Equity – Question Sheet

Case No. 1
Jonna Jaworski is an equity research analyst at Baltic
Investment Partners, a long-only equity manager. She is
preparing an equity valuation analysis for three companies:
Salt Mine Corp., Steel Mill Inc., and Central Tire. During her
preliminary work on these companies, she makes the
following observations regarding Salt Mine, a major salt
producer in the country.
Observation 1:Last year, Salt Mine reported a relatively
large nonrecurring restructuring charge.
Observation 2:Salt Mine has consistently reported
significant amounts of other comprehensive income.
Jaworski creates a residual income model for Salt Mine that
assumes a 9% cost of equity and a terminal value of zero
after 20 years. Salt mine's stock price is currently $80, and
Jaworski's condensed forecast is presented in Exhibit 1:

Jacek Chopin, an analyst and colleague, questions the

assumption of zero terminal value for Salt Mine. Chopin
proposes that the mine could operate indefinitely and
suggests calculating the terminal value as a perpetuity.
Jaworski then reviews the financial statements of Steel Mill
and creates the following per-share financial forecasts:
Equity – Question Sheet

Jaworski turns her attention to Central Tire and notes that

the capital structure is 60% debt and 40% equity and
interest expense is tax-deductible. She gathers the
following data:
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Case No. 2
Vadim Vasiliy is a corporate development analyst at Boleslav
JSC, an international conglomerate. Vasiliy has recently
identified several acquisition opportunities and asks the
firm's new junior analyst, Boris Botschenko, to assist him
with the valuation process.

Botschenko is unsure of when to use FCFF versus FCFE

when valuing companies and seeks guidance from Vasiliy.
Vasiliy answers with the following statements:

Statement 1: Instead of discounting FCFE at the required

return on equity to find equity value, one can theoretically
derive the same equity value by discounting FCFF at WACC
and subtracting the book value of debt and preferred
dividends.
Statement 2: It is more appropriate to use FCFF when a
firm has negative FCFE and no debt in its current and target
capital structure.
Statement 3: It is more appropriate to use FCFF when a
firm has a volatile capital structure.
Boleslav's management is considering acquiring a 90% stake
in Agro JSC, an agricultural equipment manufacturer. Agro
has historically paid dividends, and will continue to do so in
the foreseeable future, at a consistent dividend payout
ratio. Vasiliy tells Botschenko that FCFE should be used to
value Agro. Botschenko asks why it is more suitable to
value Agro using FCFE in place of dividends. Vasiliy
responds:

Response 1: FCFE better aligns to the short-term

profitability of the firm.
Response 2: Use of FCFE implies control and discretion
over dividend distribution.
Response 3: FCFE reflects uses of free cash flow, whereas
dividends reflect sources of free cash flow.
Equity – Question Sheet

Boleslav's board believes it can create substantial cross-

selling synergies from its existing distribution network by
acquiring Freezky JSC, a top home appliance company.
Freezky stock is currently trading at RUB 843.28.
Botschenko gathers the following data (shown in Exhibit 1)
and calculates the intrinsic equity value for Freezky using a
one-stage FCFF model:

Botschenko then develops a sensitivity analysis for another

potential investment, Trucksky JSC, a trucking company,
based on sales growth, gross margin, and capital
expenditures (CAPEX) to gauge how these variables impact
his valuation estimate. This analysis is shown in Exhibit 2:
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Case No. 3
Bruno Martins is a senior sell-side analyst covering the
technology, media, and telecom sectors. He is meeting
with Mariana Dias, one of his junior analysts, to discuss
valuing companies using their forecasted dividends. All
dividends are assumed to be paid annually at the end of the
year.

Dias is currently analyzing Terra Manufacturing and Oceano

Technologies. Both companies have a stable ROE of 12%, a
stable capital structure, no changes to their common stock
outstanding, and a constant dividend payout ratio.
However:

Terra's payout ratio is 60% and

Oceano's payout ratio is 45%.
It is the beginning of 20X3, and Dias has the following
forecast for Oceano's dividends:

Martins is valuing Oceano based on a three-year holding

period and given a required rate of return of 8%. Dias uses
two methods:

Method 1: Using the Gordon growth model to estimate

the terminal value, Dias expects Oceano's dividend to grow
at a constant 5% rate starting in 20X6.
Method 2: Using P/E to estimate the terminal value,
Dias expects Oceano's justified forward P/E ratio at the end
of 20X5 to be 11x.
Equity – Question Sheet

Martins is analyzing three other companies and asks Dias to

generate dividend expectations for each. Dias provides the
following:

Martins estimates the risk-free rate at 3% and equity risk

premium at 5%. He believes a stock would be over- or
undervalued if it's more than 8% from its calculated
intrinsic value to allow for uncertainty in the model.
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Case No. 4
Vu Nguyen is a junior analyst at Mekong Investment
Partners (Mekong), a long-only buy-side firm. Dep Tran,
Nguyen's supervisor, asks Nguyen about his knowledge of
residual income models. Nguyen replies, "Assuming a
constant growth residual income model and clean surplus
accounting, these fundamental assumptions are always
true":

Statement 1: Residual income is earnings in excess of the

cost of equity.
Statement 2: If accounting net income is positive, residual
income will be positive.
Statement 3: If ROE is less than the cost of equity, residual
income can be created.
Tran then asks Nguyen to value three stocks based on
information for fiscal year 20X5: Megawatt Inc., a
government-regulated electric utility company; Acme Cola,
the country's dominant market share soda brand; and
SemiComm, a fast-growing and high-return-earning niche
semiconductor manufacturer for the communications
industry. Specific information for each company is shown in
Exhibits 1, 2, and 3.
Equity – Question Sheet

Tran tells Nguyen to be prepared to discuss the justified

price-to-book ratio, the residual income equity charge,
economic value added (EVA), and market value added
(MVA) for these stocks. Tran adds that Nguyen should be
prepared to discuss an estimate of continuing residual
income persistence at the end of the forecast horizon for
each of the three companies, based on company-specific
characteristics and industry factors.
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Case No. 5
Hakim Rashid is a credit analyst at an investment
management firm. He is evaluating his free cash flow (FCF)
forecasts of multiple companies. Rashid first evaluates
Velocità Automotive, an Italian car parts manufacturer.
Velocità reports under IFRS and has a capital structure that
includes common stock, preferred stock, and debt. Rashid
compiles information on Velocità's 20X0 financials to use as
a basis for his forecasts and notes several items that require
special attention:

Rashid notes that Velocità:

purchased an additional €40 million of equipment in

exchange for Velocità common stock; this purchase was to
replace required operating equipment.
classifies its interest paid and dividends paid as financing
cash flows.
will reverse its deferred tax asset in the near future.
will maintain a persistent level of stock-based
compensation expense.
Karima Yusuf has developed EPS and FCFE forecasts for EU
Telecom and Kamera1 Solutions, and she provides them to
Rashid. For EU Telecom, a European wireless telecom
carrier, Rashid wishes to convert Yusuf's estimates to FCFF
Equity – Question Sheet

to use in his credit analysis. Yusuf's 20X1 estimates for EU

Telecom are shown in Exhibit 2:

Rashid then reviews the forecast for Kamera1, a German

software security firm that is experiencing slowing growth.
Kamera1 reported EPS of €3.00 in 20X0, which is the most
recently reported period. Rashid reviews Yusuf's estimates:

After 20X5, Kamera1 will grow at a 4% growth rate

indefinitely. Based on current market conditions for
Kamera1 and using the CAPM, Yusuf assumes a:

Risk-free rate of 3%
Equity risk premium of 5%
Beta of 1.4
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Case No. 6
It is December 20X1, and Ananya Gupta, CFA, is analyzing
Merlion Singapore, Inc. (MSI). After 20 years of rapid
growth, MSI has announced that it will initiate a dividend,
but growth and value creation are expected to continue for
many years. The company reports under IFRS, and Gupta
has analyzed its most recent financial statements, press
releases, and current market data. Based on these sources,
she compiles the following (in SGD):

Gupta values MSI using two different applications of the

residual income (RI) valuation model.

She applies a single-stage RI valuation model, assuming a

constant ROE and constant dividend growth. Based on the
CAPM, Gupta estimates that the company's required rate of
return is 8%.

In addition, she applies a multistage, 15-year RI valuation

model, assuming terminal value of zero, and estimates the
company's intrinsic value per share as SGD 49.58.

Gupta's supervisor questions the assumption of a terminal

value of zero, so Gupta also runs the multistage model
using two alternative assumptions:

Assumption 1: Year 15 residual income of SGD 1.73

continues in perpetuity.
Assumption 2: ROE will revert to the required return, and
residual income will eventually be zero. The persistence
factor is 0.7 and Year 15 residual income will be SGD 1.73.
Equity – Question Sheet

Another analyst observes that Gupta could just use a

dividend discount model (DDM), which would be easier to
apply. Then, a colleague from the accounting department,
Chan Ding Hao, joins the discussion and suggests Gupta
verify that MSI has not violated clean surplus accounting
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Case No. 7
Lukas Dietrich is a portfolio manager for Yama Financial.
Dietrich has a large holding of Himmel Manufacturing stock
in his portfolio and is reviewing the company after it
reported annual earnings. Himmel's earnings growth rate is
above the country's GDP growth rate but has begun to
decline. In addition, its capital requirements have been
declining and its payout ratio has been increasing.
Given the above-average yet decreasing rate of growth,
Dietrich uses the H-model to value Himmel's stock. After
the earnings report, Dietrich notes that Himmel's most
recent dividend per share was €1.00 and that shareholders'
required rate of return is 7.50%.
Dietrich expects dividends to:
transition linearly from the current 12% rate of growth over
the next 15 years, then
settle at 4% growth indefinitely.
Dietrich is also researching three companies, Rot, Blau, and
Grün, for possible inclusion in his portfolio. He forecasts
their earnings and dividends for the next six years, as
shown in Exhibit 1.

He also collects pertinent information about these

companies, as shown in Exhibit 2.
Equity – Question Sheet

For a fourth stock, Wolke Telekom, Dietrich expects

dividend growth to remain steady but wants to compare his
expectations for growth against the market's. He compiles
the following data based on his expectations:
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Case No. 8
Anna Fortier, head of acquisitions at a major food
distributor, is analyzing Modern Farm Markets, a privately
held produce retailer, as a possible target for acquisition.
Fortier discusses the target company valuation with her
team, and she states:
Statement 1: The market approach is often considered
preferable to the income- and asset-based approaches
since it relies on actual transaction data, as recommended
by accounting standards.
Statement 2: Price volatility of comparable public
company shares is irrelevant to valuations made for
acquiring a target private company.
Fortier directs the team to apply the guideline public
company method (GPCM), using an average of the market
value to invested capital (MVIC)-to-EBITDA multiples of the
comparables. She has chosen three comparable
companies: Urban Foods Inc. (UFI), Republic Company Ltd.
(RCL), and The West Hills Company (WHC). The team
gathers selected data, shown in Exhibit 1:

Fortier forecasts Modern Farm Markets' EBITDA at CAD 18

million, applies a 10% downward relative risk adjustment,
and determines no control premium is needed.
In addition to Modern Farm Markets, Fortier recently
evaluated Montagne's Fresh Market, a three-store
supermarket chain. Montagne is 100%-owned by its
founder, who wishes to retire and sell the company. Fortier
views this company as having a moderate risk profile with a
stable growth rate. She forecasted EBITDA at CAD 2.4
million.
Equity – Question Sheet

Due to the company's much smaller size and ownership

structure, Fortier used the guideline transaction method
(GTM) to value Montagne. Her team found two
transactions very similar to the proposed acquisition of
Montagne: acquisitions of 100% of two privately held small
supermarket chains. Exhibit 2 shows the targets' MVIC-to-
EBITDA multiples, after the acquirer applied a relative risk
adjustment:

While Fortier considered the Canada East Foods transaction

the most relevant for valuing Montagne, she decided to use
both guideline transactions in the valuation calculation. In
addition, her team determined that Montagne warranted a
5% downward adjustment for the relative risk. After
evaluating the results, an analyst on Fortier's team
commented on the GTM:

Comment 1: A control premium for Montagne is already

incorporated into the guideline transaction multiple.
Comment 2: When using the GTM, the difference
between the transaction date and the valuation date does
not factor in a downward relative risk adjustment.
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Case No. 9
Josue Hernandez and Maria Perez are newly hired
associates at BLL Bank. Francisco Carrera, a senior analyst
at BLL, is testing them on their knowledge of market-based
valuation, starting with price multiples. Carrera asks
Hernandez about rationales for using multiples other than
P/E. Hernandez responds with:
Rationale 1: Sales is much more difficult to manipulate
than earnings, and therefore P/S can be used without fear
of manipulation.
Rationale 2: Since dividends are a less risky component of
return than price appreciation, dividend yield is more
optimal than P/E.
Rationale 3: Since book value is cumulative, it is often
positive even when earnings are negative and P/E cannot
be used.
Carrera then asks Perez to identify some drawbacks to using
multiples other than P/E. Perez responds:
Drawback 1: Due to cost control measures, sales and P/S
are often more volatile than EPS and P/E.
Drawback 2: When cash flow is defined as earnings plus
noncash charges, certain items affecting actual cash flow
are ignored.
Drawback 3: P/B is typically viewed as inappropriate for
valuing companies with largely liquid assets, such as banks.
Carrera then asks about their familiarity with enterprise-
based multiples. He provides the two associates with the
financial information for retailer Molina Primero, shown in
Exhibit 1:
Equity – Question Sheet

Molina Primero has 10 million shares outstanding, currently

priced at MXN 4,500 per share.

Carrera mentions to Hernandez and Perez that investors

use the earnings surprise from sell-side analysts' earnings
estimates as an indicator of future stock price movement.
Some investors use the accuracy of past forecasts to
normalize surprises for a given period. Carrera provides the
two associates recent earnings information on three stocks,
shown in Exhibit 2:
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Case No. 10
Alvin Blake and Amber Cazares, sell-side analysts covering
the pulp and paper industry for a brokerage firm, are
analyzing Promenade Paper's stock. Blake has decided to
value the stock by comparing current price multiples, based
on market price, with justified multiples based on a
constant growth model. He summarizes the information in
Exhibit 1:

Cazares tells Blake that she prefers to use forecasted

earnings to value Promenade. She explains that, before
modeling future earnings, she estimates Promenade's
underlying earnings by adjusting the company's reported
earnings. Cazares then explains to Blake how to calculate a
company's underlying earnings.

Blake turns his attention to Papiro Industries. He uses

price-to-sales (P/S) multiples to evaluate whether Papiro's
stock is relatively under- or overvalued and estimates a
justified P/S multiple of 0.91 based on a constant growth
model. Cazares separately estimates a justified P/S multiple
of 1.12 using a similar calculation. She compares her
assumptions with those used by Blake to understand the
differences in the justified multiples.

Cazares says that she also uses multiples based on the

concept of earnings plus noncash charges, or cash flow (CF),
to evaluate Papiro's stock. Blake agrees that cash flow
multiples based on CF are a widely used metric but adds
that he prefers to use cash flow from operations (CFO),
sourced directly from the statement of cash flows. Blake
then lists to Cazares some of the reasons for his preference.
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Case No. 11
Lei Fan, CFA and Ju Zhang, CFA, two portfolio managers at
Sunrise Capital, are discussing potential investments. Their
discussion begins with the construction equipment industry
and Falcon Manufacturing's competitive position. Fan
states that during his initial analysis, he observed that
Falcon has been able to improve on the most popular
products sold across the industry. The improvements have
allowed Falcon to maintain selling prices higher than its
competitors.
Zhang mentions that she has analyzed Falcon's revenue
growth and profitability, compared to its peers, using ratios
based on data from its financial statements for the last five
years. She finds that Falcon has outperformed its peers for
the first four years of her analysis, and then performed on
average with peers in the last year.
During their conversation, they also discuss their latest
valuations for Falcon and make the following comments:
Fan: Investors can only estimate Falcon's intrinsic value
since knowledge of a company's investment characteristics
will always be incomplete.
Zhang: My value estimate is above the current market
price, and if I am right, convergence will make the price
increase in the near-term.
Falcon's stock currently trades at ¥780 and Zhang's forecast
model estimates the stock's intrinsic value at ¥870. Zhang
expects Falcon to maintain profitability for the foreseeable
future. Despite Falcon's consistent positive free cash flow
generation and profitability, Fan suggests that Zhang also
look at Falcon's liquidation value and compare it against the
going-concern value derived in her forecast.
Fan and Zhang have a meeting with Falcon's CFO scheduled
for later in the week. Zhang tells Fan that she will send the
valuation model she created to the CFO to facilitate
communication with her. Zhang plans to ask the CFO about
a rumored merger between Falcon and one of its
competitors and to use the model to analyze the effects of
the merger on Falcon's growth and profitability.
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Case No. 12
Rudra Dhawan, CFA, is a corporate development analyst at
Prime Technologies. He is currently analyzing two large,
publicly traded companies identified by his manager, Aditi
Madan, as potential acquisition targets. Madan suggests
starting the analysis with each company's stock price, based
on the following statements:

Statement 1: Since markets are fully efficient and other

analysts have done the research, each stock's price will
accurately represent its intrinsic value.
Statement 2: The rational efficient markets formulation
suggests that investors will not incur the expense of equity
analysis without the expectation of greater returns.
Statement 3: It does not matter which valuation model
you choose; all of them will provide valid estimates of
intrinsic value.
Dhawan begins his analysis by examining each company's
competitive positioning and financials, pulling together the
following data:
Equity – Question Sheet

After conducing this analysis, Dhawan begins forecasting

each company's financials and running valuations based on
his estimates. Madan provides Dhawan with the potential
synergies that Prime can expect to achieve by buying and
integrating each potential acquisition target.

Madan is curious about Target 1 since it is a conglomerate

and asks Dhawan what issues she should consider. Dhawan
makes two comments in response:

Comment 1: A conglomerate discount should be applied

to any company with multiple business segments.
Comment 2: The fact that Target 1 is a conglomerate may
signal that its primary business unit has underperformed.
Madan tells Dhawan that Prime will acquire one of these
companies by taking a majority stake and then taking the
acquired company private. Madan is concerned about a
scenario in which the acquisition target is purchased, the
integration fails, and Prime must then resell the target to
another buyer. Madan asks Dhawan what situational
adjustments must be made in this scenario to properly
value the company to be acquired.
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Case No. 13
Martha Hayes is a sell-side analyst covering Envision Inc.,
which is planning an IPO. Given that this will be Hayes's
first IPO, she asks her senior analyst, Benjamin Reed, CFA,
for guidance.
Reed states, "Completing an equity valuation model will
make it easier to communicate with company management
and investor relations. It will enable us to infer the market's
expectations about the company before its IPO. In terms of
process, creating a fundamental model for a private
company is largely the same as creating a fundamental
model for a public company."
Hayes begins her analysis by collecting data on Envision's
competitive position:

Hayes then collects data on Envision's financial position

from its reported financial statements:
Equity – Question Sheet

Hayes believes Envision is well positioned to survive and

grow for the foreseeable future based on this analysis. She
asks Reed which measure of value would be the most
suitable basis for their investment recommendation once
the company begins trading on the secondary market.

Reed is more concerned about how Envision will compare

with its peers once it is priced. Some of Reed's clients are
asking about whether Envision is likely to be overpriced,
fairly priced, or underpriced. Reed asks Hayes to pull
together relevant data on Envision and its publicly traded
peers with identical investment characteristics, shown in
Exhibit 3:

Hayes questions whether a relative valuation is the best

way to model Envision. Regarding model selection, she
suggests that the valuation models be consistent with:
Factor 1: the analyst's purpose of the valuation.
Factor 2: the models used for the company's competitors.
Factor 3: the way other analysts are modeling the company
for comparison.
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Case No. 14
Nathan Lavigne works as a senior analyst for a brokerage
firm. His supervisor, Agathe Castillon, asks him to update
the research report of Trottier Auto Parts, Vertou Retailers,
and Chaumont Chemical Industries as of January 1, 20X5,
using valuations based on price multiples.
Lavigne gathers information about Trottier and the auto
parts industry, summarized in Exhibit 1, and calculates the
company's justified trailing P/E ratio. He assumes a
constant growth rate for dividends and earnings, resulting
in a constant dividend payout ratio.

Castillon asks Lavigne about the assumptions underpinning

his estimates. She wants to understand how isolated
changes in the model's fundamental factors will affect
estimates of the trailing P/E and other price multiples, such
as price-to-book value. She asks specifically about the
effects of changes in the required rate of return and the
earnings growth rate. She also asks Lavigne to use the
forward P/E-to-growth (PEG) ratio to evaluate whether
Trottier's stock is undervalued or overvalued relative to the
auto parts industry.
Castillon then turns her attention to Vertou Group. Lavigne
explains that he projected earnings for three years and
gathered the following information and estimates:
Vertou's required rate of return = 11%
Vertou's expected earnings for Year 3 (E3) = €10.00
Retail industry average dividend payout ratio = 40%
Equity – Question Sheet

Retail industry average ROE = 13%

Retail industry average trailing P/E = 11.0
Castillon asks Lavigne to estimate Vertou's terminal value at
the end of Year 3 based on comparables and based on
fundamentals, using the Gordon growth model.
Lavigne switches his focus to Chaumont Chemical and
informs Castillon that the company's:
Current stock price is €57.00
20X4 EPS was €5.00
20X5 EPS is estimated to be €6.00
In addition, Lavigne has estimated the forward P/E
multiples of Chaumont's competitors in the chemical
industry, summarized in Exhibit 2:

Lavigne believes that Peer 2's forward P/E may be

abnormally high and asks Castillon to compare Chaumont's
multiple with the harmonic mean of the peer group's
multiples.
Castillon wants to expand the comparison to include
competitors from other countries, including the United
States. Lavigne warns Castillon that cross-border valuation
comparisons may show significant differences and makes
the following observations:
Observation 1: Studies show that companies
typically report lower ROE under IFRS than they would have
reported under US GAAP.
Observation 2: Goodwill and pension are among the
most relevant categories of reconciliation between IFRS and
US GAAP.
Equity – Question Sheet

Observation 3:Multiples based on cash flow are typically

more affected by accounting differences than multiples
based on EBITDA and book value.
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Case No. 15
Davish Ikram is an associate in the acquisitions department
at Stark, Inc., a publicly listed steel producer. Ikram and
Kyung Sonam, an intern at the company, are discussing
private firm valuation. Ikram advises Sonam to consider the
following:

Consideration 1: Private firms' management teams

tend to have a controlling stake in the firm. Therefore,
agency issues are less likely to arise in private firms than in
public companies.
Consideration 2: Private firms are usually smaller than
public firms within the same line of business. Thus,
management teams in private firms generally provide
better oversight and more management depth compared
with those in public firms.
Ikram analyzes potential investment opportunities in two
private firms: Firm X and Firm Y.

Firm X is a lumber mill with a significant operating history.

It is expected to receive a purchase offer from a publicly
listed competitor in the same industry. Ikram anticipates
that the deal will not go through due to antitrust laws and is
considering recommending that Stark's management make
an offer to acquire Firm X. Ikram asks Sonam to value Firm
X using the market approach.

Sonam notes that information is not available on private

market transactions of Firm X's shares. She presents
available data in Exhibit 1:
Equity – Question Sheet

Ikram asks Sonam to compare the firm's operating expenses

with those of publicly listed firms. Sonam states that
operating cost synergies from closing redundant facilities
are expected to amount to CAD 400,000 annually. In
addition, some of Firm X's offices are being used by
shareholders for noncore activities, resulting in additional
rent expense of CAD 70,000 each year. Sonam also notes
that the annual compensation of the firm's management is
CAD 5 million, 30% above market average, and that
management will most likely reject an offer to sell.

Ikram states that Stark would then make a purchase offer to

Firm Y, which is expected to grow at a stable rate. Sonam
gathers information on Firm Y, based on the current year, in
Exhibit 2:

Ikram then asks about the method used to estimate the

required return on equity. Sonam states that the expanded
CAPM and the build-up approach incorporate company-
specific risks and therefore provide a better estimate of
required return than CAPM. She then comments:

Comment 1: The build-up approach is more appropriate

to use than the expanded CAPM when guideline public
companies are not available.
Comment 2: The build-up approach considers the
sensitivity of company-specific factors to the different risk
premiums.
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Case No. 16
Kaito Fujino, a senior analyst covering the apparel industry,
asks Nori Hagino, an associate analyst, to value several
companies. The first company, Haiku Apparel, is a mature
company that distributes most of its earnings as dividends.
Its dividend growth has been constant for a considerable
period of time, and Hagino expects this to continue. Fujino
suggests modeling Haiku using either the dividend discount
model or residual income model. Hagino collects
information on Haiku's fundamentals in Exhibit 1 and uses
the single-stage residual income model. Haiku's market
price is ¥3,600 per common share.

Fujino asks what assumptions Hagino used for estimating

continuing residual income. Hagino replies that he added a
persistence factor to the model to account for a decline in
ROE over time. He adds:

Comment 1: The persistence factor accounts for how

quickly a company's ROE will revert to its long-term growth
rate.
Comment 2: Increasing the persistence factor results in a
slower decay of residual income and higher overall
valuation.
Comment 3: Extreme levels of accounting accruals and a
low dividend payout are characteristics of greater residual
income persistence.
Fujino then asks Hagino to review Himalayan Outfitters, a
foreign retailer that has expanded into Japan. Himalayan is
trading at a P/B ratio of 2.0x, a premium to peers. Fujino
calculates Himalayan's ROE at 10% and required rate of
return at 7%.
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Case No. 17
Heinrich Schultz is CFO of C-Store Corp., a private regional
convenience store chain. Schultz is evaluating C-Store's
potential minority investment in or complete acquisition of
Giraffe Fuel Distribution Inc. Schultz begins valuation work
on Giraffe by determining an appropriate discount rate and
gathers the following information.

Using the most recently reported financial data, Schultz

estimates the WACC, a long-term growth rate, and
normalized FCFF.

Giraffe's core business is very stable and predictable, while

a Giraffe subsidiary, Calf Tanker Trucks, has a history of
volatile growth of free cash flow. Calf has acquired
numerous small trucking firms over the past several years
and carries a significant amount of intangible assets on its
balance sheet.

Emma Hoffman, a financial analyst at C-Store, is assisting

Schultz in his analysis. Hoffman prepares the following
information on Calf.
Equity – Question Sheet

Schultz reviews the information and states that to complete

his excess earnings model analysis for Calf, he needs to
know Hoffman's required return estimates for:

Item 1: Working capital

Item 2: Fixed assets

Item 3: Intangible assets

Using the guideline transactions method, Hoffman then
estimates the value of equity in the event C-Store takes a
minority equity interest in Giraffe. She uses the following
estimates:

Value of equity = $150 million

Minority equity ownership stake = 10%
Control premium = 15%
Discount for lack of marketability = 20%
Equity – Question Sheet

Case No. 1
Equity – Question Sheet

Case No. 1
Equity – Question Sheet

Case No. 18
Grace Collins and Brandon Reid are investors discussing
their investments at a conference at the beginning of 20X6.
They are discussing Kosciuszko Gas and Electric, a utility
company located in Australia. Collins has used the Gordon
growth model to value Kosciuszko's stock and gives three
reasons why she used this model:

Reason 1: The company will return to a long-term level

of growth after a period of above-average growth
Reason 2: The company's long-term growth should be
close to Australia's nominal GDP growth
Reason 3: The long-term growth is equal to the
required rate of return
Reid mentions that he uses the Gordon growth model only
in certain situations due to its limitations, particularly the
significant effect that small changes to the required rate of
return and long-term growth estimates may have on the
estimated value. Collins replies that Reid should consider
using the Gordon growth model more broadly in his
research due to its strengths. She states that the model can
calculate the growth rate or required rate of return priced
into a stock or index.

Collins plans to use the Gordon growth model to estimate

Kosciuszko's P/E ratio and compare Kosciuszko with its
peers based on this valuation. She provides data on
Kosciuszko, shown in Exhibit 1:
Equity – Question Sheet

Reid wishes to use a dividend discount model to value High

Tide Bank (HTB), but he believes HTB's dividend is growing
faster than its sustainable level. He asks Collins for her
opinion and provides the following data:

Collins believes HTB is in a period of above-average

dividend growth and that this growth will slow as follows:

Dividends will grow at 10% in 20X6, 20X7, and 20X8.

Dividends will then transition to a long-term growth rate
over a 10-year period.
Dividends will grow at 3% in the long term.
Equity – Question Sheet

Case No. 1
Equity – Question Sheet

Case No. 1
Equity – Question Sheet

Case No. 19
Zebra Windows and Doors is a family-run, privately held
window and door manufacturer. Zebra has a long history of
stable operating profit growth of 3%, which is also next
year's forecast. The owners have decided to put Zebra up
for sale, through either an IPO or outright sale.
Tamika Williams is an investment banking analyst at a sell-
side firm that has been approached by Zebra. Williams is
conducting an initial valuation due diligence for a possible
IPO of Zebra. Two companies have expressed an interest in
buying Zebra outright: Strategic Buyer Inc., a competing
window and door manufacturer, and Financial Buyer Corp.,
a private equity firm.
Williams's forecasted financial information for 20X1 is
presented in Exhibit 1:

In addition, for 20X1, Williams forecasts the following:

15% cost of equity
£500,000 increase in capital expenditures (from reported
20X0 capex)
£50,000 in additional working capital
Williams has been unable to identify any comparable
guideline public companies and is concerned the company
may be too small for a successful IPO. Given the
circumstances surrounding Zebra, Williams believes the
capitalized cash flow method (CCM) will provide a good
starting point for her initial IPO valuation assessment,
although this approach is not typical.
Equity – Question Sheet

Williams has also done some preliminary analysis for the

contingency that Zebra may be acquired by Financial Buyer
in a private transaction. The resulting forecast is presented
in Exhibit 2:

Zebra recently raised equity capital in a private placement,

selling a 5% stake that valued the entire firm at £24 million,
or 6x market value of invested capital (MVIC)-to-EBITDA.
Recent acquisitions by nonstrategic buyers of comparable
private companies in the same industry have occurred at 8x
MVIC-to-EBITDA.
Equity – Question Sheet

Case No. 1
Equity – Question Sheet

Case No. 1
Equity – Question Sheet

Case No. 20
Ellis Howard is a junior equity analyst for a university
endowment fund. The fund's policy for evaluating equity
investments is to use free cash flow to the firm (FCFF) and
free cash flow to equity (FCFE) to estimate a company's
intrinsic value. Howard's supervisor asks about her
methods for forecasting FCFF and FCFE from a company's
reported net income. Howard replies:

Method 1: When determining changes in working

capital, I do not include short-term notes payable as part of
current liabilities.
Method 2: When using net income to derive FCFF or
FCFE, I do not normally add back deferred tax liabilities to
net income.
Howard is asked to evaluate Horizon ElectroCar as a
potential investment. The company's selected financial
information is shown in Exhibit 1:

The notes to the company's financial statements disclose

the following information:

The tax rate is 40%.

In 20X1, Horizon spent SGD 1.0 million to repurchase
common equity shares and borrowed SGD 1.3 million.
There are no notes payable, and all debt is long term.
The company classifies interest paid as cash from
operations (CFO).
Howard estimated Horizon ElectroCar's per-share FCFE for
20X0 to be SGD 2.50. The applicable risk-free interest rate
Equity – Question Sheet

is 2%. Exhibit 2 shows Howard's estimates for the ranges of

inputs used to value Horizon ElectroCar with a constant-
growth FCFE model:

Howard is also evaluating Innovation Resources, which is

located in Chad, where there has been high inflation in
recent years. Relevant information concerning Chad and
Innovation Resources is shown in Exhibit 3:

Finally, although Howard understands the endowment

fund's rationale for valuing equity investments based on the
company's free cash flow (FCF), she believes that other
metrics can be adequate substitutes for FCF. She makes the
following statements to support her position:

Statement 1: If a company makes no investment in fixed

capital, then EBITDA can be used as a proxy for FCFF.
Statement 2: CFO is the same as FCFE if the company's
investment in PPE is equal to its net amount of borrowing.
Equity – Question Sheet

Case No. 1
Equity – Question Sheet

Case No. 1
Equity – Question Sheet

Case No. 21
Hector Diakos is a financial analyst at an asset management
firm. His supervisor, Penelope Panagos, asks him to
research three companies from different industries—
Othonos Retailers, Sagitta Health, and Galatas Airlines—
and update their valuations.

First, Diakos analyzes Othonos, whose stock is currently

trading at €45.50. He decides to value the stock by
comparing the forward P/E ratio, based on current market
price, with a justified forward P/E ratio. Diakos:

estimates an EPS of €3.50 for the next year (ie, the next
four quarters),
builds a FCFE model that values the stock at €49.00, and
calculates a justified forward P/E ratio.
Panagos adds that the retail industry currently has an
average forward P/E of 12.0.

Diakos tells Panagos that he valued the shares of Sagitta

Health and Galatas Airlines as of 1 January 20X9. The data
used in his analysis are summarized in Exhibit 1:

Diakos evaluated Sagitta's stock using three different price

multiples: forward P/E, price-to-sales (P/S), and price-to-
book value (P/B). He explains the rationales supporting the
use of each approach to Panagos:
Equity – Question Sheet

Statement 1: P/E ratios do not require adjustments if EPS

is positive.
Statement 2: P/S ratios are less subject to manipulation
than P/E or P/B.
Statement 3: P/B ratios are deemed appropriate to value
mature and cyclical companies.
Panagos then asks about Galatas Airlines. Diakos explains
that the company's business is extremely sensitive to
business-cycle influences, which results in large variations
in its annual earnings from one year to another. Therefore,
Diakos calculates a normalized P/E ratio using the average
return on equity (ROE) method. The 20X4–20X8 period in
Exhibit 2 represents a full business cycle for Galatas.

Panagos wants to compare Galatas with competitors in the

airline industry. She is concerned, however, that it would
not be possible to rank the stocks according to multiples
since several competitors frequently experience negative
earnings. Diakos proposes a solution for ranking the stocks.
Equity – Question Sheet

Case No. 1
Equity – Question Sheet

Case No. 1
Equity – Question Sheet

Case No. 22
Quality Roofing, Inc. is a successful, privately owned
regional roofing company. CEO Amanda Gagnon has
approval from Quality's board to pursue acquiring its main
supplier of roofing materials, privately held RamCo, Inc.
Gagnon asks CFO Brady Schmidt to analyze RamCo's
financials. Schmidt reviews the income statement, shown
in Exhibit 1:

Schmidt notes that RamCo has minimal debt and stable

long-term revenue growth of 4%, but he has concerns
about two SG&A items:
Executive compensation of $1.25 million
Non-business-related CEO personal expenses of $0.10
million
Schmidt observes that the market rate for executive
compensation is $0.75 million. He also sees that RamCo
has $1.60 million of debt with an interest rate of 8.75%.
Gagnon confirms that Quality Roofing would prefer not to
change RamCo's debt load.
Schmidt consults with an independent appraiser to help
him estimate an optimal value for RamCo. The appraiser
suggests that Quality Roofing value RamCo using the
capitalized cash flow method (CCM). He indicates to
Schmidt that although no public company comparables are
available, an adjustment for industry risk is warranted for
this transaction. He also makes additional comments
related to the challenges of estimating the required rate of
return for a private company:
Equity – Question Sheet

Comment 1: Compared with a similar public company, the

lack of information concerning a private company's
operations introduces greater uncertainty and may lead to
a higher required rate of return.
Comment 2: In an evaluation of an acquisition, finance
theory indicates that the cost of capital should be based on
the buyer's capital structure and the riskiness of its cash
flows.
Finally, the appraiser and Schmidt gather additional data on
RamCo, shown in Exhibit 2:
Equity – Question Sheet

Case No. 1
Equity – Question Sheet

Case No. 23
Marina Slevin, CFA, is an equities analyst for a hedge fund.
She is analyzing three companies as investment candidates
for the fund.

Starlight Industries
Starlight Industries is a publicly traded company that
reports financial results under IFRS. Slevin's research on
Starlight produces the following information:

One family owns 60% of the common shares and occupies

12 of the 20 seats on Starlight's board of directors.
Starlight is capitalized with 30% long-term debt and 70%
common equity. The average interest rate on its debt is 8%.
Starlight recently began paying dividends, and Slevin
believes the company has the ability to greatly increase its
dividend payout since the cash reported on its balance
sheet has increased each year.
Starlight's tax rate is 25%.
Exhibit 1 shows relevant financial information for Starlight:

Slevin's supervisor asks her to estimate an intrinsic value for

Starlight using either free cash flow to the firm (FCFF) or
free cash flow to equity (FCFE). Slevin makes the following
statements in response:
Equity – Question Sheet

Statement 1: When a company pays dividends, using a

dividend discount model is more appropriate than using a
free cash flow model.
Statement 2: For Starlight, a dividend discount model
would be more appropriate than a free cash flow model
since the company is family controlled.
Her supervisor insists, however, so Slevin is determining
whether to use FCFF or FCFE to value Starlight. She offers
the following rationales to her supervisor for using FCFE
Rationale 1: FCFF is not useful for valuing a firm's equity
when the firm uses debt in its capital structure.
Rationale 2: If Starlight's capital structure remains stable,
it is simpler to use FCFE to value its equity than FCFF.
Slevin's supervisor tells her that she could also use cash
flow from operations (CFO) as a starting point to derive
Starlight's FCFF and asks what adjustments to reported CFO
would be needed. Slevin makes the following observations
in response:
Observation 1:One adjustment to CFO is to subtract
changes in the company's working capital.
Observation 2:Another adjustment to CFO is to add back
depreciation expense.
Observation 3:If Starlight treats interest paid as financing
cash flow, then the after-tax interest paid would be added
back to CFO.
Deejon Enterprises
Slevin is also evaluating Deejon Enterprises, which is a
privately owned foreign company. Slevin's assumptions
about and estimates for Deejon are shown in Exhibit 2:
Equity – Question Sheet

Horn Trading Corp.

Finally, Slevin analyzes Horn Trading Corp., a publicly traded

company based in the United States. She estimates that
Horn Trading's FCFF will grow at a constant 2% each year.
Relevant information concerning Horn Trading is shown in
Exhibit 3:
Equity – Question Sheet

Case No. 1
Equity – Question Sheet

Case No. 1
Equity – Question Sheet

Case No. 24
Sofia Almado is a research analyst with a large European
investment bank. The bank's management is considering
three companies for recommendation to its clients:
Snowcap Solutions, Broadview Analytics, and Evermore Inc.
Almado is charged with preparing valuations for each.
Selected data from the financial statements for Snowcap is
shown in Exhibit 1, which Almado will use to derive FCFF.
Snowcap's applicable tax rate is 30%.

One of Almado's colleagues asked her why she used FCFF

instead of FCFE to value Snowcap. She responded with
several ideas.
Broadview plans to repurchase common stock. The most
recent annual FCFE for Broadview is €375 million, but
Almado wishes to understand how the FCFE would be
affected by planned stock repurchases totaling €30 million
during the same period. Exhibit 2 shows selected financial
data for Broadview:
Equity – Question Sheet

Almado believes FCF models are the best option for

estimating Broadview's value. Her manager, however,
states that since Broadview has paid steady dividends for
several years, a better option would be to use dividend
discount models (DDM). Almado counters that she would
normally agree, but Broadview has characteristics that led
her to choose FCF valuation. Among them, she states that
Broadview has:
Reason 1: Low dividends relative to its positive FCFE
Reason 2: A diverse investor base without concentrated
stock positions
Reason 3: Profitability that does not align with FCF over
the forecast period
Finally, Almado is reviewing Evermore's financials as part of
her analysis. She is interested in calculating the company's
FCFF from its reported net income. She needs to determine
the proper treatment of the following noncash items:

Item 1: An impairment charge for an intangible asset

Item 2: A noncash gain related to nonoperating activities
Item 3: Amortization of discounts related to the purchase of
long-term bond holdings
Equity – Question Sheet

Case No. 1
Equity – Question Sheet

Case No. 1
Equity – Question Sheet

Case No. 25
Mei Tong, an equity fund manager at Pearl Investments, is
analyzing several companies during a market downturn,
starting with Sapphire Electronics. Sapphire's earnings are
highly cyclical and are the lowest they've been in years.
Given the current stage of the business cycle, Tong decides
to calculate P/E based on normalized earnings using the
method of historical average EPS and the method of
average return on equity. She collects the following data
from the last full business cycle:

Tong plans to compare Sapphire with competitors based on

their P/E ratios but estimates significantly different growth
rates between the companies. She decides to use the P/E-
to-growth (PEG) ratio instead of P/E. Bao Lam, a colleague
at Pearl, reminds her about several considerations when
using the PEG ratio:

Consideration 1: The PEG ratio does not account for

differences in risk between companies.
Consideration 2: Company-specific growth should be
normalized for the growth of the overall economy.
Consideration 3: The PEG ratio assumes a nonlinear
relationship between P/E and growth and must be adjusted
for linearity.
Tong and Lam discuss how to evaluate the relative value of
Granite Manufacturing compared with peers and then
appropriately rank the companies according to a price ratio.
Granite has experienced losses in recent years, and
Equity – Question Sheet

earnings are expected to remain negative for the

foreseeable future. Granite uses a unique, asset-light
manufacturing process that differs from the asset-centric
process its peers use, giving it a smaller asset base and
lower COGS than its peers.

Tong turns her attention to Sunrise Telecommunications.

She wants to compare its value with industry averages
based on several ratios. Using this comparison, she will
determine whether the company is undervalued or
overvalued. She collects the following information on
Sunrise and the industry:
Equity – Question Sheet

Case No. 1
Equity – Question Sheet

Case No. 26
Tomás Montero is a financial analyst at an independent
equity research firm. He is updating, as of January 1, 20X6,
the research reports on Industrias Melendez and Tiendas
Guadalupe. On that date, the stock prices of Melendez are
MXN 150 (per share of common) and MXN 80 (per share of
preferred).
Montero summarizes Melendez's financial statements in
Exhibit 1:
Equity – Question Sheet

Montero calculates Melendez's enterprise value (EV) and its

EV/EBITDA ratio. He also calculates the price-to-book (P/B)
ratio and compares it with the industry multiple of 1.15.
Montero presents his conclusions to his supervisor, Yolanda
Barcenas, who asks him to calculate price multiples based
on cash flow measures. Montero explains that there are
alternative definitions of cash flow, and each has specific
limitations:
Limitation 1: Cash flow from operations (CFO) is not a free
cash flow concept.
Limitation 2: CF (earnings plus noncash charges) is more
volatile than FCFE.
Limitation 3: EBITDA will exceed CFO if working capital is
consistently decreasing.
Barcenas asks Montero to include a momentum valuation
indicator in his analysis. She recommends using an
indicator that compares Melendez's stock performance
with the performance of a group of similar stocks.
Montero turns his attention to Guadalupe. He gathers
information about the company and a competitor,
Comercial Arana, summarized in Exhibit 2:

Montero notices a significant difference in the trailing price-

to-sales (P/S) multiples of both companies. He analyzes
three fundamentals—beta, profit margin, and earnings
growth rate—to understand whether any of those factors
could help explain, at least in part, the difference between
the multiples. In this analysis, Montero assumes that both
companies' dividend payout ratio and ROE will not change
in the long run.
Equity – Question Sheet

Montero also analyzes a large number of stocks in the

industry and builds a cross-sectional regression model to
predict Guadalupe's P/E. He compares the predicted price-
to-earnings (P/E) ratio with Guadalupe's current trailing P/E
to evaluate the stock. The model is:

Predicted P/E = 10.7 + (1.1 × Dividend payout ratio) − (0.2 ×

Beta) + (65.6 × Earnings growth rate)
Equity – Question Sheet

Case No. 1
Equity – Question Sheet

Case No. 1
Equity – Question Sheet

Case No. 27
uigi Pellegrini is a portfolio manager at an asset
management firm. He asks Gianna Veronese, a senior
analyst at the firm, to perform an analysis of Grivola Group,
Adamello Industries, and Secchia Systems. He directs
Veronese to calculate the companies' market-based
multiples and compare them with an appropriate
benchmark.

Veronese explains that there are alternative choices of

comparison assets when the method of comparables is
used, including a peer group, the firm's industry, or the
firm's historical multiples. After reviewing Grivola Group, a
holding company that operates in different business
segments, she states:
Statement 1: Grivola's peer group must consist of
companies from the same industry that have no significant
differences from Grivola.
Statement 2: Since Grivola operates in different business
segments, it may be classified in more than one industry or
sector.
Statement 3: The comparison of current and historical P/E
may be affected by changes in Grivola's business mix or
leverage.

Veronese adds that a multiple of a representative equity

index may also be used as a benchmark. However, since
the overall market may be over- or undervalued, she uses
two models—the Fed model and the Yardeni model—to
value the equity index multiple.
Pellegrini would like to compare Grivola with international
peers, but he expresses concern about differences in
inflation rates. Veronese answers that a justified forward
P/E can be calculated based on forecasted fundamentals
using the information in Exhibit 1. She uses a constant
growth model that assumes earnings growth for the three
companies results only from inflation and that earnings are
distributed entirely as dividends.
Equity – Question Sheet

Veronese adds that, in the analysis, she defined cash flow

as earnings plus noncash charges and considered that
Adamello's industry had a P/CF of 9.0. Adamello's income
statement is summarized in Exhibit 2:

Exhibit 3 presents additional financial information on

Adamello gathered by Veronese:

Finally, Veronese switches her focus to Secchia Systems.

Since Secchia has been paying dividends regularly, she
decides to calculate the company's trailing dividend yield
and compare it with a justified multiple based on a constant
growth model. She gathers information on the company,
presented in Exhibit 4:
Equity – Question Sheet
Equity – Question Sheet

Case No. 1
Equity – Question Sheet

Case No. 1
Equity – Question Sheet

Case No. 28
Dimitri Mazur was recently hired as a junior research
analyst at Nivki Partners, a sell-side brokerage firm. Oksana
Koval is Mazur's supervisor and is responsible for covering
consumer cyclical stocks.

Koval asks Mazur what he knows about the use of residual

income models. Mazur responds that, although there are
other discounted cash flow models, residual income models
are most suitable for companies that are:

Type 1:Non-dividend paying

Type 2: Early-stage start-ups
Type 3: Have terminal values that can be estimated
with high confidence
Koval agrees that other discounted cash flow models are
available and believes they can be useful in certain
situations. However, she states that for estimating a
company's intrinsic value:

Statement 1: An FCF approach is preferred because it

provides a more accurate estimate than a residual income
approach.
Statement 2: Dividend discount models are too simplistic
and provide a less accurate intrinsic valuation assessment.
Koval then provides Mazur with the most recent annual
financial information on Work Shoe, Inc. She asks him to
review this information and be prepared to calculate an
intrinsic value:
Equity – Question Sheet

Koval then turns her attention to Auto Parts, Inc. (AP), a

leading after-market auto part retailer in the country. AP
has grown steadily over the past few years, and Koval
expects that trend to continue.

Koval adds the following assumptions for AP:

Earnings per share will grow at 10% of beginning book value

for each of the next three years.
The present value of residual income per share for the next
three years is €3.74.
Ending book value per share in three years' time is €30.15.
In three years' time, AP will trade at a price-to-book ratio of
1.6.
Koval mentions that several years ago, AP acquired an
exclusive 10-year license to sell a particular brand of
automotive battery for a nominal fee. This battery brand is
now the most popular in the country.

AP is also rumored to be the target of a takeover by an

equal-size direct competitor. Koval asks Mazur to consider
the possible implications for the estimated residual income
intrinsic value of the combined company if AP were
acquired in a fair value cash transaction that produced no
goodwill.
Equity – Question Sheet

Case No. 1
Equity – Question Sheet

Case No. 1
Equity – Question Sheet

Case No. 29
Ilse Hauser is an investor performing valuations on several
companies. She read about Turbo Mechanical in an online
article and wants to follow up with her own residual income
valuation. Turbo is a rapidly growing auto parts
manufacturer with a 6% WACC and 20% tax rate. Hauser
compiles Turbo's latest financials:

During her research, Hauser notices that an industry leader,

Strasse Industries, plans to acquire a specialty
manufacturer, Rennen Auto. Both are mature companies,
with no expected future growth, that pay out all of their
income as dividends and have required rates of return of
10%. This will remain true after the acquisition. Strasse is
acquiring Rennen for €2 billion in an all-cash deal with no
planned synergies. Hauser collects financial information on
both companies and calculates that Rennen's fair value is
€2 billion, including its customer list.

Hauser notices that Strasse has been reporting foreign

currency translation losses in other comprehensive income
over the past two quarters. Based on her macroeconomic
forecast, she expects the PV of future foreign currency
translation gains/losses to net to zero.
Equity – Question Sheet

Reiner Eskelson, another investor Hauser collaborates with,

asks Hauser why she uses the residual income model over
other discounted cash flow models. Hauser provides the
following reasons:

Reason 1: Residual income can be used even when

cash flows are unpredictable.
Reason 2: Book value is less susceptible to
manipulation than income statement metrics.
Reason 3: The model does not assume the cost of debt
is appropriately reflected by interest expense.
Equity – Question Sheet

Case No. 1
Equity – Question Sheet

Case No. 30
Jeremy Collins and Bridget Parker manage an equity fund of
dividend-paying stocks and are conducting a quarterly
evaluation of the fund's constituents. They are also
assessing several companies that have recently initiated
dividends for inclusion in the fund. Collins collects
information (shown in Exhibit 1) about shares of Federal
Mills, which initiated a dividend last year.

Collins and Parker agree to use the two-stage dividend

discount model for Federal Mills, given a short-term boost
to earnings growth from a new product. They are
discussing the best methods to calculate the terminal value,
using the estimated final dividend and earnings values
calculated by the model. Parker suggests three alternative
methods:

Method 1: Calculate the terminal year stock price using

a price ratio.
Method 2: Forecast the value of all future dividends
using the Gordon growth model.
Method 3: Calculate the terminal value as the dividend
discounted by the long-term growth rate.

For another stock recently added to the fund, Garrison

Media, Parker begins calculating the rate of return required
by investors based on its current stock price of $15. She
expects Garrison's dividend growth rate to decline linearly
during a transition period before reaching a constant
growth rate. Parker's estimates are provided in Exhibit 2:
Equity – Question Sheet

Collins then evaluates Traverse Technologies, which

initiated a dividend last year. Collins expects Traverse's
growth to slow in phases from its current pace, but he also
believes the company will pay a special dividend. The
special dividend does not affect the base dividend used to
calculate payments in future years. Collins presents his
estimates in Exhibit 3:
Equity – Question Sheet

Case No. 1
Equity – Question Sheet

Case No. 31
Axelrod Partners, an investment banking firm, has been
retained by two firms, HR-Pay Corp. and Potterville
Financial, as each is preparing for an IPO.

HR-Pay is an online payroll and human resource software

provider that is rapidly growing market share and revenue
but is not yet profitable. HR-Pay is currently in the process
of raising equity capital to strengthen its financial position
by selling a 5% stake through a restricted stock private
placement. This sale will be in advance of the IPO, which is
expected to occur in the coming months. No individual
shareholder owns more than 25% of HR-Pay.

Catherine Evans, an investment banking analyst at Axelrod,

is creating a financial model for HR-Pay while also
considering an appropriate valuation for the restricted stock
sale. Evans is contemplating whether a discount for lack of
marketability (DLOM) for HR-Pay's restricted stock is
appropriate. Evans believes that using the guideline public
company method (GPCM) based on market value of
invested capital (MVIC) to EBITDA multiple is an appropriate
approach for the IPO valuation. She compiles the following:

In addition to researching comparable private sales of stock

prior to a subsequent IPO, Evans is also considering a DLOM
based on an option pricing model, which estimates the
DLOM as the value of the option as a percent of HR-Pay's
price. Evans narrows her choices down to the following
three option models, based on:
Equity – Question Sheet

Option model 1: At-the-money put option

Option model 2: In-the-money call option

Option model 3: Out-of-the-money call option

Evans turns her attention to Potterville, a private financial

holding company with affiliated companies that provide
traditional banking, investment management, and real
estate development. Potterville is wholly owned by a single
family, except for a 15% minority equity interest owned by
Jim Landry, a private investor. Family members hold all
significant management positions in the entire
organization.

Potterville needs growth funding to expand the business

and intends to sell a 10% equity stake in the IPO. Evans
believes that, in this situation, an asset-based valuation
approach using the GPCM is appropriate. Based on this
information and her own estimates, Evans's initial valuation
estimate for Potterville is £100 million.
Equity – Question Sheet

Case No. 1
Equity – Question Sheet

Case No. 1