Exam 3

Front 1

Appeal of Residual Income

Back 1

Company's income statement includes a charge for the cost of debt financing in the form of interest expense, but it does not include any kind of charge for the cost of equity financing.

Front 2

Economic Value Added (EVA)

Back 2

Stern Stewart & Company; until a business returns a profit that is greater than its cost of capital, it operates at a loss, pays taxes, returns less to the economy than it devours in resources. "Destroys well"

Front 3

4 ways EVA can be increased

Back 3

1) Increase the ROIC generated by existing capital

2) Reduce the WACC on existing capital

3) Invest in new projects where ROIC exceeds the WACC

4) Discontinue existing projects where ROIC is below the WACC

Front 4

Market Value Added

Back 4

MVA= market value of the company- total capital

OR

MVA/Total Capital

Front 5

Tobin's q

Back 5

Developed by Tobin as the ratio of market value to replacement cost

=Market value of debt and equity/ replacement cost of assets

Front 6

Equity q

Back 6

Popularized by Smithers and Wright in Valuing Wall Street

=market value of equity/ net worth at replacement cost

Front 7

Limitations in using Tobin's q and Equity q

Back 7

1) hard to estimate replacement costs

2) intangible assets add to firm value but that value isn't recorded in financial statements (value of tangible assets)

Front 8

OECD Classification of Intangible Assets

Back 8

1) computerized information

2) innovative property (copyrights, trademarks)

3) economic competencies (brand equity, networks)

Front 9

When to use residual income model

Back 9

-firm doesn't pay dividends or unpredictable dividends

-firm has negative free cash flows for many years but will one day have positive cash flows

-great deal of uncertainty in forecasting terminal values

Front 10

Clean Surplus Relation

Back 10

assumes changes in the book value of equity derive solely from earnings and dividends (changes flow through the income statement)

Bt=Bt-1+Et-Dt => Dt=Et+Bt-1-Bt

Front 11

Residual Income (RI) Model

Back 11

the value of a share of stock equals its book value per share plus the present value of expected future residual income per share

Front 12

Single State (Constant Growth) Residual Income Model equation

Back 12

=B0+ROE-r

------------------ X B0

r-g

Front 13

Key Determinants of Intrinsic Value According to the RI Model

Back 13

book value and the relationship between ROE and required return

Front 14

Multistage Residual Income Model

Back 14

valuation model that can be used when residual income is forecast for finite time horizon with a terminal value included at the end of the time horizon to reflect continuing residual income after the forecast horizon

Front 15

Remember this for exam

Back 15

Terminal value in the residual income model is not as large of a driver of intrinsic value as it is in other models because the RI Model tends to be front-end loaded due to its reliance on beginning book value. This can be an advantage since forecasting errors tend to magnify over time.

Front 16

The RI Model is closely-related to what?

Back 16

The Price-to-Book Ratio

positively correlated to ROE

Negatively correlated to r

Front 17

Residual Income Fades Over Time

Back 17

model has a persistence factor of w equal to between 0 and 1. 0 means that RI will not continue after T. higher persistence factor the greater the stream of RI.

The model assumes ROE regresses towards r and that RI fades to 0

Front 18

Limitations of RI Model

Back 18

-Model is based on accounting data that can be manipulated by management

-Accounting data used for inputs may require significant adjustments

-Model requires the clean surplus relation holds, analyst makes appropriate adjustment when the clean surplus relation does not hold.

Front 19

Problems with Accounting Data: Reported EPS

Back 19

RI based on recurring items

-unusual items

-extraordinary items

-restructuring charges

-discontinued operations

-accounting changes

Front 20

Problems with Accounting Data: Book Value

Back 20

balance sheet should be adjusted for significant off-balance sheet assets and liabilities

-Inventory

-Deferred tax assets and liabilities

-Pension plan assets and Liabilities

-operating leases

-special purpose entities

-reserves and allowances (bad debts)

-intangible assets

Front 21

Problems with Accounting Data: Intangible Assets

Back 21

-important to include intangibles that can be separated from the entity (sold) in the book value of equity

-goodwill is not usually recognized as an asset unless it results from an acquisition

-research and development must be included

Front 22

Violations of Clean Surplus Relation

Back 22

happens when accounting standards permit changes directly to stockholders' equity, bypassing the income statement

-changes in the mrkt value of LT securities

-foreign currency translation adjustments

-certain pension adjustments

-fair value chngs in come financial instruments

Front 23

Absolute Valuation Models

Back 23

specify an asset's intrinsic value

Front 24

Relative Valuation Models

Back 24

compare an asset's value on a cross-sectional or time series basis

Front 25

Justified Price Multiple

Back 25

analyst's estimated fair value for that multiple

Front 26

Determinants of P/E

Back 26

1) positively related to growth

2) negatively related to required return

Front 27

Given g= b X ROE

Back 27

1) ROE>r, increases the retention rate increase P/E

2) ROE

Front 28

Why is P/E ratio still the most closely-followed price multiple by equity analysts?

Back 28

commonly believed that equity markets price expectations about a firm's earnings growth

Front 29

Limitations of Using P/E

Back 29

1) EPS can be negative for individual stocks, and the P/E ratio doesn'tmake sense with neg denom

2) Earnings often have volatile or transient components which makes comparisons hard

3) Mgmt has the discretion under GAAP to make various ACCT choices that can harm the comparability of P/E over time or across companies

Front 30

Trailing/ Current P/E

Back 30

makes use of the most recent four quarters of EPS. (Trailing 12 months or TTM)

Front 31

Leading or forward P/E

Back 31

makes use of the next year's expected earnings

Front 32

Underlying EPS or Ongoing EPS

Back 32

excludes anything from reported earnings that is considered an unusual or non-recurring item. identify the "true" earnings from a company's core operations

Front 33

Pro forma EPS

Back 33

reflect earnings that have been adjusted from GAAP by the reporting company by excluding one or more costs to give what the company believes to be a truer picture of its underlying profitability

Front 34

Adjustments to EPS

Back 34

1) transitory, nonrecurring components of earnings that are company specific

2) changes in the choice of accounting methods over time

3) transitory components of earnings due to the business cycle or the cyclicality of the industry the firm operates in

4) potential dilution of EPS if the option to purchase shares via employee/executive stock options, warrants, or convertibles is used

Front 35

Molodovsky Effect

Back 35

countercyclical property of P/E

Front 36

normalized EPS or Normal EPS

Back 36

the level of EPS that the company could achieve currently under mid-cyclical conditions

Front 37

Two Methods Used to Determine Normalized EPS

Back 37

1) method of historical avg EPS( doesn't account for changes in the size of business)

2) method of average ROE (PREFERRED METHOD)

Front 38

method of average ROE

Back 38

Preferred method

calculated as the average ROE from the most recent full cycle, multiplied by current book value per share.

Front 39

Irrational Exuberance

Back 39

Robert Shiller adjusts the S&P 500 and EPS for CPI inflation and uses the avg of the last 10 years of monthly data for EPS to compute P/E

Front 40

Basic Earnings Per Share

Back 40

reflect reported earnings divided by the weighted average number of shares actually outstanding during the period

Front 41

Diluted eranings per share

Back 41

reflect division by the number of shares that would be outstanding if holders of the securities as executive stock options, equity warrants, and convertible bonds exercised their options to obtain common stock

Front 42

Fed Model

Back 42

named by Ed Yardeni based on the result of the Hymphrey-Hawkins report to congress. Fed Model is misleading and is not endorsed by the federal reserve

Front 43

Fed Model Predictions

Back 43

1) stocks are undervalued (overvalued) if the earnings yield on the S&P 500 is greater than (less than) the T-bond yield

2) stocks are undervalued (overvalued) if the P/E ratio for he S&P 500 is less than (greater than) the reciprocal of the T-bond yield.

Front 44

Problems with the Fed Model

Back 44

1) completely ignores the equity risk premium

2) the relationship is far from constant over time

3) compares a real variable, the earnings yield, to a nominal variable, the T-bond yield

4) biased towards stocks- use forecasts for OI which is higher than NI

Front 45

Rule of 20

Back 45

valuations are fair when the sum of the market's price-earnings ratio and the rate of inflation is equal to 20

fair value P/E- 20.0 inflation rate

Front 46

Price to book value (P/B)

Back 46

stock or level variable which appears on the balance sheet; represents the investment that common shareholders have made in the company

Front 47

Common Shareholder's Equity (Book Value)

Back 47

=common stock+additional paid-in capital + retained earnings- treasury stock

Front 48

additional paid-in capital

Back 48

difference between the market value and par value of common shares when they were issued

Front 49

Limitations of P/B

Back 49

-best suited for liquid companies

-doesn't reflect the benefit of human capital or other intangible assets

-may not reflect the effects of inflation due to historic cost accounting conventions

-capital insensitive firms usually have a higher book value making comparisons difficult

Front 50

P/B relationship

Back 50

1) Positively related to ROE

2) Negatively related to required return

Front 51

Price-to-sales (P/S)

Back 51

calculated as price per share divided by annual net sales per share (gross sales less returns and discounts)

Front 52

Reasons to use P/S

Back 52

-sales as top line number on the income statement are not as easy to manipulate

-not sensitive to the business cycle

-doesn't suffer from the problem that EPS can be negative for some firms

Front 53

Problems using P/S

Back 53

to create value for investors, a firm must generate earnings; revenues not equal to profits

Front 54

P/S relationship

Back 54

positively related to profit margin and the dividend/ earnings growth rate

negatively related to its required return

Front 55

Price-to-cash flow (P/CF)

Back 55

calculated as price per share divided by some per share measure of cash flow

=EPS+ per share non cash charges

Front 56

FCFE : Free cash flow to equity

Back 56

=Net income + Ncc -FCInv - WCInv+ Net borrowing

Front 57

EBITDA: earnings before interest, taxes, depreciation, and amortization

Front 58

Why use P/CF

Back 58

-better measure because considerable non-cash expenses

-less subject to accounting manipulation than earnings

-typically more stable than earnings

Front 59

Dividend Yield (D/P)

Back 59

calculated as the dividend per share divided by the price per share

high dividend yield is an indication of value!

Front 60

why use the dividend yield?

Back 60

-component of total return

-investors rely on income from investments to maintain current lifestyles

-income from dividends is taxed the same as capital gains

Front 61

Limitations of D/P

Back 61

raising the payout ratio implies a decrease in b and g. while a higher payout ratio results in a larger dividend, it also implies a slower rate of earnings growth and price appreciation known as dividend displacement of earnings

Front 62

enterprise value multiples

Back 62

market value of common equity

+ market value of preferred stock

+ market value of debt

- cash and short-term investments

= enterprie value

Front 63

Enterprise Value (VA) to EBITDA

Back 63

-most widely used enterprise value ratio

-flow to both debt and equity so comparison is appropriate

Front 64

Enterprise value to sales (EV/sales)

Back 64

-alternative to P/S

-some revenue is used to pay principal and interest on debt

Front 65

Momentum Indicators

Back 65

-price ( technical indicators)

-fundamental ( earnings)

Front 66

Earnings Momentum

Back 66

occurs when a company continues to show accelerating earnings growth from quarter to quarter (LT sign)

-positive earnings trends

-EPS estimate upgrades

-positive earnings surprises

Front 67

Good Value Investors

Back 67

operate in the bottom left quadrant of the cycle; need to be contrarian buyers

Front 68

Good Growth Investors

Back 68

operate in the top left quadrant of the cycle; need to be contrarian sellers

Front 69

Relative Strength or Price Momentum Indicators

Back 69

compare a stock's performance during the current period with :

1) its own past performance

2) performance of other stocks

3) performance of an industry or market index

Front 70

Relative Strength Index

Back 70

-developed by Wilder

-momentum indicator that measures the speed and change of price movements

-between 0-100

-overbought when about 70

-oversold when below 30

=average gain/ average loss

Front 71

Moving Averages

Back 71

average share price over a certain number of days and shows the volatility of day to day and week to week movements to show general direction of price