Study session 12 in the Level II CFA Program curriculum concludes the material on equity investments with four readings (34-37) and could be some of the most important readings for your career as an equity analyst. These are really the basic concepts that you are going to be using and you need to master them to be able to handle the greater detail you’ll see in your professional roles.
Free Cash Flow Valuation
Free cash flow to the firm is available to all suppliers of capital and should use the WACC for a discount rate. Free cash flow to equity is only applicable to equity suppliers so the required return on equity is used as the discount rate.
The most difficult part in FCF calculations, for me, was the adjustments to net income to arrive at FCFF. Remember: depreciation, amortization, restructuring expenses, losses on fixed asset sales, deferred tax liabilities, after-tax interest expenses and preferred stock dividends are all added back to net income. Any gains on the sale of fixed assets, the amortization of long-term bond premiums, deferred tax assets, and investments in FC and WC are all subtracted from net income.
It’s a pain but you absolutely have to understand and be able to calculate all the approaches of FCF estimation: net income, net cash flow, EBIT, EBITDA, and FCFE from FCFF. Start with the calculation from net income to get a good feel for the adjustments and what is being built into FCF, this should make the other equations more intuitive.
Remember that these are relative valuations and do not necessarily mean that an asset is intrinsically under- or over-valued. The advantage is that they are simple, intuitive and well-known.
Understand the difference between trailing- and leading- price multiples. Trailing earnings need to be adjusted for cyclicality, accounting differences, dilution, and non-recurring items. This is why many use normalized earnings through the ROE method or historical average.
Be able to calculate all the price multiples with inputs,
Trailing P/E = (retention rate * growth)/ (return common equity – growth)
P/B = (ROE – growth)/ (return common equity – growth)
P/S =( (current earnings/current sales)*(retention rate)* growth)/ (return common equity – growth)
Remember that Enterprise Value equals: Market value of equity, preferred stock, and debt minus cash and investments. From here it is fairly simple to get the EV/EBITDA and EV/Sales multiples.
Residual Income Valuation
Residual income is a firm’s net income minus the required return of shareholders. The advantage over the dividend discount model is that more of the intrinsic value is captured upfront in the book value rather than through an estimated terminal value.
The RI model is only appropriate with clean surplus accounting, when there are no changes in the book value except for earnings and dividends. The book value used in the RI model should be adjusted for off-balance sheet items.
The disadvantages of the RI model are that it relies on easily manipulated financial statement data, clean surplus must hold, and the amount of adjustments that may be needed. The model is most appropriate with companies that do not pay a dividend, when there are negative FCF, or the terminal value is difficult to estimate.
Be able to calculate RI from net income or NOPAT
RI= Net Income – Capital Charge
= Net Income – (Equity capital * cost of equity)
RI = NOPAT – Total Capital Charge
= NOPAT – ((after-tax cost of debt * debt capital) – (cost of equity * equity capital))
Private Company Valuation
Understand the company specific (life cycle, size, markets, management) and stock specific (liquidity of equity, concentration of control, agreements on liquidity restrictions) factors for valuation.
Most of the valuation calculations (FCFF) have been used in other sections so focus on the idea behind each valuation method as well as advantages/limitations.
The discount equation for lack of control and marketability is fairly testable so understand how to perform the calculation and ideas around it. The lack of control discount (DLOC) is the percentage deducted from the pro rata share of an equity interest to reflect absence of control (when valuation is being done for a minority interest in the target). The lack of marketability discount (DLOM) reflects the absence of marketability (liquidity, share and transfer restrictions, concentration of ownership).
DLOC = 1- (1/(1+control premium))
DLOM = Value of at-the-money puts/Value of stock before any DLOC
Study session 13 in the Level II CFA Program curriculum covers alternative investments. The material is quite a bit more complex than what you saw at Level 1 so don’t fall behind.
‘til next time, happy studyin’
Joseph Hogue, CFA