CFA Level II

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Equity

Topic Area Weights in CFA Level Ⅱ

Topic Area Weights (%)
Ethics and Professional Standards 10%-15%
Quantitative Methods 5%-10%
Economics 5%-10%
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Financial Reporting and analysis 10%-15%

Corporate Finance 5%-10%
Portfolio Management 5%-15%
Equity 10%-15%
Fixed Income 10%-15%
Derivatives 5%-10%
Alternative Investments 5%-10%
Total: 100%

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CONTENTS
目录
Equity valuation: applications and processes

Return concepts

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Industry and company analysis

Discounted dividend valuation

CONTENTS
目录
Free cash flow and other valuation

Market-based valuation
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Residual income valuation

Private company valuation

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Equity valuation: applications and processes

 Definitions of values
 Applications of equity valuation
 The valuation processes

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Definitions of values

 Different kinds of values

 Intrinsic value (IV):
 IVanalyst−price=(IVactual−price)+(IVanalyst−IVactual)
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 For most investment decisions, use Intrinsic

value (IV).

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Definitions of values

Price
IVanalyst
Valuation error
IVactual

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True mispricing

Market price
Time

Definitions of values

 Fair market value: the price at which an asset

would change hands between a willing,
informed, and able buyer and a willing,
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informed, and able seller.

 Investment value: is the value of a stock to a
particular buyer.

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Definitions of values

 Going‐concern value
 Under a going-concern assumption:
Company will maintain its business

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activities into the foreseeable future.

Definitions of values

 Non‐going‐concern value
 Under a non‐going‐concern assumption:
Company will finish its operating and all
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assets will be sold out.

 Liquidation value=Value of asset sold−Value
of liability
 Generally, Going‐concern value ＞ Liquidation value

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Equity valuation: applications and processes

 Definitions of values
 Applications of equity valuation
 The valuation processes

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Applications of equity valuation

 Objectives of valuation
 Stock selection
• 分析师通过比较某只股票的内在价值和该
股票的市场价格或其它可比股票的市场价
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格来做出投资决策。
 Inferring (Extracting) market expectations.
• 当前的市场价格反映投资者对未来的预期。

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Applications of equity valuation

 Evaluating corporate events

• 市场专家(market professionals)使用估值技
术 来 确 定 公 司 兼 并 (mergers), 收 购

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(acquisitions), 剥离(divestitures), 管理层收
购[ management buyouts (MBOs) ]及资本
重组(recapitalization)的影响。

Applications of equity valuation

 Rendering fairness opinions

• 分析师使用估值技术来确保少数股东在收购兼
并过程中能获得或支付一个公平合理的价格。
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 Evaluating business strategies and models

• 公司雇佣分析师来评估拟定的公司战略对股票
价格的影响，以确保实现股东利益最大化。

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Applications of equity valuation

 Communication with analysts and investors

• 估值方法的存在会使得公司管理层、股东及
分析师之间在沟通影响公司价值的相关问题

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时更加方便（facilitate communication and
discussion）。

Applications of equity valuation

 Valuation of private business

• 投资者可以基于分析师的估值做出关于未上市
公司的投资决策。
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Applications of equity valuation

 Share-based payment (compensation)

• 在实施股权激励计划（restricted stock grants）
时需要采用估值技术来决定股权授予价格。

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Equity valuation: applications and processes

 Definitions of values
 Applications of equity valuation
 The valuation processes
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The valuation processes

 Understand the business

 Forecast company performance
 Select the appropriate valuation model

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 Convert the forecasts into a valuation
 Apply the valuation conclusions

Understand the business

 Industry and competitive analysis

Five Forces Three Generic Strategies
Intra-industry rivalry Cost leadership
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New entrants Differentiation

Substitutes Focus
Supplier power
Buyer power

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Understand the business

 Analyzing the quality of financial statement

 研究表明: 公司的股价反映了财务报表质量问题,
财务信息披露非常透明的公司的股价会更高。

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Understand the business

 Accelerating or premature recognition of income.

 Reclassifying gains and non‐operating income.
 Expense recognition and losses.
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 Amortization, depreciation, and discount rates.

 Off‐balance‐sheet issues.

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Forecast company performance

 预测公司业绩的两个角度:
 The economic environment of the company’s
operating;

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 The company’s own operating and financial
characteristics.
 预测公司业绩的两种方法:
 Top‐down forecasting approach;
 Bottom‐up forecasting approach.

Select the appropriate valuation model

 Kinds of valuation model

Dividend discount model (DDM)
Free cash flow to equity model (FCFE)
Absolute valuation
Free cash flow to the firm model (FCFF)
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models
Residual income model (RI)
Asset-based valuation
Relative valuation P/E, P/B, P/CF, etc.
models

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Select the appropriate valuation model
 Sum‐of‐the‐parts valuation & conglomerate discount
 Sum‐of‐the‐parts valuation (breakup value or private
market value): 评估公司内各个独立运营主体的价值
（ value of individual independent going concern

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parts ），并将其相加来得到公司整体的价值.
• 非常适合于在不同行业多元化经营的公司
(Conglomerate).
 Conglomerate discount: market applies a discount to
the value of a company that operates in multiple
unrelated industries instead of in a single industry.

Select the appropriate valuation model

• Explanations for conglomerate discounts:

 Internal capital inefficiency;
 Endogenous (internal) factors;
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 Research measurement errors.

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 Select the appropriate valuation model

 Criteria to choose an appropriate approach

 是否与被估值公司的特征相一致(consistent with
the characteristics)；

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 已获取的信息或数据的质量是否适合使用该模型；
 使用该模型是否符合估值目标。

CONTENTS
目录
Equity valuation: applications and processes

Return concepts
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Industry and company analysis

Discounted dividend valuation

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Return concepts

 Definitions of return
 Equity risk premium (ERP)
 Methods to estimate required return on equity (re)

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Definitions of return
 Holding period return:
p1 −p0 +CF1 p1 −p0 CF1
R= = +
p0 p0 p0
=price return+cash flow yield
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 Realized (holding period) return: backward‐looking return.

 Expected (holding period) return: forward‐looking return.
 Required rate of return (opportunity cost): the minimum
return an investor requires given the asset's risk.

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Definitions of return

 Expected(ex ante) alpha = Expected return -

required return
 Realized(ex post) alpha = Actual return -

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contemporaneous required return
 Expected return = required return +
(intrinsic value0−price0 ⁄price0
 Expected return > required return implies
undervaluation.

Definitions of return

 Discount rate：对递延消费和承担风险的补偿。
取决于投资品的特点,而不是购买者。
 Internal rate of return (IRR)：If the markets are
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efficient, then IRR equal to required return.

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Return concepts

 Definitions of return
 Equity risk premium (ERP)
 Methods to estimate required return on equity (re)

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Equity risk premium (ERP)

 Definition and application of equity risk premium

 Historical estimate
 Forward-looking (ex ante) estimate
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Definition and application of equity risk premium

 Definition:
 Equity risk premium = required return on
equity index − risk‐free rate

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Definition and application of equity risk premium

 Application:
 CAPM: required return on share I = current
expected risk‐free return + βi×(equity risk
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premium)
 Build‐up method: required return on sharei
=current expected risk-free return
+Equity risk premium
±Other risk premium/discounts

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 Equity risk premium (ERP)

 Definition and application of equity risk premium

 Historical estimate
 Forward-looking (ex ante) estimate

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Historical estimate

 ERP = historical mean return for a broad-based

equity index −risk-free rate
 Strength:
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 Objectivity & simplicity.

 If investors are rational, estimates are unbiased.

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Historical estimate
 Weakness:
 Assume mean & variance of return are stationary；
• Expected premium is counter-cyclical(逆周期):
low during good times, and vice versa.

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 If there is survivorship bias in equity market data,
the ERP should be adjusted downward；
 Geometric mean ERP will less than or equal to
arithmetic mean ERP；
 If the yield curve is upward-sloping，bond-based
ERP will smaller than bill-based ERP.

Equity risk premium (ERP)

 Definition and application of equity risk premium

 Historical estimate
 Forward-looking (ex ante) estimate
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Forward-looking (ex ante) estimate

 Forward-looking (ex ante) estimate:

 Estimates of ERP are based on current
information and expectations for the future.

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 Pros and cons:
• It’s less affected by nonstationary and
survivorship bias;
• It’s will be affected by economic models
errors and behavioral biases.

Forward-looking (ex ante) estimate

 Gordon growth model (GGM) estimate

 Macroeconomics model (Supply-Side) estimate
 Survey estimate
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 Comparison and summary

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Gordon growth model (GGM) estimate

 GGM equity risk premium

=One-year forecasted dividend yield on
market index

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+Consensus long-term earnings growth rate
−Current long-term government bond yield

D1
 ERP= +g−RFR
P0

Gordon growth model (GGM) estimate

 Weakness:
 GGM estimates will change through time.
• Dividend yield is lower & earning growth
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rate is higher during economic boom.

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Gordon growth model (GGM) estimate

 Assume stable earning growth rate may not

appropriate.

• It’s reasonable when applied to developed

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equity markets, but not appropriate for
emerging market.

 Solve IRR from “Equity Index Price =

PVfast(r) + PVtransition(r) + PVmature(r)”.

Example
(1) Current price level of market index=1,480;
(2) Current year’s dividend on market index=31.25;
(3) Year-ahead forecasted dividend on market index=33.60;
(4) Long-term earnings growth rate for market index=6.00%;
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(5) Current long-term gov. bond yield=4.00%;

(6) Current short-term gov. bond yield=2.75%.
Q: What is the equity risk premium using GGM method?

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Answer

Forecasted dividend yield=33.6/1,480=2.27%;

Consensus long-term earnings growth rate=6.00%;
Current long-term government bond yield=4.00%;

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D1
ERP= +g−RFR=2.27%+6.00%−4.00%=4.27%.
P0

Forward-looking (ex ante) estimate

 Gordon growth model (GGM) estimate

 Macroeconomics model (Supply-Side) estimate
 Survey estimate
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 Comparison and summary

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Macroeconomics model (supply-side) estimate
 ERP = 1+Expected inflation
× 1+Expected growth in real EPS
P
× 1+Expected growth in −1
E

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+Expected income component
−Expected risk free return
=(1+EINFL)(1+EGREPS)(1+EGPE)−1+EINC−ERF

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Macroeconomics model (supply-side) estimate

 Expected inflation = (YTM of 20-year T-bonds)−(YTM of

20-year TIPS)
 Expected growth in real EPS = real GDP growth = labor

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productivity growth rate + labor supply growth rate
 Expected growth in P/E: If market is overvalued, EGPE
< 0(Decrease).

Macroeconomics model (supply-side) estimate

 Expected Income component=Expected yield on index

 Expected risk-free return=Long-term government
bond yield
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 Strength: use proved models & current information.

 Weakness: only appropriate for developed countries.

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Example
Zn Inc, with the expected growth rate in real EPS
3.00%, has the expected growth rate in P/E
equals 1.50% and expected income component
equals 2.50%. After checking the information in

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Bloomberg, the expected TIPS yield is 2.15%, the
expected inflation is 1.81%, the long-term
government bond yield is 4.00% and the current
short-term government bond yield is 2.75%.
What is the equity risk premium using
Macroeconomics model?

Answer

ERP= 1+EINFL 1+EGREPS 1+EGPE −1+EINC−ERF

= 1+1.81% 1+3.00% 1+1.50% −1+2.50%−4.00%
=4.94%
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Forward-looking (ex ante) estimate

 Gordon growth model (GGM) estimate

 Macroeconomics model (Supply-Side) estimate
 Survey estimate

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 Comparison and summary

Survey estimate

 Use the consensus of the opinions from a

sample of people.
 Strength: survey results are easy to obtain.
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 Weakness: wide disparity between the

consensuses obtained from different groups.

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Forward-looking (ex ante) estimate

 Gordon growth model (GGM) estimate

 Macroeconomics model (Supply-Side) estimate
 Survey estimate

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 Comparison and summary

Comparison and summary

 Comparison and summary
Estimates Strength Weakness
1. Objectivity &
Expected premium is
Simplicity;
Historical counter-cyclical.
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2. If investors are
Estimates Stationary assumption
rational, estimates
is NOT appropriate.
are unbiased.
1. Not rely on
1. Subjective.
Forward stationary
2. Subject to other model
looking assumption.
errors and behavioral
Estimates 2. Less survivorship
biases.
bias problem.

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Comparison and summary
 Comparison and summary
Estimates Strength Weakness
1. Change through
1. Popular method. time and need to be

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GGM 2. Reasonable for updated.
developed countries. 2. Assumption of a
stable growth rate.
Supply-Side 1. Proven models. Only appropriate for
Estimates 2. Current information. developed countries.
Survey Wide disparity from
Easy to obtain.
Estimates different groups.

Return concepts

 Definitions of return
 Equity risk premium (ERP)
 Methods to estimate required return on equity (re)
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Methods to estimate required return on equity (re)

 CAPM
 Multifactor model
 Build-up method

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 Strength and weakness comparison
 Other consideration

CAPM

 CAPM (one factor model):

Required return on sharei
= current expected risk-free return
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+ βi(equity risk premium)

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CAPM

 估计Beta的方法:
 Actively traded public company.
• 表示市场收益的指数的选择: The S&P

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500 & the NYSE composite.
• 样本数据的时间跨度和频率的选择:
 Five years of monthly or weekly data;
 Two years of weekly data for fast
grow market.

CAPM

 Adjusted beta (Blume method).

 Adjusted beta = (2/3) × (Unadjusted beta) +
(1/3) × 1
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 Beta drift: the tendency of the estimated

beta to revert to 1 over time.

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CAPM

 Tiny traded or nonpublic company.

 Step 1: 选择同行业的可比公司[ benchmark
company(comparable) ];
 Step 2: 估计可比公司的Beta;

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 Step 3:可比公司Beta去杠杆unlevered
benchmark’s beta;

1
• βA of XYZ=βE of XYZ×
1+ Debt of XYZ
Equity of XYZ

CAPM

 Step 4:目标公司Beta加杠杆lever up unlevered

beta for tiny traded or nonpublic companies.

Debt of ABC
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• βE of ABC=βA of ABC× 1+
Equity of ABC

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Methods to estimate required return on equity (re)

 CAPM
 Multifactor model
 Build-up method

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 Strength and weakness comparison
 Other consideration

Multifactor model

 Fama和French 1992年对美国股票市场决定不
同股票回报率差异的因素的研究发现，股票的
市场的beta值不能解释不同股票回报率的差异，
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而上市公司的市值、账面市值比、市盈率可以
解释股票回报率的差异。

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Multifactor model
 Multifactor model can have greater explanatory
power than CAPM.
 Required Return = RF + (Risk premium)1 +
(Risk premium)2 + … + (Risk premium)n

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• (Risk premium)I = (Factor sensitivity)I ×
(Factor risk premium)i
 Factor sensitivity, or factor beta, 对某一
因素(factor)的敏感性。
 Factor risk premium, 资产预期收益对某
一因子敏感性的单位风险溢价。

Multifactor model
 Fama-French model (FFM) and Pastor-Stambaugh
model (PSM).
Required Return = RF+ βMkt,j × RMkt −RF
Small/large cap + βSMB,j × RSmall −RBig
FFM
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+ βHML,j × RHBM −RLBM PSM

High/low B/M liq
+ βj × RLL −RHL
解释 :
If βSMB,j >0, Small-cap
If βHML,j >0, Value-oriented
liq
If βj >0, High-liquidity

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Multifactor model

 Macroeconomic Multifactor models (Burmerster,

Roll, and Ross model).
 Required Return on stock j

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=RF+(βCR,j×CR)+(βTHR,j×THR)+(βIR,j×IR)
+(βBCR,j×BCR)+(βMTR,j×MTR)

Multifactor model
• Confidence risk (CR) ： 未 预 期 到 的 risky corporate
bonds与government bonds收益率差异的变化；
• Time horizon risk (THR) ： 未 预 期 到 的 long-term
government bonds & treasury bills收益率差异的变化；
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• Inflation risk (IR)：未预期到的inflation rate的变化；

• Business-cycle risk (BCR)：未预期到的the level of
real business activity的变化；
• Market timing risk (MTR)：其他四个因素未解释的
equity market return。

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Methods to estimate required return on equity (re)

 CAPM
 Multifactor model
 Build-up method

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 Strength and weakness comparison
 Other consideration

Build-up method

 Build-up model:
 ri =RF+Equity risk premium±One or more
premium (discounts)
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 Applied to closely held companies (β is

not available)

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 Build-up method

 Bond yield plus risk premium method:

 ri = YTM on the company’s long-term debt
+ Risk premium

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 Applied to companies have publicly-traded debt.

Methods to estimate required return on equity (re)

 CAPM
 Multifactor model
 Build-up method
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 Strength and weakness comparison

 Other consideration

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Strength and Weakness Comparison
 Strength and weakness comparison
Methods Strength Weakness
1. Low explanatory power.
2. Choosing appropriate factor;
CAPM Simple.

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Stock trades in over one
market.
Usually higher
Multifactor explanatory Complex and expensive.
power.
1. Simple.
Use historical values, Not
2. Apply to
Build-up relevant to current market
closely held
conditions.
companies.

Methods to estimate required return on equity (re)

 CAPM
 Multifactor model
 Build-up method
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 Strength and weakness comparison

 Other consideration

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Other consideration

 International consideration
 Exchange rate risk
 Data and model issues in emerging markets

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 Country spread model: Equity risk premium
= Equity risk premium for a developed
market + Country premium
• E.g. Country premium = yield on bonds
in emerging market – yield on bonds in
developed market.

Other consideration

 Country risk rating model: use risk ratings

(published by institutional investor) as the
independent variable.
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40
Other consideration

 WACC
 The cost of capital 是公司资金提供者(包括股
东 和 债 权 人 ) 整 体 要 求 的 收 益 率 (overall

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required rate of return);
 按照debt和equity的市价加权;
 WACC is appropriate for the whole firm value.

Other consideration

Debt
 WACC= cost of debt 1−tax rate
Equity+Debt
Equity
+ cost of equity
Equity+Debt
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 To obtain Equity value:

 Step1: WACC → Firm Value;
 Step2: Equity Value = Firm Value − Market
Value of long-term debt.

41
 Other consideration

 Selecting discount rate

 Cash flow to equity → the required return on equity
 Cash flow to the firm → WACC

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 Nominal cash flows → nominal discount rates
 Real cash flows → real discount rates

CONTENTS
目录
Equity valuation: applications and processes

Return concepts
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Industry and company analysis

Discounted dividend valuation

42
Industry and company analysis

 Approaches for equity valuation models

 Top-down approach
• 从整体经济开始。

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 Bottom-up approach
• 从单个公司或部门开始。
 Hybrid approach
• 结 合 top-down approach 和 bottom-up
approach，可以发现使用单一方法可能
存在的问题。

Industry and company analysis

 Top-down approach to forecast revenue

 Growth relative to GDP growth
• Revenue growth=gGDP×(1+x%)
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 Market growth and market share

• Estimate market growth.
• Estimate market share.
• Revenue=market growth ×market share.

43
Industry and company analysis

 Bottom-up approach to forecast revenue

 A bottom-up approach begins at an
individual company or its segments.

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• Time series: based on historical revenue
growth rate.
• Return on capital: based on balance
sheet accounts.
• Capacity-based measure: based on
same-store sales growth.

Industry and company analysis

 Economies of scale
 Characteristics of economies of scale:
• Production volume↑→operating margins↑
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(average cost↓)
• Sales volume & sales margins: positively
correlated

44
Industry and company analysis

 Economies of scale may appear:

 When larger companies (with higher sales)
have larger margins.

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 To evaluate: common-size income
statements:
• Economies of scale in COGS: lower
COGS / sales.
• Economies of scale in SG&A: lower
SG&A / sales.

Industry and company analysis

 Forecasting costs: COGS

Historial COGS
COGS = ×Estimate revenue
Historical revenue
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= (1−Gross margin)×Estimate revenue

45
Industry and company analysis

 Forecasting costs: COGS

 Consider the probability that continuation of
trend in gross margin.

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 Examining competitors gross margin.
 Examining volume & price of a firm’s inputs,
especially in the short run.
 Forecast various product categories &
business segments separately.

Industry and company analysis

 Forecasting costs: SG&A
 Fixed component:
• R&D expense: be set by management and
uncorrelated with revenues.
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• Administration expenses, management

salaries, IT operations: It’s depends on the
size of the company, not changes in sales.
 Variable component: directly related to sales
volumes
• Selling and distribution costs.

46
Industry and company analysis

 Forecasting costs: interest

 Net debt=gross debt − [ cash, cash
equivalents, short-term securities ]

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 Gross interest expense: depends on gross
debt & market interest rates.
 Net interest expense = gross interest
expense − interest income on cash & short-
term debt securities

Industry and company analysis

 Forecasting costs: Tax

 Income tax expense
• Three primary tax rates:
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 Statutory rate: the percentage tax

charged in the country.
 Effective tax rate: income tax
expense/pretax income.
 Cash tax rate: cash taxes
paid/pretax income.

47
Industry and company analysis

• Deferred tax items:

• Income tax expense = cash tax due
+△deferred tax liabilities

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−△deferred tax assets

Industry and company analysis

• Corporation having taxable income in several

countries:
 Effective tax rate=weighted average of
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effective tax rates in each country.

 Effective tax rate will increase if a company
has relatively higher earnings growth in a
high tax country, and vice versa.

48
Industry and company analysis

 Retained earning=Net Income−Dividend

 Working capital items:
 Inventory

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forecaste annual COGS
• Inventory=
inventory turnover ratio

Industry and company analysis

 Accounts receivable
• Account receivable = days sales
forecasted sales
outstanding ×
365
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• Receivable
annualsales
turnover=
average receivables
 Working capital items increase at the same
rate as revenue.

49
Industry and company analysis

 PP&E:
 Analyst can assume PP&E grows at the
same rate as revenue (historical average

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proportion of sales), but should also consider:
• Maintenance capital expenditures
• Growth capital expenditures

Industry and company analysis

 Return on invested capital (ROIC)
NPPLAT
ROIC=
Invested capital
 NPPLAT：Net operating profit less adjusted
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for taxes
 Invested capital = operating assets −
operating liabilities
 ROIC is a return to equity and debt.
 The higher the ROIC the better.

50
Industry and company analysis

 Return on capital employed(ROCE)

Pretax operating profit

ROCE=
Invested capital

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Industry and company analysis
 Competitive position based on a porter’s five forces
 Companies have less pricing power when:
• Threat of substitute products is high.
• Switching costs are low.
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• Intensity of industry rivalry is high.

• Industry concentration is less.
• Fixed costs & exit barriers are high.
• Industry growth is slow/negative.
• Products are not differentiated.
• Bargaining power of customers is high.

51
Industry and company analysis

 Company prospects for earnings growth are

lower when:
• Bargaining power of suppliers is high.

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 Company have more pricing power & better
prospects for earnings growth when:
• Threat of new entrants is low.

Industry and company analysis

 Forecast sales & costs subject to inflation &
deflation
 Understand company’s hedging and vertical
integration:
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• Hedge exposure in input prices through

derivatives.
• Make fixed-price contract for future delivery.
• Switch to a substitute input.

52
 Industry and company analysis

 Company neither hedges input price exposure

nor is vertically integrated:
• Increase in costs is passed on to customers.

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• Expected effect of price increases on sales
volume & sales revenue.

Industry and company analysis

 Monitor input prices change:

• Significant factors affecting input prices.
 Weather, characteristics of input markets.
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 Governmental regulation and taxation, tariffs.

 Estimate effects of an increase in input prices:
• Company may cut other costs if increase on
input prices is temporary, not appropriate for
long-term increases.

53
Industry and company analysis

 Company sales and inflation or deflation

 If demand is relatively price inelastic,
revenues will benefit from inflation.

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 If demand is relatively price elastic, revenue
can decline even if unit prices are raised.

Industry and company analysis

 Effects of technological development

 Advances in technology will:
• Decrease production costs;
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• Increase profit margins;

• Increase industry supply & unit sales;

54
Industry and company analysis

• Improve substitutes/wholly new products:

 Cannibalization factor:
 Different for different sales channels.

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 Lower for business customers than for direct.

Example

Alpha, Inc., manufactures LED lightbulbs for sale

to businesses as well as to households. 75% of
Alpha's unit sales are to business customers.
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Technological advances have enabled bulb

manufacturers to produce a new bulb that is
more energy efficient, and Alpha is planning to
introduce a bulb next year that uses this new
technology. Projected sales for the new bulb are
shown below:

55
Example

Alpha, Inc., manufactures LED lightbulbs for sale

to businesses as well as to households. 75% of
Alpha's unit sales are to business customers.

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Technological advances have enabled bulb
manufacturers to produce a new bulb that is
more energy efficient, and Alpha is planning to
introduce a bulb next year that uses this new
technology. Projected sales for the new bulb are
shown below:

Example

Market Unit
Businesses 87,000
Households 11,000
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Total Units 98,000

Calculate the lost unit sales of current product
due to cannibalization, assuming a
cannibalization factor of 50% for businesses and
20% for households.

56
Answer

Cannibalization in business market segment =

87,000×0.50 = 43,500 units
Cannibalization in household market segment =

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11,000×0.20 = 2,200 units
Total lost unit sales = 45,700 units

Industry and company analysis

 Choice of explicit forecast horizon

 For highly cyclical companies:
• Forecast horizon should be long
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enough that the effects of the current

phase of the economic cycle are not
driving above-trend or below-trend
earnings effects.

57
Industry and company analysis

• Include the middle of a business cycle.

 Normalized earnings are expected mid-cycle
earnings. (Current effects of events and

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cyclicality are no longer affecting earnings.)

Industry and company analysis

 Projections beyond short-term forecast horizon

 Assuming continuation of a trend growth rate
of revenue over the previous period.
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 Estimate pro forma financial results based

on projection of each future revenue.
 Using earnings/some measure of cash flow
over forecast period.

58
Industry and company analysis
 Estimate terminal value:
• Relative valuation approach:
 Price multiples approach.
• Discounted cash flow approach:

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 Expected earnings/cash flow: normalized
to mid-cycle value.
 Expected future growth rate.

Industry and company analysis

 Recognize inflection points (拐点):

• Changes in overall economic environment.
• Changes in business cycle stages.
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• Changes in government regulations.

• Technology.

59
Industry and company analysis

 Sales-based pro forma company model

 Using segment information and creating
segment forecasts.

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 Using sensitivity analysis or scenario
analysis to ensure estimation.

Industry and company analysis

 Steps in developing a sales-based pro forma model

Items Financial Reporting
Estimate revenue growth and
Income Statement
future expected revenue
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Estimate COGS Income Statement

Estimate SG&A Income Statement
Estimate financing costs Income Statement

60
 Industry and company analysis

 Steps in developing a sales-based pro forma model

Items Financial Reporting
Estimate income tax expense and
Income Statement
cash taxes

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Model working capital accounts Balance Sheet
Estimate capital expenditures and
Balance Sheet
net PP&E
Construct a pro forma cash flow
Cash Flow Statement
statement

CONTENTS
目录
Equity valuation: applications and processes

Return concepts
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Industry and company analysis

Discounted dividend valuation

61
Discounted dividend valuation

 Dividends as a measure of cash flow in the

following cases:
 Companies have a history of paying dividends;

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 Dividend policy is consistent related to earnings;
 From the perspective of minority shareholders.

Discounted dividend valuation

 DDM formula
Formula
D1 +P1
One-period DDM V0 =
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1+r
D1 D2 +P2
Two-period DDM V0 = +
1+r (1+r) 2
D1 D2 Dn +Pn
Multi-period DDM V0 = + +⋯+
1+r (1+r)2 (1+r) n

62
Discounted dividend valuation

 Gordon growth model (GGM)

 Two-stage growth model
 H-model

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 Three-stage growth model
 Spreadsheet model
 Sustainable Growth Rate (SGR)

Gordon growth model (GGM)

 GGM:
n
D ×(1+g) D0 ×(1+g)2 D × 1+g
 V0 = 0 + +⋯+ 0 n +⋯
(1+r) (1+r) 2
1+r
D ×(1+g) D1
= 0 =
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r−g r−g
 The assumption of GGM:
 Paying dividends every year;
 Dividends will grow at a constant rate, g, forever;
 Growth rate(g)<Required rate(r).

63
Gordon growth model (GGM)

 股票的价值可以被拆分为两部分：
 1) 假 设 公 司 未 来 不 进 行 再 投 资 (without
earnings reinvestment)时的现值；

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 2) 未 来 成 长 机 会 的 现 值 (present value of
growth opportunity, PVGO) 。

E1
 V0 = +PVGO
r

Gordon growth model (GGM)

 Justified P/E
P0 (1−b)
 leading P/E: P E= =
E1 r−g
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P0 (1−b)×(1+g)
 trailing P/E: P E= =
E0 r−g
 Valuing a fixed-rate perpetual preferred stock
DP
 VP =
rP

64
Gordon growth model (GGM)

 Advantage:
 适用于支付稳定股利的成熟公司；
 适用于估计市场指数；

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 比较直观、易于理解；
 可用于确定价格隐含增长率(price-implied
growth rates) g, 要求回报率r, 未来成长机会
的现值PVGO；
 是其他估值方法的有效补充。

Gordon growth model (GGM)

 Disadvantage:
 对估计出的g和r很敏感；
 不适用于不支付股利的股票；
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 增长模式是不可预知的，估计出的价值不可靠。

65
Example

MD’ shares, listed in New York Stock Exchange,

trade at $120 on Dec 31, 2015. Suppose that the
expected earning is $3.5 per share, required

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return is 5%, and the shares are properly priced.
Calculate the PVGO and the portion of the
leading P/E related to PVGO.

Answer

E1
 V0= +PVGO
r
3.5
 $120= +PVGO→PVGO=$50
5%
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$120
 P/E Firm= =34.29X
3.5
$50
 P/E PVGO= =14.29X
3.5
 So 5/12, or 41.67% of the firm’s leading P/E
ratio is attributable to PVGO

66
Discounted dividend valuation

 Gordon growth model (GGM)

 Two-stage growth model
 H-model

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 Three-stage growth model
 Spreadsheet model
 Sustainable Growth Rate (SGR)

Two-stage growth model

D0 (1+gs)t D0 (1+gs)t ×(1+gL )

 Formula: V0 = ∑nt=1 +
(1+r)t (1+r)n ×(r−gL)

Dividend
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growth (g)
gS

gL

Stage 1 t Stage 2 Time

67
Discounted dividend valuation

 Gordon growth model (GGM)

 Two-stage growth model
 H-model

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 Three-stage growth model
 Spreadsheet model
 Sustainable Growth Rate (SGR)

H-model
D0 1+gL +D0 ×H×(gS −gL )
 Formula: V0 =
r−gL
Dividend
growth (g)
gS
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gL

Stage 1 t Stage 2 Time

 H=t/2 is the half-life(in years) of high growth period.

68
Example

Hong Kong LST Limited currently pays a

dividend of HKD 0.20. The growth rate is
currently 20% and expected to decline linearly

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over the next 4 years to a stable rate of 5%
thereafter. The required return is 12%. Calculate
the current value of Hong Kong LST Limited.

Answer

4
HKD0.2×(1+5%) HKD0.2× 2 (20%−5%)
V0= +
12%−5% 12%−5%
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=HKD3+HKD0.86=HKD3.86

69
H-model
 H-model only provides an approximation of
the value.
 Exact answer has the following steps:
 Forecasting each of the t ten dividends;

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 Discounting them back to the present at r;
 Two dimension promotions supplies more
accurate result:
 Shorter high growth period, t.
 Smaller the spread between the short-term
and long-term growth rates, gs−gL.

Discounted dividend valuation

 Gordon growth model (GGM)

 Two-stage growth model
 H-model
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 Three-stage growth model

 Spreadsheet model
 Sustainable Growth Rate (SGR)

70
Three-stage growth model

 The first version (The general three-stage model)

Dividend
growth (g)

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gS

gM

gL

Stage 1 t1 Stage 2 t2 Stage 3 Time

Three-stage growth model

 The second version

Dividend
growth (g)
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gS

gL

Stage 1 t1 Stage 2 t2 Stage 3 Time

71
Example
Xupe healthcare Group had the current annual
dividend equaling to $0.1. Dividends are expected
to grow at as fast as 60% over the next 2 years,
then declined linearly to 10% over the next 6

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years, and a long-term equilibrium growth rate,
10% would be sustained perpetually.
Due to the intrinsic higher risk in advanced
healthcare industry, 18% might be an appropriate
discount rate.
Calculate the value of Xupe healthcare Group.

Answer
D2 1+gL +D2 ×H×(gS −gL )
V2 =
r−gL
D2 = 0.1×(1+60%)2 = 0.256
0.256× 1+10% +0.256×6×(60%−10%)
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V2 = 2 =8.32
18%−10%

Time CF Value Future Discounted

1 0.1×(1+60%) 0.16 0.1356
2 0.1×(1+60%) 2 0.256 8.32 6.1591
Total 6.2947

72
 Discounted dividend valuation

 Gordon growth model (GGM)

 Two-stage growth model
 H-model

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 Three-stage growth model
 Spreadsheet model
 Sustainable Growth Rate (SGR)

Spreadsheet model
 Spreadsheets make it easy for analysts to calculate
multi-stage valuation models, growth rates or
required rates of return.
 Steps to using a spreadsheet for valuation:
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 Determine the base level of cash flow;

 Estimate changes of cash flows for the
foreseeable future;
 Estimate the terminal value;
 Discount all future cash flows and terminal value.

73
Discounted dividend valuation

 Gordon growth model (GGM)

 Two-stage growth model
 H-model

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 Three-stage growth model
 Spreadsheet model
 Sustainable Growth Rate (SGR)

Sustainable Growth Rate (SGR)

 Sustainable growth rate (SGR, g) is the rate at

which earnings (and dividends) can continue
to grow indefinitely.
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 假设公司的debt to equity ratio不变；

 假设公司不发新股；
 SGR=b×ROE

74
Sustainable Growth Rate (SGR)

 PRAT Model: SGR=P×R×A×T

 R=Retention ratio(R)=(net income – dividends)
/ net income

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 ROE=Profit margin(P)×Asset turnover(A)×
Financial leverage(T)

Sustainable Growth Rate (SGR)

net income
• Profit margin=
sales
sales
• Asset turnover=
asset
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asset
• Financial leverage=
equity
• Accurate calculation: using beginning asset &
beginning equity.
• Approximation: using average asset &
average equity.

75
Sustainable Growth Rate (SGR)

 DuPont Model
 ROE=Tax retention rate Interest burden
Operating margin Asset turnover Leverage

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Net Income EBT EBIT Sales Asset
 ROE=
EBT EBIT Sales Asset Equity

Discounted dividend valuation

 Pros and cons for discounted cash flow

 Advantages:
• 理论上可行；
• 股利的波动率较小。
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 Disadvantages:
• 不适用于不支付股利的公司；
• 仅适用于估计少数股东权益；
• 股利政策并一定能反映公司的盈利能力。

76
 Discounted dividend valuation

 Appropriateness for discounted cash flow

 有股利支付历史；
 股利政策与盈利能力相关；
 仅适用于估计少数股东权益。

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CONTENTS
目录
Free cash flow and other valuation

Market-based valuation
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Residual income valuation

Private company valuation

77
Free cash flow valuation

Cash
Working revenues
capital
investment Cash operating expenses
(including taxes but

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Fixed capital excluding interest
investment expense)

FCFF

Interest payments to
FCFE bondholders
Net borrowings
from bondholders

Free cash flow valuation

 Free cash flow to the firm (FCFF)：扣除了所

有的营运费用(含税费)、营运资本投资及固定
资本投资之后，公司的所有资金提供者可支配
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的现金流。
 Free cash flow to the equity (FCFE)：扣除了
所有的营运费用(含税费)、债券的本金和利息
支付、营运资本投资及固定资本投资之后，公
司的普通股股东可支配的现金流。

78
 Free cash flow valuation

 Choice of FCFF/FCFE
 Firm Value: FCFF discounted at the WACC.
 Equity Value: FCFE discounted at the required

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return on equity.
 Firm Value – Market Value of Debt = Equity Value

Free cash flow valuation

 It is more straightforward to use FCFE for

the company’s capital structure is not
particularly volatile.
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 If a levered company has negative FCFE or

a changing capital structure，the FCFF is
generally the best choice.

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 Free cash flow valuation

 Appropriateness for FCFE/FCFF

 Appropriate for firms:
• 公司不支付股利；

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• 股利政策与盈利能力不相关；
• 自由现金流与长期盈利能力相关；
• 站在控股股东(controlling shareholders)角度；
• 公司是收购目标(target for takeover)。

Free cash flow valuation

 Various FCFF valuation approaches
 From NI: FCFF=NI+NCC+Interest×(1−t)−FCInv−WCInv
 From EBIT: FCFF=EBIT×(1−t)+Dep−FCInv−WCInv
 From EBITDA:
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FCFF=EBITDA×(1−t)+(Dep+Amo)×t−FCInv −WCInv
 From CFO: FCFF=CFO+Interest×(1−t)−FCInv

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Free cash flow valuation

 Various FCFE valuation approaches

 From FCFF:
FCFE=FCFF−Interest×(1−t)+NB

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 From NI:
FCFE=NI+NCC−FCInv−WCInv+NB
 From EBIT:
FCFE=EBIT×(1−t)−Interest×(1−t)+Dep−F
CInv−WCInv+NB

Free cash flow valuation

 From EBITDA:
FCFE=EBITDA×(1−t)−Interest×(1−t)+Dep×t−
FCInv −WCInv+NB
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 From CFO: FCFE=CFO−FCInv+NB

 From Target Debt to Equity Ratio:
FCFE=NI+Dep−WCInv−FCInv
+(WCInv+FCInv−Dep)×DR

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Free cash flow valuation
 #1: NCC: noncash cash flow
 Depreciation and amortization: add back;
 Provision for restructuring charges & other
noncash losses: add back;

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 Income from restructuring reversal & other
noncash gain: subtract;
 Amortization of bond discount: add back;
 Amortization of bond premium: subtract;
 Deferred tax liability increase: add back;
 Deferred tax asset increase: subtract.

Example of FCFF calculation

John Galliano, CFA, is analyzing the financials of

Robert Department Stores. He intends to use a
free cash flow to the firm (FCFF) model to value
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Robert’s common stock. In the 2016 financial

statements and footnotes he has identified the
following items:

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 Example of FCFF calculation

Item #1: Robert reported depreciation and software

amortization of $23 million in 2016.
Item #2: The deferred tax liability increased by $17

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million in 2016.
Item #3: Robert reported income of $6 million in
2016 from the reversal of previous restructuring
charges related to store closings in 2015.
Item #4: Net income totaled $173 million in 2016.

Example of FCFF calculation

Item #5: The net increase in noncash net working capital

accounts was $47 million in 2016.
Item #6: Net capital spending totaled $86 million in 2016.
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Item #7: Robert reported interest expense of $19 million.

83
Example of FCFF calculation

John estimated Robert’s marginal tax rate to be

35%. He also expects Robert to be profitable for
the foreseeable future, so he does not expect

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the deferred tax liability to reverse. As the base-
year projection for his FCFF valuation, John
calculates FCFF for 2016 as:
FCFF2016 = $173 + [$19(1 − 0.35)] − $47 − $86 +
$23 + $17 - $6 = $92.35 million

Free cash flow valuation

 #2: WCInv: working capital investment
 WCInv = Ending WC−Beginning WC
= Ending (current asset−current liability)
− Beginning (current asset−current liability)
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Current asset: Excluding cash & cash equivalents;

 Current liability: Excluding notes payable & current
portion of long-term debt;
 △Working capital<0, reduction in working capital,
“+” cash inflow.
 △Working capital>0, Increase in working capital, “−”
cash outflow.

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Free cash flow valuation
 #3: FCInv: fixed capital investment
 FCInv = Capital expenditure
−proceeds from sales of long-term assets
 If no long-term assets sold

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 FCInv = CAPEX = Gross PP&Et − Gross PP&Et-1
 FCInv = Net PP&Et − Net PP&Et-1 + Depreciation
 Gross PP&Et=Net PP&Et+Accumulate
Depreciation

Free cash flow valuation

 If long-term assets sold
 FCInv = Capital expenditure
−proceeds from sales of long-term assets
 FCInv = Gross PP&Et − Gross PP&Et-1 + Gross
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PP&Edisposal
 FCInv = Net PP&Et − Net PP&Et-1 + Depreciation
− gain + loss

85
Free cash flow valuation

 #4:Net Borrowing
 NB = Long-and short-term new debt
− Long-and short-term debt repayment

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=Long-term debtt - Long-term debtt-1
+ short-term debtt - short-term debtt-1
• Including: notes payable & current portion
of long-term debt.

Free cash flow valuation

 #5: Preferred stock

 FCFF=NIcom+NCC+Interest×(1−t)+Divpre−FCInv
−WCInv
 FCFF=Nicom&pre+NCC+Interest×(1−t)−FCInv
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−WCInv
 FCFE=FCFF−Interest×(1−t) - Divpre +NB

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 Free cash flow valuation

 #6: Target Debt-to-Asset Ratio(DR)

Debt
 Target Debt−to−Asset Ratio=
Asset
 Debt = Asset×DR

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 △Debt = Net Borrowing
= △Asset×DR
= (WCInv+FCInv−Dep)×DR

Free cash flow valuation

You are a candidate of CFA, to analyze the

financial statement of ST’s Delicatessen. You had
a 2017 income statement and balance sheet, as
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well as 2018 income statement, balance sheet,

and cash flow from operations forecasts (as
shown in the tables below). Assume there will be
no sales of long-term assets in 2018. Calculate
forecasted free cash flow to the firm (FCFF) and
free cash flow to equity (FCFE) for 2018.

87
 Free cash flow valuation
ST’s Balance sheet
2018 2017 2018 2017
Forecast Actual Forecast Actual
Cash $10 $5 Accounts payable $20 $20
Accounts
30 15 Short-term debt 20 10

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receivable
Inventory 40 30 Current liabilities $40 $30
Current assets $80 $50 Long-term debt 114 100
Gross PP&E 400 300 Common stock 50 50
Accumulated
(190) (140) Retained earnings 86 30
depreciation
Total liabilities and
Total assets $290 $210 $290 $210
owner’s equity

Free cash flow valuation

ST’s Income Statement
2018 Forecast 2017 Actual
Sales $300 $250
Cost of goods sold 120 100
Gross profit 180 150
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SG&A 35 30
Depreciation 50 40
EBIT 95 80
Interest expense 15 10
Pre-tax earnings 80 70
Taxes(at 30%) 24 21
Net income $56 $49

88
 Free cash flow valuation
ST’s Cash Flow From Operations Forecast for 2018
Net income $56
+depreciation 50
−WCInv 25

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Cash flow from operations $81

Answer of FCFF and FCFE calculation

FClnv=400−300=100
WClnv=(AcctsRec2018+Inv2018−AcctsPay2018)
−(AcctsRec2017+Inv2017−AcctsPay 2017)
=(30+40−20)−(15+30−20)=50−25=25
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FCFF=NI+NCC+[ Int×(1−tax rate) ]−FClnv−WClnv

=56+50+[ 15×(1−0.3) ]−100−25=−8.5
FCFF=[ EBIT×(1−tax rate) ]+Dep−FClnv−WClnv
=[ 95×(1−0.3) ]+50−100−25=−8.5
FCFF=[ EBITDA×(1−tax rate) ]+(Dep×tax rate)
−FClnv–WClnv
=[ 145×(1−0.3) ]+(50×0.3)−100−25=−8.5

89
Answer of FCFF and FCFE calculation
Net borrowing=(114+20)−(100+10)=24
FCFE=FCFF−[ Int×(1−tax rate) ]+net borrowing
=−8.5−10.5+24=5
FCFE=NI+Dep−FClnv−WClnv+net borrowing

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=56+50−100−25+24=5
FCFE=CFO−FClnv+net borrowing
=81−100+24=5

Free cash flow valuation

 Single-Stage (Constant-Growth) FCF Model
 Single-stage FCFF model 是用FCFF代替股
利 D ， 用 WACC 代 替 要 求 收 益 率 r 的 Gordon
growth model。
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• Value of the firm

FCFF1 FCFF0 (1+g)
= =
WACC−g WACC−g
 Single-stage FCFE model 是用FCFE代替股
利D的Gordon growth model。
FCFE1 FCFE0 (1+g)
• Value of equity= =
r−g r−g

90
Free cash flow valuation

 Single-Stage FCF Model international

consideration
 当一个国家通货膨胀率较高或者波动性较大

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(inflation rates are volatile)时，分析师应该
估计实际现金流(real cash flow)，实际增长
率(real growth rate)和实际要求收益率(real
discount rate)。

Free cash flow valuation

 Two-Stage and Multistage FCF Models

 FCF models的growth rate 可以是FCFF或
FCFE 的 growth rate ， 也 可 是 income 的
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growth rate，还可以是sales的growth rate。

91
Example of calculating value with 2-stage FCFF
American Water is a public utility company operating in
the United States and Canada. It was founded in 1886,
and was listed in NYSE in 2008.
Most of American Water's services are locally managed

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utility subsidiaries that are regulated by the U.S. state in
which each operates. American Water also owns
subsidiaries that manage municipal drinking water and
wastewater systems under contract and others that
supply businesses and residential communities with
water management products and services.

Example of calculating value with 2-stage FCFF

American Water earned a net profit margin of 4% on
revenues of $946,000,000 this year. Its fixed capital
investment was $350,000 and depreciation was
$115,000. Working capital investment equals 1% of
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sales every year.

Net income, fixed capital investment, depreciation, and
sales are expected to grow at 5.5% per year for the
next 3 years. After 3 years, the growth in sales, net
income, fixed capital investment, and depreciation will
decline to a stable 4% per year.

92
 Example of calculating value with 2-stage FCFF
The tax rate is 40%, and American Water has
178,000,000 shares of common stock outstanding and
no long-term debt. Calculate the value of the firm and
its equity using the FCFF model if the WACC is 5%

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during the high-growth stage and 4.5% during the
stable stage.

Answer of calculating value with 2-stage FCFF

0 1 2 3 4
Sales 946,000,000 998,030,000 1,052,921,650 1,110,832,341 1,171,928,119

NI 37,840,000 39,921,200 42,116,866 44,433,294 46,877,125

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Dep. 115,000 121,325 127,998 135,038 142,465

FCInv 350,000 369,250 389,559 410,984 433,589

WCInv 9,460,000 9,980,300 10,529,217 11,108,323 11,719,281

FCFF 28,145,000 29,692,975 31,326,089 33,049,023 34,866,720

93
 Answer of calculating value with 2-stage FCFF

The terminal value (as of Year 4, discounted at

the stable WACC of 4.5%) is:
Terminal
FCFF4 $34,866,720

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value= = =$6,973,343,958
WACC−g 4.5%−4%
The cash flow from Year 1 to Year 3 could be
placed in a table to evaluate the value of the firm.

Answer of calculating value with 2-stage FCFF

Cash Flow Terminal Value Discounted Cash Flow

Year 1 29,692,975 28,279,024
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Year 2 31,326,089 28,413,686

Year 3 33,049,023 6,973,343,958 6,052,385,688

Value 6,109,078,397

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Answer of calculating value with 2-stage FCFF

Notice that the WACC in the high-growth stage (5%)

is different than the stable stage (4.5%).
To perform this calculation quickly and accurately, use

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the following keystrokes on your financial calculator:

Answer of calculating value with 2-stage FCFF

CF0=0; C01=29,692,975; C02=31,326,089;

C03=(33,049,023+6,973,343,958);
I=5; CPT→NPV=6,109,078,397.
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While it has 178,000,000 shares of common

stock outstanding, the value of equity per share
equals $34.32.

95
Example of calculating value with 3-stage FCFE
Activision Blizzard, an international prestigious
video and network games manufacturer, is
expected growth in 3 distinct stages in the future.
Its most recent FCFE per share is $1.73. The

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following information has been compiled:

Example of calculating value with 3-stage FCFE

It will embrace a 2-year high-growth period, FCFE
growth rate is 30%, and required rate of equity
return is 20%. Then a transitional period will come.
In this time, FCFE will decline by 5% per year to
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the indicated stable growth rate, 10%, in 4 years,

with the shareholders’ required return 18%. At last,
a stable growth time will approach and the
shareholder’s will claim 17% required rate of return.
Calculate the value of the firm's equity using the
three-stage FCFE model.

96
Answer of calculating value with 3-stage FCFE

High-Growth Year 1 Year 2

Growth Rate 30% 30%
FCFE 2.2490 2.9237

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PV at 20% 1.8742 2.0303

Transitional Year 3 Year 4 Year 5 Year 6

Growth Rate 25% 20% 15% 10%
FCFE 3.6546 4.3856 5.0434 5.5477
PV at 18% and 20% 2.1508 2.1872 2.1316 1.9871

Answer of calculating value with 3-stage FCFE

The transitional present values are computed

using a combination of the 20% initial discount
rate and the transitional 18% rate. For example,
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the present value of FCFE4 is computed as

4.3856
=$2.1872 ;
1.22 1.182

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Answer of calculating value with 3-stage FCFE

6.1025
Terminal Value= =$95.8963;
17%−10%
Discounted terminal value
95.8963

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= =$34.3488;
1+20% 2×(1+18%)4
Value per share is the wholly accumulated
discounted cash flow, equaling $46.7101.

Free cash flow valuation

 Sensitivity analysis
 敏感性分析是探究估值模型的结果对输入变
量的敏感程度。能帮助分析师确定对估值影
响最大的变量。
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 通过综合敏感性分析，可以评估各种预测误
差（forecasting errors）的重要性。

98
Free cash flow valuation
 Two major sources of forecasting errors
 没能准确估计未来现金流增长率；
• 增长率的预测取决于公司未来的盈利能力，
而盈利能力又取决于企业的销售增长率、

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利润率、处于生命周期的哪个阶段、竞争
策略以及整个行业的整体盈利能力等。
 预测FCFF或FCFE时选择的基准年份不具有
代表性。
• 所有的分析和估计都基于基准年份的
FCFF或FCFE。

Free cash flow valuation

 Comparison between different methods
 FCFE→Equity Value (control, bigger)
 DDM→Equity Value (minority, smaller)
• 股利政策不能体现公司的长期盈利能力。
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 Dividends, share repurchase, and share issues

• No effect on FCFF.
 Changes in leverage
• No effect on FCFF; Minor effect on FCFE.

99
Free cash flow valuation

 Net income is a poor proxy for FCFE.

 净利润扣除了非现金支出(如，折旧);
 不包含没有体现在利润表上的现金流(例如

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investments in working capital or fixed assets
及net borrowings);
 FCFE=NI+NCC−FCInv−WCInv+Net borrowing

Free cash flow valuation

 EBITDA is a poor proxy for FCFF.

 FCFF=EBITDA×(1−tax rate) + (Dep×tax rate)
− FCInv−WCInv
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 EBITDA没有考虑折旧的税盾效应，也没有考虑
working capital和fixed capital对现金流的影响。

100
Free cash flow valuation

 通过P/E Ratio计算Terminal value

 Terminal value in year n = (trailing P/E)
×(earnings in year n)

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 Terminal value in year n = (leading P/E)
×(forecasted earnings in year n+1)

Free cash flow valuation

 Determining level of stock price

Stock market price > model price Overvalued
Stock market price < model price Undervalued
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Stock market price = model price Fairly valued

101
 Free cash flow valuation

 Pros and cons for FCFE/FCFF

 Advantage：
• 不管公司支付或不支付股利都适用；

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• 更适合于估计控股权价值。
 Disadvantage：
• 如果自由现金流为负会使得结果不准确。

CONTENTS
目录
Free cash flow and other valuation

Market-based valuation
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Residual income valuation

Private company valuation

102
Market-based valuation

 Method of comparable values基于可比相似公司

股票价值的平均值去估计目标公司的股票价值。
 是 一 种 相 对 估 值 方 法 (relative valuation
method), 可以得出目标公司的股票价格相比

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于可比公司(benchmark value)是高估或低估
的结论。

Market-based valuation

 A justified price multiple 指的是如果股票被合

理定价时的价格乘数。
 Actual multiple大于justified price multiple，
股票被高估(overvalued)；Actual multiple小
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于 justified price multiple ， 股 票 被 低 估

(undervalued)。

103
Market-based valuation

P/E: price-to-earnings ratio

PEG: P/E-to-growth ratio
P/B: price-to-book ratio

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P/S: price-to-sales ratio
P/CF: price-to-cash flow ratio
EV/EBITDA: enterprise value-to-EBITDA ratio
Dividend Yield: common dividend to the market price

P/E
 Leading P/E or Prospective P/E =
Market price per share
Next 12 month (NTM) EPS
 Next 12 month EPS: forecasted EPS over
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next 12 months;
 如果盈利的波动性比较大，则对下一年盈利
的预测可能不可靠。

104
P/E

Market price per share

 Trailing P/E =
Trailing 12 month (TTM) EPS
 Trailing 12 month EPS : EPS over previous
12 months;

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 如果公司的主营业务发生了变化，如公司发
生 了 收 购 、 兼 并 或 资 产 重 组 ， 则 Trailing
P/E不可用。

P/E

 Justified P/E
P 1−b
 Justified leading P/E =
E1 r−g
P (1−b)(1+g)
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 Justified Trailing P/E =

E0 r−g
 Effect:
• Positively related to g;
• Negatively related to r;
• Justified trailing P/E > Justified leading
P/E, only when g>0.

105
P/E
 Advantages:
 EPS is the primary determinant of value;
 Most popular;
 Differences in P/E related to long-run average

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stock returns.
 Disadvantages:
 Earnings might be negative;
 Volatile earning;
 Management discretion distorts.

P/E
 Earnings adjustment for calculating the
Trailing P/E
 Adjustments for Nonrecurring items;
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 Adjustments for Business-Cycle Influences

• Molodovsky effect
 At the top of the cycle → High P/E,
low EPS.
 At the bottom of the cycle → Low
P/E, high EPS.

106
P/E

• Normalized earnings
 Method one: Method of historical average
EPS;

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E1+E2+…+En
 EPS= ;
n
P
 P/E= 0 ;
EPS
 EPS is estimated over the most recent
business cycle;
 Business’s size effects is ignored.

P/E

 Method two: Method of average ROE

 EPS=Average ROE×BVPS most recent year
P0
 P/E=
EPS
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 Average ROE is often measured over the

most recent business cycle.
 BVPS reflects the effects of firm size
changes more accurately.
 It is preferred than average EPS method.

107
P/E

 Dealing with zero or negative earnings

• Use normalized earnings.
• Use earnings yield (E/P).

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EPS
 E/P=
Market Price per Share
 A high E/P suggests a cheap security, and
a low E/P suggests an expensive security.

PEG

 P/E to Growth (PEG) Ratio

P/E ratio
 PEG ratio=
g
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• PEG is a ‘standardized PE’ for stock

with different expected growth rates.
• The lower PEG, the higher
attractiveness, all else being equal.

108
PEG

 Drawbacks of PEG ratio:

• PEG assumes P/E ratio and g has a linear

relationship.

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• PEG does not consider risk differences;

• PEG does not reflect the duration of growth.

P/B
 P/B ratio
Market value of equity Market price per share
= =
Bookvalue of equity Book value per share
 BV of Equity = BV of common
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shareholder’s equity = asset – liability –

preferred stock

109
P/B

 Adjustment:
• Using tangible BV = BV of Equity –
intangible assets;

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• Adjusted for off-balance sheet asset &
liability;
• Adjusted to ensure comparability (FIFO vs
LIFO).

P/B

 Advantages:
 BV almost always > 0;
 BV is more stable than EPS;
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 Appropriate for firms having liquid assets;

• Firms in finance / investment / insurance /
banking industry.
 Appropriate for firms expected to liquidation;
 Differences in P/B related to long-run average
stock returns.

110
P/B

 Disadvantages:
 It does not reflect the value of intangible
economic assets. Such as human capital,

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good reputation;
 Size differences cause misleading
comparisons;
 It is influenced by accounting choices;
 Due to inflation/technology, BV can be differ
significantly from MV.

P/B

 Justified P/B
ROE−g
 Justified P/B=
r−g
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• P/B increases as ROE increases.

• P/B increases as the spread between
ROE and r increases.
• If (r−g)>(ROE−g), P/B decreases as g
increases.

111
P/S

market value of equity

 P/S =
total sales
market price per share
=
sale per share

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P/S

 Advantages:
• Sales revenue is always positive and
meaningful, even for distressed firms.
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• Sales revenue is not easily manipulated.

• It is not so volatile as P/E ratios.
• Useful in valuing mature, cyclical, and start-
up firms.
• Differences in P/B related to long-run average
stock returns.

112
P/S

 Justified P/S
E0 (1−b) (1+g)
 Justified P/S=
S0 r−g
= Net profit margin Justified

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trailing P/E
 Effect:
 P/S increases as net profit margin increases.
 P/S increases as g increases.

P/CF

 Advantages:
 Manipulation cash flow is harder than EPS.
 P/CF is more stable than P/E.
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 Handles the problem of differences in the

quality of reported earnings.
 Differences in P/B related to long-run average
stock returns.

113
P/CF

 Disadvantages:
• Difficult to estimate true CFO.
• FCFE is better, but more volatile and more

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frequently negative.

P/CF

 四种CF的定义:
 Earnings-plus-noncash-charges (CF)
• CF = NI + Dep
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 Adjusted cash flow (adjusted CFO)

• Adjusted CFO = CFO + [(net cash interest
outflow) (1-tax rate)]
 FCFE
• FCFE = CFO – FCinv + net borrowing
 EBITDA

114
Example of calculating P/CF

A Chinse food group reported net income of

￥56.774 million, depreciation and amortization of
￥21.105 million, net interest expense of ￥10.036
million, and cash flow from operations of ￥48.793

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million. The tax rate is 25%. Calculate the P/CF
ratio using CF and adjusted CFO as proxies for
cash flow. The Chinse food group has 1,823
million shares of common stock outstanding,
trading at ￥1.5 per share.

Answer of calculating P/CF

CF = 56.774+21.105 =￥77.879 million

Adjusted CFO = 48.793 + 10.036 × (1−25%)
=￥56.320 million
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Market value of equity=1,823×1.5=￥2,748 million

P 2,748
= =35.286 times
CF 77.879
P 2,748
= =48.793 times
Adjusted CFO 56.320

115
EV/EBITDA
 Enterprise Value = Market value of common
stock + Market value of preferred equity +
Market value of debt+Minority interest − Cash &
Investments

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 EBITDA = recurring earnings from continuing
operations + interest + taxes + depreciation +
amortization = EBIT + depreciation +
amortization
 Cash flow available for debt and equity.

EV/EBITDA

 Advantages:
 Comparing firms with different degrees of
financial leverage.
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 Useful for capital-intensive business with

high depreciation & amortization.
 EBITDA is usually positive even when EPS
is not.

116
EV/EBITDA

 Disadvantages:
 If working capital is growing, EBITDA will
overstate CFO.

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 Ignoring different revenue recognition.
 FCFF is more appropriate with EV than
EBITDA.

EV/EBITDA

 Alternative measure of EV/EBITDA

 Alternative measure of EV/EBITDA could
change the numerator or the denominator.
• Numerator could be replaced as TIC.
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• Denominator could be replaced as EBIT,

FCFF or S.
 Total invested capital (TIC), or market value
of invested capital, is the market value of
the company’s equity and debt, including
cash and short-term investment.

117
EV/EBITDA

 Justified EV/EBITDA
 Justified EV/EBITDA based on fundamentals
= EV based on expected fundamentals /

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EBITDA forecast based on fundamentals
• Positively related to the expected growth
rate in FCFF and expected profitability.
• Negatively related to weighted average
cost of capital (WACC).

Dividend Yield

 Dividend yield advantages:

 Contribution to total investment return;
 Not so risky as capital appreciation
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component of total return.

 Dividend yield disadvantages:
 Ignoring capital appreciation;
 Dividend paid now displace future earnings.

118
Dividend Yield

 trailing D/P

4 most recent quarterly dividend

=
market price per share

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 leading D/P

forecasted dividends over next 4 quarters

=
market price per share

Dividend Yield

 Justified dividend yield

D0 r−g
 Justified trailing dividend yield: =
P0 1+g
D
 Justified leading dividend yield: 1 =r−g
P0
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 Positively related to the required rate of return.

 Negatively related to the forecasted growth
rate in dividends.
• High dividend yield → value stock

119
Market-based valuation

 Comparable method using price multiples

 Basic ideas:
• Multiples < benchmark → the stock’s

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value is undervalued
• Multiples > benchmark → the stock’s
value is overvalued
 Fundamentals of stock and benchmark
are similar.

Market-based valuation

 P/E benchmarks:
• P/E for another company’s stock in similar
industry with similar operating characteristics.
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• Average/Median P/E for peer group within

similar industry.
• Average/Median P/E for the industry.
• P/E for equity index.
• Average historical P/E for the stock.

120
Market-based valuation

 Fed Model
 Fed model holds that overall stock market to
be overvalued (undervalued) when the

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earnings yield on the S&P 500 Index is
lower (higher) than the 10-year U.S.
Treasury bonds yield.

Market-based valuation
 Sources of Differences in Cross-Border Valuation
 Differences in international context: accounting
methods, cultures, risk, and growth
opportunities.
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• 会计准则在以下几个项目的处理上常常有差
异: goodwill, deferred income taxes, foreign
exchange adjustments, R&D, pension
expense, 及tangible asset revaluations.
 Differences in macroeconomic contexts lead to
different market benchmarks.

121
Market-based valuation

 Momentum valuation indicators

• Unexpected earnings (earning surprises) =
Reported EPS – Expected EPS.

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 Positive surprise leads to persistent
positive abnormal returns.
• Standardized unexpected earnings (SUE):
Reported EPS−Expected EPS
SUE=
Standard Deviation of (Reported EPS−Expected EPS)
Unexpected earnings
=
Standard Deviation of Unexpected earnings

Market-based valuation
• Relative strength indicators compare a stock's
performance during a given time period with its
own historical performance or with some group
of peer stocks.
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 Examples:
 Compares a stock’s compound rate of
return between a period with its past.
 Stock’s performance/performance of an
equity index.

122
Market-based valuation
1
 Weighted harmonic mean P/E= n w
∑i=1 i
Xi
 Example: One priced at $10 with earnings of
$1 per share (P/E=10) and one priced at

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$16 with earnings of $2 (P/E=8). For a
portfolio with one share of each stock,
earnings per share are 1+2=3 and the
"price" of a portfolio share is 10+16=26. The
portfolio price-to-earnings is 26/3 =8.67.

Market-based valuation

8+10
• Arithmetic mean = =9
2
10 16
• Weighted mean = 10+ 8=8.76
26 26
2
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• Harmonic mean = =8.88

1 +1
10 8
• Weighted harmonic mean
1
= =8.67
10 1 +16 1
26 10 26 8

123
 Market-based valuation
 If there are extreme (too high or too low) outliers:
 Arithmetic mean will be the most affected.
 Harmonic mean focuses more on smaller
values.

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 When measuring a portfolio or index with
extreme P/E should use the median or weighted
harmonic mean.
 For an equal weighted portfolio or index, the
harmonic mean and weighted harmonic mean
will be equal.

CONTENTS
目录
Free cash flow and other valuation

Market-based valuation
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Residual income valuation

Private company valuation

124
Residual income valuation

 Residual income
 Residual income models
 Continuing residual income

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 Accounting issues in applying RI models

Residual income

 RI = Net Income − Equity × Cost of Equity(re)

 Economic value added (EVA)：企业管理层在
一年内为股东创造的增加值。
 EVA = NOPAT − WACC% × TC
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= EBIT×(1−t)−$WACC
• NOPAT: Net operating profit after tax;
• TC: total capital;
• $WACC: Dollar cost of capital.

125
Residual income

 Net operating assets (NOA)

 NOA = operating assets − operating liabilities
 Operating assets = total assets − cash &

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equivalent
 Operating liabilities = total liabilities – short-
term debt – long-term debt

Residual income

 Explanation
 Cash & equivalent could be used to pay
back liabilities .
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 Net financial obligation could be excluded

from operating business.

126
Residual income

 Market value added (MVA)

 MVA=market value−total capital
• 用来衡量自公司成立以来管理层决策所
创造的价值。

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Residual income

 Residual income的优缺点
 优点:
• 适用于自由现金流为负、支付股利或不
支付股利的公司。
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 缺点:
• 管理层可能会操纵会计利润

127
Example of calculating EVA and MVA

Matos Corp reports NOPAT of $22.4M, a WACC of

10.2%, and invested capital of $188M at the
beginning of the year and $192M at the end of the

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year. The market price (year-end) of the firm's
stock is $38 per share, and Matos Corp has
935,000 shares outstanding. The market value
(year-end) of the firm's long-term debt is $86M.
Calculate Matos Corp's EVA and MVA.

Answer of calculating EVA and MVA

EVA calculation:
$WACC=10.2%×188=19.176M
EVA=22.4−19.176=3.224M
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MVA calculation:
MV of Matos Corp = 38 × 935,000 / 1,000,000
+86 =121.53M
MVA=121.53−192=−70.47M

128
Residual income valuation

 Residual income
 Residual income models
 Continuing residual income

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 Accounting issues in applying RI models

Residual income models

 RI = NI − BVEquity× re
 RIt = EPSt re BVPSt−1
= ROE−re BVt−1
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 Clean surplus relation:

BVPSt = BVPSt−1 + EPS t− D t
 Dt = EPSt 1−b
• b is the retention rate.

129
Residual income models

 Residual income valuation model 将股票内在

价值拆分为两部分：
 Current book value of equity;

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 Present value of expected future residual
income.
RI RI2 RI3
 V0=B0+ 1 + + +…
1+r 1+r 2 1+r 3

Example of calculation residual income

Nintendo is founded on September 23, 1889, in

Kyoto, Japan. It is a Japanese multinational
consumer electronics and software company and
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the largest video game company in the world.

Nintendo has a required rate of return of 6%. The
current book value is 10,000 JPY. Earnings
forecasts for 2018, 2019, 2020, 2021 and 2022
are 530, 610, 610, 610 and 960 JPY respectively.

130
 Example of calculation residual income

Dividends in 2018, 2019, 2020, 2021 are

forecasted to be 180, 260, 260, 340 JPY
respectively. The dividend in 2022 is as similar as

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a liquidating dividend, which means that Nintendo
will payout its entire book value in dividends.
Calculate the value of Nintendo's stock using the
residual income model.

Answer of calculation residual income

2016 2017 2018 2019 2020

Beginning book value
10,000.00 10,350.00 10,700.00 11,050.00 11,320.00
per share (Bt-1)
Earnings per share
530.00 610.00 610.00 610.00 960.00
forecast (Et)
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Dividends per share

180.00 260.00 260.00 340.00 12,280.00
forecast (Dt)
Forecast book value
10,350.00 10,700.00 11,050.00 11,320.00 -
per share (Bt-1+Et−Dt)
Equity charge per
600.00 621.00 642.00 663.00 679.20
share (r×Bt-1)
Per share RI [ Et− 
−70 −11 −32 −53 280.80
(r×Bt-1) ]

131
Answer of calculation residual income
IV0 = 10,000
70 11 32 53 280.2
− − − − +
1+6% 1+6% 2 1+6% 3 1+6% 4 1+6% 5

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= 10,065

Residual income models

 Single-stage residual income valuation model :
(ROE−r)×B0
V0=B0+
r−g
 Assume constant ROE and earnings growth.
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 ROE=r, market value=book value.

 ROE>r, market value is higher.
 ROE<r, market value is lower.
(ROE−r)×B0
 is the additional value to create
r−g
extra return beyond cost of equity.

132
Residual income models

 Residual income implied growth rate

 Under the assumption that intrinsic value is
equal to current market price:
B0 (ROE−r)

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g=r−
V0−B0

Residual income models

 Strengths of residual income model

 Using accounting data, easy to find.
 Terminal value does not dominate intrinsic
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estimate.
 Applicable when cash flow are volatile.
 Applicable to firms that do not pay dividend
and do not have positive free cash flow.
 Focusing on economic profitability rather
than accounting profitability.

133
Residual income models

 Weakness of residual income model

 Accounting data can be manipulated.
 Accounting data requires adjustments.

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 Clean surplus relation may not hold.
 Assumption that the cost of debt capital is
reflected appropriately by interest expense.

Residual income models

 Appropriateness for residual income model
 Appropriate for firms that:
• It does not pay dividends, or the payments
is too volatile.
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• Free cash flow are negative.

• Terminal value forecast is highly uncertain.
 Not appropriate for firms that:
• Clean surplus accounting relation is violated.
• Significant uncertainty concerning book value
& re.

134
Residual income valuation

 Residual income
 Residual income models
 Continuing residual income

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 Accounting issues in applying RI models

Continuing residual income

 Continuing residual income: residual income

that is expected over the long-term.
 Assumptions of continuing residual income at
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the end of the short-term period:

 Residual income is expected to persist at
its current level forever.
 Residual income is expected to drop
immediately to zero.

135
Continuing residual income

 Residual income is expected to decline over

time as ROE falls to the cost of equity (in
which case residual income is eventually zero).

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 Residual income is expected to decline to a
long-run average level consistent with a
mature industry.

Continuing residual income

 V0=B0+ PV of interim high−growth RI + PV of
continuing residual income
 Step 1: Calculate the current book value
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per share.
 Step 2: Calculate residual income in each
year 1 to T-1 during the interim high-growth
period and discount them back to today at
the required return on equity.

136
Continuing residual income

 Step 3: Calculate continuing residual income

that begins at the end of the high-growth
period starting in year T, and then calculate the

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present value of continuing residual income as
of the end of year T-1.

Continuing residual income

 PV of continuing residual income in year
RIT
T−1=
1+r−
 Residual income persists at its current
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level forever
• =1, PV of continuing RI in year T−1
RIT RI
= = T.
1+r−1 r
 Residual income drops immediately to zero
• =0, PV of continuing RI in year T−1
RIT RI
= = T.
1+r−0 1+r

137
Continuing residual income

 Residual income declines over time to zero

• 1≥ ≥0, PV of continuing RI in year T−1
RIT
= .
1+r−

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 Residual income declines to long-run level in
mature industry
• PV of continuing RI in year T=PT−BT
• PT = BT × (forecasted price-to-book ratio)
• PV of continuing RI in year T-1
(PT−BT)+RIT
=
1+r

Continuing residual income

 持续性因素的强度在一定程度上取决于企业竞争优
势的可持续性和行业结构。
Higher persistence factors Lower persistence factors
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Low dividend payouts High return on equity

Historically high residual
Significant levels of
income persistence in the
nonrecurring items
industry
High accounting accruals

138
Example of multistage residual income model

Myriad Genetics, Inc. a personalized medicine

company, Myriad Genetics is expecting an ROE
of 25% over each of the next five years. Its

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current book value is $9.90 per share, it pays no
dividends, and all earnings are reinvested. The
required return on equity is 15%. Forecasted
earnings in years 1 through 5 are equal to ROE
times beginning book value.

Example of multistage residual income model

Calculate the intrinsic value of the company

using a residual income model, assuming that
after five years, continuing residual income falls
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to zero.

139
Answer of multistage residual income model

Ending Required Equity Residual

Year Et Book Value Rate of Charge Income E-
(Bt-1) Return (R×Bt-1) R×Bt-1
0 9.9

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1 2.48 12.38 15% 1.49 0.99
2 3.09 15.47 15% 1.86 1.24
3 3.87 19.34 15% 2.32 1.55
4 4.83 24.17 15% 2.90 1.93
5 6.04 30.21 15% 3.63 2.42

Answer of multistage residual income model

Assumed that RI after 5 years is 0 (w=0), the

terminal value at the end of Year 4 is
$2.42
=$2.10
1+15%
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Intrinsic value
0.99 1.24 1.55 1.93+2.10
=$9.9+ + + +
1+15% 1+15% 2 1+15% 3 1+15% 4
=9.9+5.12
=$15.02

140
Answer of multistage residual income model
If the assumption changed to suppose RI after 5
years to remain constant at $2.42 forever. Calculate
the new intrinsic value of Myriad Genetics.
If it assumes that RI persists at the same level

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forever, RIn-1=RIn, w=1, the terminal value at the end
of Year 4 is $2.42/15%=$16.13.
Intrinsic value
0.99 1.24 1.55 1.93+16.13
=$9.9+ + + +
1+15% 1+15% 2 1+15% 3 1+15% 4
= 9.9 +13.14 = $23.04

Answer of multistage residual income model

If Myriad Genetics’ RI will decay over time to zero

with a persistence factor of 0.85. Calculate the new
intrinsic value.
Terminal value at the end of Year 4 is
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$2.42
=$8.07
1+15%−85%
Intrinsic value
0.99 1.24 1.55 1.93+8.07
=$9.9+ + + +
1+15% 1+15% 2 1+15% 3 1+15% 4
= 9.9 + 8.53 = $18.43

141
Answer of multistage residual income model

Supposing Myriad Genetics’ ROE falls to a long-run

average level and the price-to-book ratio falls to 1.6
at the end of Year 5. Calculate Myriad Genetics’

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intrinsic value.
The book value per share at the end of Year 5 is
$30.21, which means the market price is expected
to be $30.21×1.6=$48.37.

Answer of multistage residual income model

PV of continuing RI in year 4 is:

48.37−30.21+2.42 93.05
= =$17.90
1+15% 1.15
Intrinsic value
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0.99 1.24 1.55 1.93+17.90

=$9.9+ + + +
1+15% 1+15% 2 1+15% 3 1+15% 4
=9.9+14.16=$24.05

142
Residual income valuation

 Residual income
 Residual income models
 Continuing residual income

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 Accounting issues in applying RI models

Accounting issues in applying RI models

 Clean surplus violations

 Variations from fair value
 Intangible asset effects on book value
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 Nonrecurring items and other aggressive

accounting practices
 International accounting differences

143
Clean surplus violations

 The clean surplus relationship may not hold

when items are charged directly to
shareholders’ equity and bypassing the

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income statement.
 Ending book value = Beginning book value
+ Net income − Dividends

Clean surplus relationship

 PUFE−R
• P: adjustments for minimum pension liability;
• U: unrealized gain or loss from available-for-
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sale securities;
• F: foreign currency translation gain or loss;
• E: effective portion of cash flow hedging
derivatives;
• R(only IFRS): changes in fair value of PPE
under re-valuation model.

144
Variations from fair value
 Adjustments to balance sheet to reflect fair value:
 Operating leases: capitalized, increasing
assets & liabilities;
 Off-balance sheet assets and liabilities:

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consolidate;
 Reserves and allowances: adjusted;
• Allowance for bad debt, which offset
accounts receivables.
 Inventory: LIFO should be adjusted to FIFO.

Variations from fair value

 Pension asset/liability: adjusted to reflect

funded status.
 Deferred tax liabilities: eliminated and reported
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as equity if it is not expected to reverse.

145
Intangible asset effects on book value

 Two intangible assets require special attention

 Intangibles recognized at acquisition;
 R&D expenditures.

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Intangible asset effects on book value
 Adjustments for intangible assets
 Amortization of intangibles: remove
amortization before computing ROE;
 R&D expenditure: ROE estimate for mature
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company should reflect long-term

productivity of R&D;
 Nonrecurring items & other aggressive
accounting practices: adjusted;
 International accounting differences:
considered.

146
CONTENTS
目录
Free cash flow and other valuation

Market-based valuation

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Residual income valuation

Private company valuation

Private company valuation

 Company-specific factors
 Stock-specific factors
 Reasons for performing valuations
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 Definitions of value
 Earnings normalization and cash flow
estimation issues
 Major approaches to evaluate private company

147
Company-specific factors

 Stage of life-cycle: 公司所处的生命周期会对估

值过程产生影响。
 Size: 未上市公司通常规模较小、风险较大.
 Quality & depth of management: 规模较小的未

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上市公司很难吸引到优秀的管理层，这将会增加
风险、降低增长潜能。

Company-specific factors

 Management/shareholder overlap: 未上市公司

较少受到来自外部投资者的压力。
 Pressure from short-term investor: 未上市公司
管理层不会面临二级市场短期股价表现的压力，
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会更加关注于公司长期发展。

148
Company-specific factors

 Quality of financial & other information: 监管部

门对未上市公司没有强制披露财务信息及其它信
息的要求。在进行投资分析时可利用的未上市公
司公开信息较为有限。

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 Taxes: 未上市公司比上市公司更加关注税收问题。

Private company valuation

 Company-specific factors
 Stock-specific factors
 Reasons for performing valuations
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 Definitions of value
 Earnings normalization and cash flow
estimation issues
 Major approaches to evaluate private company

149
Stock-specific factors
 Liquidity: 通常，未上市公司股东人数较少，股票
流动性较差。
 Concentration of control: 在未上市公司常常会出
现大股东以牺牲小股东的利益为代价来为自己谋

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利的情况。
 Restrictions on Marketability: 未上市公司常常会
与股东签订协议来限制股东出售股票。

Private company valuation

 Company-specific factors
 Stock-specific factors
 Reasons for performing valuations
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 Definitions of value
 Earnings normalization and cash flow
estimation issues
 Major approaches to evaluate private company

150
Reasons for performing valuations

 Transaction-related valuations
 Private financing
 Initial public offering (IPO)

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 Acquisition
 Bankruptcy
 Share-based payment (compensation)

Reasons for performing valuations

 Compliance-related valuations
 Financial reporting: 例如，商誉减值测试;
 Tax purpose.
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 Litigation-related valuations

151
Private company valuation

 Company-specific factors
 Stock-specific factors
 Reasons for performing valuations

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 Definitions of value
 Earnings normalization and cash flow
estimation issues
 Major approaches to evaluate private company

Definitions of value
 Fair market value
 Can be defined as price. Often used for tax
reporting context in US.
 Market value
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 Used for appraisals of real estate & other

real assets.
 Fair value for financial reporting
 Used in financial reporting.

152
Definitions of value
 Fair value for litigation
 It is similar to fair value for financial reporting.
 Investment value
 The value to a particular buyer.

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 Intrinsic value
 It is from investment analysis and it is
attempts to capture any short-term mispricing.

Private company valuation

 Company-specific factors
 Stock-specific factors
 Reasons for performing valuations
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 Definitions of value
 Earnings normalization and cash flow
estimation issues
 Major approaches to evaluate private company

153
Earnings normalization and cash flow
estimation issues
 Normalized earnings
 Strategic and nonstrategic buyers
 Estimating cash flow

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Normalized earnings

 Analysts need to adjust the impact of the

following items to estimate the normal earnings
of private companies:
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 Nonrecurring and unusual items.

 Discretionary or tax-motivated expenses.
• e.g., Excessively high owner
compensation or of personal expenses
charged to the firm.

154
Normalized earnings

 Major shareholders use company-owned assets.

 Closely controlled firm does business with its
owners/other business controlled by its owners.

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Normalized earnings

 Owners family members as employees and paid

amounts above the market value or have
connections to firm.
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 Owners of firms which perform poorly may

receive compensation below market value.

155
Normalized earnings

 The differences in depreciation method and

inventory recognition method.
 The financial report of a private firm is only

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reviewed but not audited.

Example of normalized earnings

Mr. Wang is the major shareholder and CEO of

Triumph Investment, a P2P and microcredit
institution. Triumph Investment reports the following:
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156
Example of normalized earnings
Wang‘s compensation of ￥1,000,000 is included
in the firm's SG&A expenses; Triumph Investment
leases a BMW X5 from Mr. Wang’s father without
any fees; Triumph Investment purchases some

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luxury offices in downtown, these offices are
reported SG&A expense of ￥ 200,000 and
￥ 400,000 of depreciation expense; Triumph
Investment's capital structure has too heavy
leverage.

Example of normalized earnings

Zelin Hsu determines that a market-based

compensation figure for Mr. Wang’s position is
￥ 250,000 and that these luxury offices are not
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needed for core operations. The market lease rate

of the BMW X5 is ￥80,000.
Based on the information above, what adjustments
should the analyst make to Triumph Investment's
reported income to estimate normalized earnings,
assuming the firm will be acquired?

157
Answer of normalized earnings

Because the normal market compensation is

￥250,000, SG&A expenses should be reduced
by ￥ 750,000 to reflect a normalized

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compensation expense.
Because the market lease for this BMW X5 is
￥80,000 higher than reported, SG&A expenses
should be increased by ￥80,000 to reflect a
normalized lease fees.

Answer of normalized earnings

Because the luxury offices are non-core, SG&A
expenses should be reduced by ￥200,000 and
depreciation expense should be reduced by
￥400,000 .
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Because the capital structure is non-optimal, Hsu

will drop interest expense from the calculation of
operating income under the assumption that the
capital structure will be changed if the firm is
acquired. As we will see, interest expense is added
back when calculating free cash flow to the firm.

158
Earnings normalization and cash flow
estimation issues
 Normalized earnings
 Strategic and nonstrategic buyers
 Estimating cash flow

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Strategic and nonstrategic buyers
 Strategic transaction: Gain synergies.
 Adjusted to normalized earnings.
 Add synergies: increase in revenues
/reduction in costs.
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 Financial transaction, or nonstrategic transaction:

Obtain financial return.
 Adjusted to normalized earnings.

159
Earnings normalization and cash flow
estimation issues
 Normalized earnings
 Strategic and nonstrategic buyers
 Estimating cash flow

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Estimating cash flow

 Controlling and non-controlling equity

interests have different values.
 If future operations are uncertain, examine
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several scenarios for CF.

 Vfirm=weighted average of Vfirm of each
scenario, using their separate discount rate
and probability.
 Vfirm=weighted average of each scenario
cash flow vie a single discount rate.

160
Estimating cash flow

 Being aware of potential bias in management

estimates.
 Overestimated goodwill and underestimated

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future capital needs.
 FCFF is more appropriate when significant
changes in capital structure.

Example of estimation of FCFF

An analyst has normalized the earnings and

expenses for a private firm under consideration as
an acquisition. Because the capital structure is
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non-optimal, the analyst assumes that the capital

structure will be changed if the firm is acquired and
will use the FCFF approach to value the firm.
The following assumptions are used to create a
pro forma income statement and to estimate FCFF.

161
 Example of estimation of FCFF
Current revenues $20,000,000
Revenue growth 4%
Gross profit margin 30%
Depreciation expense as a percent of sales 2%

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Working capital as a percent of sales 10%
SG&A expenses $2,200,000
Tax rate 30%
Additionally, capital expenditures will cover depreciation
plus 6% of the firm's incremental revenues.
Create a pro forma income statement and estimate FCFF.

Answer of estimation of FCFF

Pro Forma Income Statement

Current revenues times the growth
Revenues $20,800,000
rate: $20,000,000×1.04

Cost of Revenues times one minus the gross

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$14,560,000
goods sold profit margin: $20,800,000×(1−0.30)

Gross Revenues times the gross profit

$6,240,000
profit margin: $20,800,000×0.30
SG&A
$2,200,000 Given in the question
expenses
Pro forma Gross profit minus SG&A expenses:
$4,040,000
EBITDA $6,240,000−$2,200,000

162
Answer of estimation of FCFF

Revenues times the given

Depreciation
$416,000 depreciation expense:
and amortization
$20,800,000×0.02
EBITDA minus depreciation and
Pro forma EBIT $3,624,000 amortization:

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$4,040,000−$416,000
Pro forma taxes EBIT times tax rate:
$1,087,200
on EBIT $3,624,000×0.30
Operating EBIT minus taxes:
$2,536,800
income after tax $3,624,000−$1,087,200

Answer of estimation of FCFF

Adjustments to obtain FCFF

Plus:
Add back noncash charges from
depreciation and $416,000
above
amortization
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Expenditures cover depreciation

Minus: capital and increase with revenues:
$464,000
expenditures $416,000+[ 0.06×($20,800,000
−$20,000,000) ]
The working capital will increase
Minus: increase
$80,000 as revenues increase 0.10×
in working capital
($20,800,000−$20,000,000)
$2,408,80 Operating income net of the
FCFF
0 adjustments above

163
Private company valuation

 Company-specific factors
 Stock-specific factors
 Reasons for performing valuations

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 Definitions of value
 Earnings normalization and cash flow
estimation issues
 Major approaches to evaluate private company

Major approaches to evaluate private company

 Income approach
 Market approach
 Asset-based approach
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 Valuation discounts and premiums

 Business valuation standards and practices

164
Income approach

 Income approach：The value of an asset is the

present value of its future income.
 Free cash flow method (如: discounted cash

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flow method);
 Capitalized cash flow method;
 Residual income or excess earnings method.

Income approach

 Free cash flow method

 The free cash flow method here is a two-
stage model, and the terminal value could
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be calculated by constant growth model and

price multiple.

165
Income approach

 Capitalized cash flow method (CCM)

 Capitalized cash flow method is a single-
stage model.

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FCFF1
 Vfirm= →VE=Vfirm−Vdebt
WACC−g
FCFE1
 VE= , it is rarely used
re−g

Income approach

 Residual income or excess earnings method

 Excess earnings(EEM)= Firm earning
− Working capital R working capital
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− Fixed assets R fixed assets

Excess earnings
 Vintangible=
re−g
 Vfirm=V Intangible+V Working capital+V Fixed Asset
 VE=V Firm−V Debt

166
Example of excess earnings method (EEM)
Working capital $300,000
Fixed assets $1,000,000
Normalized earnings (year just ended) $130,000
Required return for working capital 6%

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Required return for fixed assets 10%
Growth rate of residual income 5%
Discount rate for intangible assets 14%
Use the data in the table above to calculate
company value.

Answer of excess earnings method (EEM)

Step 1: Based on the required rates of return for

working capital and fixed assets, the required
earnings are:
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working capital: $300,000×6%=$18,000

fixed assets: $1,000,000×10%=$100,000
Step 2: Calculate the excess earnings.
Excess earnings
=$130,000−$18,000−$100,000=$12,000

167
Answer of excess earnings method (EEM)

Step 3: Value the intangible assets.

Value of intangible assets
=($12,000×1.05)/(0.14−0.05)=$140,000

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Step 4: Sum the asset values.
Firm value
=$300,000+$1,000,000+$140,000=$1,440,000

Income approach

 Factors Required to Adjust the Discount Rate

 Size premium: discount rates rise for small
private companies.
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 Cost of debt: private firm has higher cost of

debt, which would lead higher WACC.

168
Income approach

 Acquirer vs target: higher discount rate is

appropriate for the target.
• It is a common mistake for acquirers to use

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lower cost of capital.

Income approach

 Projection risk: private firm has unavailable

and volatile data make the discount rate higher.
 Lifecycle stage: difficult to estimate discount
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rate for a private firm in early stage due to high

level of unsystematic risk, so it is inappropriate
to use CAPM model.

169
Income approach

 CAPM for Private Company Equity

 CAPM: may not be appropriate for private
firms that have little chance of going public

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or being acquired by a public firm.

Income approach

 Expanded CAPM: consider additional premiums

for size and firm specific (unsystematic) risk.
• Expanded CAPM = CAPM + size premium +
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firm specific premium

170
Income approach

 Build-up method:
• rprivate equity=RF+Equity premium+Size premium
+Industry premium+Firm specific premium

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Major approaches to evaluate private company

 Income approach
 Market approach
 Asset-based approach
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 Valuation discounts and premiums

 Business valuation standards and practices

171
Market approach

 Guideline Public Company Method (GPCM)

 Guideline Transactions Method (GTM)
 Prior Transaction Method (PTM)

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Guideline Public Company Method (GPCM)

 GPCM uses price multiples from public

companies data with adjustments.
 Controlling equity interest: adding control
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premium to public(Non-controlling) multiple.

• Control premium = pro rata value of
controlling interest - pro rata value of
non-controlling interest

172
Guideline Public Company Method (GPCM)

 Transaction type: strategic and financial

transaction.
• Strategic transaction leads higher price

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premium, while financial transaction has
smaller price premium.

Guideline Public Company Method (GPCM)

 Market conditions: if M&A is hot in current time,

share prices of public companies already
reflect some premium, so extra control
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premium should not be added.

 Type of consideration: some historical M&A is
exercise via share or the mixture of cash and
share, if the share price is temporary higher,
premium would be overstated.

173
Guideline Public Company Method (GPCM)

 Reasonableness: valuation would differ over

time and the multiple should be adjusted.

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Guideline Public Company Method (GPCM)

 The common method of control premium

adjustment:
 Adjusting control premium based on raw
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MVIC (debt+ equity) multiple.

 Use multiple with control premium and
normalized EBITDA to estimate invested
capital.
 Adjusted value of equity = Invested capital −
Debt capital

174
Market approach

 Guideline Public Company Method (GPCM)

 Guideline Transactions Method (GTM)
 Prior Transaction Method (PTM)

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Guideline Transactions Method (GTM)

 GTM uses pricing multiples from historical

acquisitions of public or private companies.
 Prior acquisition values for entire companies
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that already reflect any control premiums

are used, so no additional adjustment for a
controlling interest is necessary.

175
Guideline Transactions Method (GTM)

 使用Multiples from historical transactions时需要考

虑的问题:
 Transaction type: if it is nonstrategic transaction,

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historical multiple should be adjusted.
 Contingent consideration: contingencies should
be adjusted.

Guideline Transactions Method (GTM)

 Type transaction: cash or stock.

 Available of data: historical data for comparable

are limited relevant and accurate.

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 Date of data: too old data would be not relevant.

176
Market approach

 Guideline Public Company Method (GPCM)

 Guideline Transactions Method (GTM)
 Prior Transaction Method (PTM)

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Prior Transaction Method (PTM)

 PTM uses transactions data from the stock of

the actual subject.
 Most appropriate when valuing minority
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(non-controlling) interests.
 The previous transactions would be arm's-
length, of the same motivation (strategic or
financial) as the subject transaction, and
fairly recent.

177
Major approaches to evaluate private company

 Income approach
 Market approach
 Asset-based approach

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 Valuation discounts and premiums
 Business valuation standards and practices

Asset-based approach

 The value of firm equity

= The fair value of its assets
−The fair value of its liabilities
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 The lowest valuation of three approaches

because this method just focuses asset part
value instead of the value of asset combination.

178
Asset-based approach

 Asset-based approach适合于:
 Firms near liquidation.
 Finance firms with asset & liability based

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on market price.
 Investment companies, such as REITs.
 Small companies/early stage companies.
 Natural resource firms.

Major approaches to evaluate private company

 Choice of three method

 Lifecycle-stage
• Early stage: Asset-based approach.
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• Higher growth stage: Income approach.

• Mature stage: Market approach.
 Firm size
• Large public firms: Market approach.

179
Major approaches to evaluate private company

 Income approach
 Market approach
 Asset-based approach

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 Valuation discounts and premiums
 Business valuation standards and practices

Valuation discounts and premiums

 Discount for Lack of Control (DLOC)

 Minority shareholders have less power to
select the directors and management.
1
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 DLOC=1−
1+control premium
Comparable Private Target Adjustment
Controlling Controlling No
Controlling Non-controlling DLOC
Non-controlling Controlling Control Premium
Non-controlling Non-controlling No

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Valuation discounts and premiums

 Discount of lack of marketability (DLOM)

 If an interest in a firm cannot be easily sold,
discounts for lack of marketability (DLOM)

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would be applied.
• Impending IPO/firm sale: DLOM decrease.
• Payment of dividend: DLOM decrease.
• Shorter payment duration: DLOM decrease.

Valuation discounts and premiums

• Contractual restrictions on selling stock:

DLOM increase.
• Greater pool of buyers: DLOM decrease.
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• Risk & value uncertainty increase: DLOM

increase.

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Valuation discounts and premiums

 估计公司价值：
Comparable Private Target Adjustment
Illiquid Illiquid No

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Liquid Illiquid DLOM

Valuation discounts and premiums

 估计DLOM的三种方法:
• The first method: Price of restricted shares
compared to price of publicly traded shares.
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• The second method: Price of pre-IPO shares

compared to price of post-IPO shares.

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Valuation discounts and premiums

• The third method: DLOM = Put option price

(at-the-money) /stock price.
 Advantage: Firm risk can be factored into

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option price.
 Disadvantage: Put option provide a selling
price, not actual liquidity.

Valuation discounts and premiums

 Total discount
 DLOC and DLOM are multiplicative, not additive.
• 1−Total Discount=(1−DLOC)×(1−DLOM)
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• Total Discount =1−(1−DLOC)×(1−DLOM)

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Major approaches to evaluate private company

 Income approach
 Market approach
 Asset-based approach

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 Valuation discounts and premiums
 Business valuation standards and practices

Business valuation standards and practices

 Valuation standards:
 Uniform standards of professional appraisal
practice (USPAP).
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 International valuation standards.

 Statement of standards on valuation
services (SSVS).

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Business valuation standards and practices

 Challenges with implementation of standards:

 Most buyers are still unaware.
 Most valuation reports are private.

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 It is necessarily limited due to the
heterogeneity of valuations.
 Valuation will depend on the definition of
value used.

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THANKS

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