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!

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.