has huge amount of debt because the FCFE might be very low or negative in this case. FCFE is used if the company is stable and mature.

4. Some important formulas that we need to memorize:

FCFF= NI+ NCC+(Int(1-Tax Rate))-FCInv-WCInv

FCFF=EBIT(1-t)+Depr-FCInv-WCInv

FCFF=EBITDA(1-t)+(Depr*t)-FCInv-WCInv

FCFF=CFO+Int(1-t)-FCInv

FCFE=FCFF-(Int(1-t)+net borrowing

FCFE=NI+NCC-FCInc-WCInv+Net Borrowing

FCFE=CFO-FCInv+Net Borrowing

For forecasting FCFE, we use=NI-[(1-DR)*(FCinv-Dep)]-[(1-DR)*WCInv], where DR= % of Debt Financing

Working Capital Investments exclude cash, cash equivalents, notes payable and the short term part of the long term debt.

NCC includes Depreciation, Amortization, Gains (-), Losses (+), Restructuring Costs (+ if expenses), restructuring costs (income resulting from reversal should be subtracted), amortization of bond discount should be added and amortization of bond premium needs to be subtracted.

5. Earning components such as net income, EBIT, EBITDA and CFO should not be used as cash flow measures to value a firm. These earnings components either double count or ignore parts of the cash flow stream.

6. The revelant discount rate for FCFF is WACC and for FCFE, it is the cost of equity.

7. Dividends, share repurchases, and share issues have no effect on FCFF/FCFE. Only the change in the debt amount has some effect on the FCFE. When we retire debt, then initially FCFE falls, then in later years, it increases because of the reduction in interest expense.

8. We can calculate FCFF/FCFE using One stage, Two stage or three stage discount models, where the future cash flow streams are discounted at the appropriate discount rate.

9. The terminal value can be calculated in two ways- Using the single stage or multiple stage approach. Or using a valuation multiple such as trailing or leading P/E multiplied by the Earnings estimate.

Reading 46: Dividend Discount Valuation

I have been reading this chapter since yesterday and I’ve made some good progress with the material here- mainly due to the fact that most of it is not new to me. We have been re introduced to concepts such as DDM, Gordon Growth Model (GGM) etc.

The Curriculum has a very nice summary at the end. So, I don’t think I’ll be putting up any notes for this reading. It will be a waste of time for me. I have another eight pages left to read. Also, the chapter end problems.

I’ll post some formulae tomorrow. That’s all.

I need to complete Equity Valuation by 12/31. That’s another 250 pages to read. As of now, it sounds a little daunting, but I think I should be able to manage it, provided I don’t get drunk and waste time. Moreover, I need to remind myself to study.

Reading 45: US Portfolio Strategy- Seeking Value

The Reading introduces us to a research report by Goldman Sachs. The report itself talked about grouping industries and companies into two groups- over valued and under valued. Various techniques for analysis have also been discussed. While the official curriculum explicitly states that we need to understand the method of analysis instead of learning industry/company specifics, this is exactly what it doesn’t address! Hmmpff.

So, I had to fall back on Schweser to learn the answers for the different LOSs. The main points are as follows-

1. A 10-year moving average should be used because it provides a near term historic benchmark against which the current valuations can be measured. The methodology used in this study uses a standard deviation of the distribution associated with the 10 yr moving average used when computing the average valuation scores.

2. Whenever multiple variables are used to measure the same financial characteristic, it is important that their correlations be positive. This provides assurance to the analyst that his study will generate the same over/under valuation and he will have more confidence in the overall score.

3. The PEG ratio= P/E/ Growth Rate. It should be used with care when we deal with low growth, no growth and negative growth companies because the PEG ratio becomes quite useless in these scenarios.

High PEG ratio means that the stock is over valued and a low PEG ratio means that the stock is under valued. The typical range should be between 1 and 2. Suppose that the stock is of low growth- Then the PEG ratio will get inflated artificially, even though this might not be true (Eg- P/E= 3, g= 1%, PEG= 3. But a stock with a P/E of 3 will hardly ever be over valued).

In case of no growth stock, PEG ratio will be infinite, which doesn’t make sense. Stocks that have negative growth will have a negative PEG ratio, which again is meaningless.

4. Whenever a valuation model uses DCF, then the model becomes very sensitive to the discount rate.

For example, V= D1/(r-g). So, any change in ‘r’ will produce a large change in the value of the stock.

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Any of you reading this post- Dd you go through all those charts and graphs in the Curriculum? Should I learn anything else from this Reading? Thanks!