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.

******

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!

Reading 44: Company Analysis and Stock Valuation

This reading is a small one and took me only around 45 minutes. The first part is a repetition and re-introduces the concept of franchise P/E.

Intrinsic P/E= Base P/E + Franchise P/E

Franchise P/E= FF*G, where FF= (ROE-r)/(ROE*r) and G= g/(g-r)

There is a new concept in this Reading, called the Growth Duration Model, which basically states that the ratio of the P/Es of a high growth and a non growth stock should be proportional to their composite growth rates. The growth estimate must consider both the rate and how long this growth rate can be sustained- that is, the duration of the expected growth.

ln (P/E (g): P/E (a))= Tln(1+dg+gg)/(1+da+ga)

The numerator is the P/E and the composite growth rate of the growth stock and the denominator is the P/E and the composite growth of the non growth stock.

dg and da= dividend yield of the growth and the non-growth stocks

gg and ga= growth rate of the high growth and the non growth stocks.

T= the number of years for which the growth stock needs to have above average growth rate in order to justify the high P/E ratio.

From the Gordon Growth Model, r= Dividend Yield (D/P)+ Capital Gains Yield (g). So, the denominator can be reduced to (1+r). Keep that in mind.

So, if the implied growth rate according to the model is greater that what you believe is reasonable, then we would sell that stock. On the other hand, if the implied growth rate acc. to the model is less than what you believe is reasonable, then you would buy that stock.

Factors to Consider:

1. We use the expected rate of growth.

2. Technique assumes equal risk and equal payout ratio.

3. This technique assumes that stocks with higher P/E have the higher growth rates. However, this might not be true. High P/E stocks might have low growth rates and vice versa.

This inconsistency between the P/E and the growth rate might occur due to several reasons-

a. Major difference in the risk involved

b. Inaccurate growth estimates- The higher P/E stock might have a higher growth rate and the lower P/E stock might have a lower growth rate.

c. If the higher P/E stock has a lower growth rate, then it is over valued. (Consider a. and b. before considering c.)

d. If a low P/E stock has a high growth rate, then it might be under valued. (Consider a. and b. before considering d.)

So, the results of our modeling will only be as good as our assumptions and other data inputs.

Reading 43: Valuation in Emerging Markets

After about 4 days, I finally picked up my book again. Blame it on my Graduation excitement. Yeah- I’m an MBA now.

I did this reading from Schweser after seeing that the official reading is too long. I might come back to the official curriculum in case I’m having trouble solving questions. I worked out the concept checkers at the end of Schweser material and they are really good.

Main Concepts:

1. The real valuation approach discounts real cash flows at the real rate of return, while the nominal valuation approach discounts nominal cash flows at the nominal rate of return. But the value of the firm using both the methods will be almost the same.

2. Cash flow forecasting for real markets tends to be challenging because of the high inflationary environment. Three issues require particular attention-

• Income taxes are based on nominal earnings; so an estimation of nominal EBITA is required.
• Real NWC and Nominal NWC are not the same. We need to divide Nominal NWC by the inflation rate to arrive at the Real NWC. The change in the nominal NWC captures the flow effect, but the holding loss in real NWC is ignored. So, in an inflationary environment, the investment in Real NWC increases and the real FCF decreases.
• Nominal capital expenditures are difficult to calculate by simply calculating sales and related expenditures because of the high inflation. So, we need to calculate the real sales, real capital expenditures, real EBITDA and depreciation on a real basis.

3. FCF= NOPLAT+ Depreciation- Change in NWC- Change in Net Capital Expenditure

NOPLAT= EBITA- Taxes

4. Steps for valuing a firm in an emerging economy on a real and nominal basis are-

• Calculate the revenue, EBITDA, Invested Capital and EBITA on a real basis.

[Note: Invested Capital= Net PPE (End)+ NWC;

Net PPE (End)= Net PPE (Beg)- Depreciation +Capital Expenditure.

Depreciation is calculated by Dividing the Beg. PPE by the number of years.]

• Calculate the Revenue, EBITDA, Depreciation and EBITA on a nominal basis.
• Calculate the real NOPLAT
• Calculate FCF on a real and nominal basis.
• Estimate firm value in both real and nominal terms by discounting the real and nominal FCF at the real WACC and the nominal WACC. The nominal WACC is not the same every year because of the inflation rate. (1+nominal rate)= (1+real rate)(1+ inflation rate)

Effect on Financial Ratios: Generally the ratios in real terms are accurate and the ratios in nominal terms are incorrectly estimated. ROIC (Return on Investment Capital= NOPLAT/Beg. Invested Capital) is overstated in nominal terms. NWC/Revenue is correctly states in both real and nominal terms. Ratio of PPE/Revenue is generally understated in nominal terms.

5. There are two ways of incorporating emerging market risk in the valuation process- a. Adjusting the cash flows in a scenario basis b. Adjusting the discount rate by adding a country risk premium. Adjusting the cash flows has more support because of the following reasons-

• Country risks are diversiable
• Companies respond differently to country risk. (All companies might not use the same country risk premium. So it’s better to adjust the individual cash flows).
• There is no systematic method to calculate a country risk premium.
• When managers have to discuss emerging market risks and their effects on cash flow in scenarios, they gain more insights than they would get from country risk premium.

6. Calculation of WACC should follow these guidelines-

Risk free rate= 10 yr US Govt Bond Yield + Difference in inflation betn. both the countries

Beta= Industry beta from a globally diversified market index.

Market Risk Premium should be between 4.5-5.5% (long term average risk premium on a global market index)

Pre-tax cost of debt= Local Risk free rate + US credit spread on comparable debt

Marginal Tax Rate- Only taxes that apply to the interest expense should be included. Other taxes or credits should be modeled directly in the cash flows.

Some assumptions that are used while calculating WACC-

We have adopted the perspective of an international investor who has a diversified portfolio. As long as international investors have access to local investment opportunities, local prices will be based on an international cost of capital. Another assumption is that most country risks are diversifiable from the perspective of a global investor. We therefore need no addl. risk premium in the cost of capital when discounting cash flows.

7. When using the Country Risk Premium approach, we should keep the following points in mind-

Do not simply use the sovereign risk premium which is the difference betn. the long term US bond yield and a dollar denominated local bond’s yield with the same maturity. This is because this difference will reasonably approximate the country risk premium only if the cash flows of the corporation being valued moves closely in line with the payments on government bonds.

We need to understand estimates from different analyst sources because the underlying assumptions will vary. For eg- A high country risk premium might be used along with a very high growth rate and a low country risk premium might be used with a low growth rate. So the final value might still be the same.

We should not set the country risk premium too high. One way to do this is to compare the expected return using the CAPM Model with the historical real rate of return.

Reading 42: Industry Analysis

This reading was quite interesting. I used Schweser as a study guide to get a gist of the entire chapter and then used the Curriculum for my main reading. Took me about 2.5 hours, I guess. I worked out the concept checkers at the end of Schweser 2007.

Main points:

The model of an Industry Analysis should include-

Industry Classification

External Factors

Demand analysis

Supply Analysis

Profitability

International Competition and Markets (Not covered by the LOS).

Let’s discuss each of these parts in details now-

I. Industry Classification- Can be done either by Industry Life Cycle or Business Life Cycle.

a. Industry Life Cycle- Pioneer, Growth, Mature and Decline are the 4 stages.

Pioneer- 7/10 start up businesses fail to survive.

Growth- Even when the economy is doing poorly, growth industries can experience positive profits. They prosper independent of the business cycle.

Mature- Within a mature industry, there might be a couple of growth companies. They can achieve this by acquisition or improved quality/service.

Decline- Remaining participants consolidate. The better managed survivors anticipate this fate and avoid it by using cash flow to diversify into promising industries.

b. Business Life Cycle- Industry classified as either-

Growth -above normal rate of expansion and independent of the business cycle. Eg- Computer Software Industry).

Defensive- Stable performance throughout the business cycle. Egs- Utilities, food, cigarettes and beer industry and govt. contractors.

Cyclical- Produce discretionary products, the consumption of which depends upon the economic optimism. Egs- Auto industry, heavy equipment and machine tool producers. Certain cyclical firms experience earnings patterns that do not correlate well against the general economy, but trend against other economic variables. (Brokerage firms use the stock prices as their base and agricultural firms that are related to the crop price cycle).

Problems with Industry Classification-

a. Self-deception- placing all not all companies in a mature industry are mature companies.

II. External Factors-

There are five external factors:

Technology- For pioneer industries, the question is will the market accept the innovation? For mature industries, the question is- will the industry face obsolescence from competing technologies?

Govt- New regulations, changes etc. can impact an industry either positively or negatively. For eg- Tobacco industry facing problems.

Social changes- Either due to fashion or lifestyle changes. Fashion changes are of a shorter duration and more unpredictable. Eg- women’s clothing line. Lifestyle changes take place over long periods of time and easier to determine.

Demographics- Studying the vital stats of population, such as distribution, age and income. They are easier to identify and track compared to other external factors, but disagreement occures in sizing up its impact on relevant industries.

Foreign influences-Foreign policies and restrictions.

III. Demand Analysis- Can be achieved in three ways-

a. Top Down Economic Analysis when the revenues correlate strongly to one economic statistic.

b. Industry Life cycle- Categorizing the industry within its life cycle position.

c. External Factors

Customer Study- Segmenting the customers into submarkets (based on user type, type of business, geographic, sex, age etc.) to study a smaller number of factors that contribute to demand.

For established industries, the analyst should contact long time customers to figure what drives demand in each submarket.

For growth industries- the analyst considers new outlets for the industry’s products.

Untested industries- We need to determine if the new industry fulfills a need that exists and isn’t being met by another industry. Assuming a new is verified, analysts typically forecast new industry sales based on the experience of a similar industry.

Input/Output Analysis- A rising consumption of the finished product boosts demand for industries supplying the intermediate steps.

IV. Supply Analysis-

In the long term, it is appreopriate to assume that supply will equal demand. In the short term, there can be a shortfall in supply in case of -

a. Capacity intensive industries where the lead time is high, or

b. When capacity is diabled due to natural disasters.

The analyst should obtain data on the aggregate size of the potential supply of output from a given industry- incl. foreign industry- and compare this with projected demand for the industry output (called capital utilization data, which is equal to the total capacity divided by the total demand).

V. Profitability, Pricing and the Industry Study

A supply/demand forecast gives an indication of future profitability. A projected oversupply will retard investment since it augurs lower prices.

Factors contributing to pricing include:

a. Product segmentation- Most industries effectively segment their product offerings by brand name, reputation, or service, even when the products are quite similar.

b. Degree of industry concentration

c. Ease of industry entry

d. Price changes in key supply inputs

****

I left out the pages that talked about International Competition and Markets because it’s not covered by any of the relevant LOSs.