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Midterm Review - Key Concepts

This document discusses key concepts related to estimating the cost of capital and discounted cash flow valuation models. It covers estimating the risk-free rate, equity risk premium, beta, and cost of debt. It also discusses adjusting reported earnings and cash flows, estimating growth rates, and choosing the appropriate DCF model based on factors like stable versus changing leverage. The document provides explanations of calculation methods for various inputs to the DCF valuation.

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Gurpreet
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78 views10 pages

Midterm Review - Key Concepts

This document discusses key concepts related to estimating the cost of capital and discounted cash flow valuation models. It covers estimating the risk-free rate, equity risk premium, beta, and cost of debt. It also discusses adjusting reported earnings and cash flows, estimating growth rates, and choosing the appropriate DCF model based on factors like stable versus changing leverage. The document provides explanations of calculation methods for various inputs to the DCF valuation.

Uploaded by

Gurpreet
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as XLSX, PDF, TXT or read online on Scribd
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Cost of Capital

Concept Sub-Concept
Risk-free rate (Rf)

Equity risk premium (ERP)


Historical ERP

Implied ERP

Emerging market ERP

Beta
Regression Beta & the
CAPM Model

Bottom-Up Beta

Cost of debt
Three approaches

Firms in emerging
markets
Market value of debt

Estimating Earnings and Cash Flows


Converting reported
earnings to cash flows
for valuation

Trailing 12-month
earnings
Adjusting for R&D expense
Steps to capitalize R&D

Adjusted earnings and


book equity

Adjusting for operating


leases

Adjusting for one-time


income/expense
Choosing a tax rate

Adjusting capital
expenditures

Adjusting investments
in working capital

Estimating Growth and Terminal Value


Growth rate
Historical growth rate

Analyst Forecasts

Fundamental growth
rate

Three variations of
fundamental growth rate
Terminal value

Choosing the Right DCF Valuation Model


Free cash flow to the
firm (FCFF)
Free cash flow to equity
(FCFE)

Choosing cash flows

Choosing a discount
rate
Choosing a growth
pattern
Explanations
Mature Markets: Long-term Government bond rate
Emerging market: Sovereign Bond Rate – Default Spread, where default spread
can be estiamted by:
1. Sovereign bond rate in US$ – US Treasury bond rate with same maturity
2. Sovereign CDS rate – US CDS rate
3. Sovereign rating based spread

Arithmetic verage: simple average: (return1 + return2 + … + returnN)/N


Geometric average: compounded return over a time period: (ValueN/Value1)^(1/N)-
1
Historical ERP around the world is just below 4% over the past century

Estimate expected return of a stock index with the expected dividend and long-term
growth rate. For one-stage growth:
ERP = (index dividend next year/current index level + dividend growth rate) - risk-
free rate

ERP of emerging market = risk premium for a mature equity market + country
default spread

Rj = ⍺ + β*Rm
⍺: excess return of stock j, aka Jensen's Alpha
⍺ > Rf*(1-β): stock j performs better than expected
⍺ < Rf*(1-β): stock j performs worse than expected
β: riskiness of stock j relative ot the market
β > 1: stock j is riskier than the market
β < 1: stock j is less risky than the market

Estimate beta of a business based on the betas of other comparable businesses:


1. Find comparable businesses and obtain their regression beta
2. Calculate the average of their unlevered beta: βU = βL/[1+(D/E)*(1-t)]
3. Find the levered beta of the business being analyzed: βL = βU*[1+(D/E)*(1-t)]
Note: take weighted average βU for a firm with multiple sectors before step 3

1. Yield to maturity of the firm's outstanding bond


2. Risk-free rate + default spread based on the firm's credit rating
3. Risk-free rate + synthetic default spread based on the firm's interest coverage
ratio, where interate coverage ratio = EBIT/interest expense

Cost of debt = risk-free rate + firm default spread + country default spread
For firms do not have marketable bond outstanding, convert book value to market
value using the PV function, where
FV = book value of debt
PMT = interest expense on the debt
N = average maturity of the debt
Rate = pre-tax cost of debt

Step 1: Update earnings


Step 2: Correct earnings misclassifications
- Capitalize R&D expenses
- Capitalize operating leases
- Adjust for one-time income and expenses

Year-to-date value in the latest quarterly report + value in the latest annual report -
year-to-date value in the quarterly report of the same quarter last year

R&D is reported as operating expense in income statement, but is considered


capial expense for valuation purposes.

Steps to capitalize R&D:


Step 1: Determine the amortizable life (n) of R&D expenses: Amortization rate = 1/n
Step 2: Collect the firm’s R&D expenses over the past n years
Step 3a: Estimate the amortization of research asset: Amortization of R&D = R&D
expense in the year*amortization rate
Step 3b: Estimate the value of research asset: Value of research assets = sum of
the unamortized value of R&D going back to year n-1

Adjusted EBIT = EBIT + R&D expenses of current year – amortization of research


asset
Adjusted net income = Net income + R&D expenses of current year – amortization
of research asset
Adjusted book equity = Book equity + value of research asset

Operating lease expenses used to treated as operating expenses but should be


treated as financing expenses.
Beginning in 2019, both IFRS and GAAP require companies to capitalize leases
and show the resulting debt on the balance sheets.

Remove one-time income/expenses that are truly one-time from operating income.
Income/expenses that occur every n years should be amortized over n years.
Choose marginal tax rate over effective tax rate.
The effective tax rate assumes that taxes can be deferred forever which results in
overvaluation.

Capital expenditures should include R&D expense and acquisition costs:


Adjusted net capex = (Capex – depreciation) + current year’s R&D expenses -
amortization of research assets
Adjusted net capex = Capex – depreciation + current year’s acquisition costs -
amortization of such acquisitions

Non-operating items should be exlculded:


- Cash and investments in marketable securities
- Short-term debt and the portion of long-term debt that is due in the current period

Arithmetic average = (g-1+ … + g-n)/n


Geometric average = (earning0/earnings-n)^(1/n) - 1
Regressions

Generally perform better than historical growth rates when:


- The forecast period is short (next quarter versus 5 years)
- The firm is large in size
- Forecasting at the industry level than at the company level

Fundamental factors determining a firm's growth rate:


- Earnings reinvestment rate
- Return on investments

Growth in earnings per share:


g = ROEt+1 ⨉ Retention Ratio + (ROEt+1 – ROEt)/ROEt
Retention Ratio = 1 – Payout Ratio
ROE= Net Income/ Book Equity
Growth in net income:
g = ROEt+1 ⨉ Equity Reinvestment Rate + (ROEt+1 – ROEt)/ROEt
Equity Reinvestment Rate = (Net Capex + Change in WC – Change in Debt)/
Net Income
Growth in operating income:
g = ROCt+1 ⨉ Reinvestment Rate + (ROCt+1 – ROCt)/ROCt
Reinvestment Rate = (Net Capex + Change in WC)/ After-Tax Operating
Income
ROC = After-tax Operating Income/ (Book Equity + Book Debt – Cash)
The present value of a firm's cash flows in the stable growth stage, in which
- The growth rate should be no higher than the growth rate of the economy
- The only source of growth is through reinvestment
- The firm's beta is close to 1 and financial leverage is close to the industry
average
- ROC converges to the cost of capital and ROE converges to the cost of equity

Terminal value of equity = net income in (n+1)*(1 - stable g/ROE)/(cost of equity -


stable g)
Terminal value of the firm = after-tax operating income in (n+1)*(1 - stable
g/ROC)/(cost of capital - stable g)

on Model
FCFF = EBIT*(1-tax) – (Capital expenditures - Depreciation) – change in non-cash
working capital
FCFE = Net income – (Capital expenditures - Depreciation) – change in non-cash
working capital + (new debt issued – debt repayments)

If the firm has a fixed debt ratio for funding reinvestment,


FCFE = Net income – net capex*(1 – 𝛿) – 𝛥WC*(1 – 𝛿),
where 𝛿 = (debt issued – debt repaid)/(net capex + 𝛥WC)

Use FCFE if
Equity (or stock) is being valued
The firm has stable level of financial leverage
Use dividend if
FCFE cannot be estimated easily, and
The expected dividends are close to FCFE over an extended period
Equity (or stock) is being valued
Use FCFF if
The firm’s financial leverage is too high or too low, and is expect to change over
time
The firm (rather than equity) is being valued

Use the cost of equity for FCFE and dividends


Use the cost of the capital for FCFF
Stable growth for firms that are mature, large, and growing at a stable rate close to
or less than growth rate of the economy
Two-stage growth for
Large firms & firms growing at a moderate rate (overall growth rate ≤ 10%) or
Firms with barriers to entry with a finite life (e.g. patents)
Three-stage growth for
Small firms and firms growing at a very high rate (overall growth rate >10%) or
Firm with significant barriers to entry into the business

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