Equities Cllase 1 Junio 2020

CFA® Preparation
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EQUITIES
Francisco Parga Valle,CFA
Francisco Parga, CFA

CFA® Preparation
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EQUITY VALUATION: APPLICATIONS AND PROCESSES I ½ 31 de Enero

RETURN CONCEPTS I Pending
INDUSTRY AND COMPANY ANALYSIS II ½ 31 de Enero
DISCOUNTED DIVIDEND VALUATION II 2/2 31 de Enero
FREE CASH FLOW VALUATION III 7 de Febrero
MARKET-BASED VALUATION: PRICE AND ENTERPRISE VALUE MULTIPLES III 14 de Febrero
RESIDUAL INCOME VALUATION III Pending
PRIVATE COMPANY VALUATION III Pending

CFA® Preparation
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EQUITY VALUATION:
Applications and
Processes

Define valuation and intrinsic value and explain sources of perceived CFA® Preparation
mispricing. www.dbf-finance.com
valuation of an asset or security by someone who

VALUATION Process of determining the value of an asset Intrinsic has complete understanding of the characteristics of
Value the asset or issuing firm
Steps
Difference between I.V. and Stock
Mispricing price
① Understand the business
Mispricing breakdown
② Forecast Company performance IV analyst Price IV actual Price IV analyst IV

actual
25
③ Select the appropriate valuation model
20
15
④ Convert the forecasts into valuation model 10 20

15
5 10
0
⑤ Apply the valuation conclussions Actual Price I.V. Analyst I.V. Actual
20 10 15 10 20 15

Explain the going concern assumption and contrast a going concern value to a CFA® Preparation
liquidation value. www.dbf-finance.com
Going assuming that a company will continue to operate

Concern as a business, and not going out of business
It cannot be assumed that the business will survive

Liquidation
Value Estimate of what the assets of the firm
would bring if sold separately, net of the
company’s liabilities.

Describe definitions of value and justify which definition of value is most CFA® Preparation
relevant to public company valuation. www.dbf-finance.com
valuation of an asset or security by someone

Intrinsic VALUATION AND PM
who has complete understanding of the
Value characteristics of the asset or issuing firm GUYS
Analysts should know the

purpose of valuation:
• For most investment
DUE DILIGENCE decisions, intrinsic value.
Investment the value of a stock to a particular buyer. GUYS • For acquisitions,
Value investment value
Depends on the buyer’s specific needs and expectations, and
synergies with existing buyer assets.
the price at which a hypothetical willing, AUDIT

Fair Market
informed, and able seller would trade an GUYS
Value
asset to a willing, informed, and able buyer

CFA® Preparation
Describe applications of equity valuation.
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VALUATION estimating the value of an asset
using a model based on the comparing it to the observable market value of “comparable” assets
variables the analyst believes
influence the value of the asset
STEPS
① Understand the business
② Forecast Company performance
③ Select the appropriate valuation model
④ Convert the forecasts into valuation model
⑤ Apply the valuation conclussions

CFA® Preparation
Describe applications of equity valuation.
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VALUATION estimating the value of an asset
using a model based on the comparing it to the observable market value of “comparable” assets
variables the analyst believes
influence the value of the asset
USES
① Stock selection ⑥ Communication with analysts and investors
② Interpretation of the market ⑦ Valuation of private business
③ Determine the value of corporate actions ⑧ Portfolio management Not stand alone
④ Fairness Opinions Planning Defining investment objectives & constraints
⑤ Planning and Consulting Executing

Describe questions that should be addressed in conducting an industry and CFA® Preparation
competitive analysis. www.dbf-finance.com
Michael Porter five elements of industry structure→ Five Forces
5 forces Generic Strategies
① Threat of new entrants in the industry. ① Cost leadership→ Low-cost Producer
② Threat of substitutes. ② Product differentiation
③ Bargaining power of buyers. ③ Focus
④ Bargaining power of suppliers. Segmentation→ Focused on a Group

of clients or products
⑤ Rivalry among existing competitors.

Describe questions that should be addressed in conducting an industry and CFA® Preparation
competitive analysis. www.dbf-finance.com
Quality of Financial Statement Information Assessment
① Accelerating or premature recognition of income
② Reclassifying gains and nonoperating income

Capitalization of expenses, Delaying the recognition of
③ Expense recognition and losses. expenses, classifying operating expenses as nonoperating
expenses
④ Amortization, depreciation, and discount rates.
⑤ Off-Balance-sheet issues SPEs, operating leases, etc…

Contrast absolute and relative valuation models and describe examples of each CFA® Preparation
type of model www.dbf-finance.com
Absolute valuation models Relative valuation models
Estimates the intrinsic value of an asset without Determine the value of an asset taking into account the
considering the value of other firms value of other assets.
Value of a company= the discounted present value of the cash P/E ratio
flows expected in the future
Dividend discount models IF P/E company > P/E comparables Relatively

Overvalued
Free cash flow approach
Residual Income Approach
Asset Based Models

CFA® Preparation
Describe sum-of-the-parts valuation and conglomerate discounts.
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Sum-of-the-parts value Conglomerate Discount
Investors “should” apply a markdown to the value of a

① Value the individual parts of the firm company that operates in multiple unrelated industries,
compared to the value a company that has a single
② Add them to determine the “Total” VALUE of company industry focus.
Conglomerate discount is the difference between market

value and sum-of-the-parts value.
Recommended when the Company operates:
Explanations of Conglomerate Discounts:
1. Different divisions (or products)
① Internal capital inefficiency→ Bad capital allocation
2. With different risk characteristics and/or business models
Endogenous factors → unrelated business
② acquisitions to hide poor operating performance.
③ Incorrect Measurement: Poor Research

Explain broad criteria for choosing an appropriate approach for valuing a given CFA® Preparation
company. www.dbf-finance.com
Before selecting an approach for valuing a company, an analyst should assess whether the model:
① Fits the characteristics of the company (dividend paying company?, earnings growth can be estimated?,
significant intangible assets?)
② Is appropriated based upon the quality and availability of input data
③ Is suitable given the purpose of the analysis. → Dividend vs cash flow models in minority vs controlling interest
The analyst does not have to consider only one→ Triangulation Pwc and McKinsey

CFA® Preparation
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-EQUITY VALUATION: Industry

and Company Analysis

Compare top-down, bottom-up, and hybrid approaches for developing inputs CFA® Preparation
to equity valuation models. www.dbf-finance.com
Bottom-up Top-Down HYBRID
Starts with analysis of the Starts with expectations of Incorporates elements of both top-
Company macroeconomic variables down and bottom-up
Historical revenue growth Expected GDP growth Most common type

Compare “growth relative to GDP growth” and “market growth and market CFA® Preparation
share” approaches to forecasting revenue. www.dbf-finance.com
Growth relative to GDP growth Market Growth and Market Share
GDP Growth X% Estimate of the Estimate of the

industry growth rate market share
GDP Growth 1+X%
Different Businesses
Different relationships
with GDP
Different Geographies

Evaluate whether economies of scale are present in an industry by analyzing CFA® Preparation
operating margins and sales levels www.dbf-finance.com
average cost of production decreases as industry sales increase

Economies of scale
Higher operating margins as production volume increases
If Economies of scale Larger companies have higher margins

exist in an Industry
Calculation of
Economies of Scale
Observe common-size income statements
Economies of scale in COGS Lower COGS as a % of sales in larger companies
Economies of scale in SG&A Lower SG&A as a % of sales in larger companies

Forecast the following costs: cost of goods sold, selling general and CFA® Preparation
administrative costs, financing costs, and income taxes. www.dbf-finance.com
COGS
Historical COGS
Forecast Estimate of future
COGS revenues
Revenues
Forecast 1 Gross Estimate of future

COGS Margin revenues
Take into Trends in Trend

consideration Margins persistence
Examine gross
Volume & Price Commodity type Consider Hedging
margins of firms
Analysis inputs (downside and
competitors
upside)
SG&A
Less sensitive than

SG&A´s fixed cost
COGS to changes in
component is greater
sales volume
than variable cost
Selling and distribution
Sales people salaries If a breakdown of

SG&A can be Forecast separately
obtained
General and Administrative
R&D IT operations If a breakdown of
SG&A by segment Forecast separately
Corporate
headquarters can be obtained
Management
salaries

Financing costs
Gross Debt
Gross Interest
expense Market
interest rates
Net debt is gross debt minus cash, cash equivalents, and short-
term securities. Net interest expense is gross interest expense
minus interest income on cash and short-term debt securities.

Income Tax Expense
① Statutory Tax Rate Tax rate in the country where the firm is domiciled
② Effective Tax Rate Income tax / EBT
③ Cash Tax Rate (Cash taxes paid)/ EBT
Permanent differences (Non deductible expenses)

Differences between ① and ②
Multinational operations
Differences between ② and ③ Deferred taxes

CFA® Preparation
Describe approaches to balance sheet modeling.
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Balance Sheet items derived from I.S forecasts Once the forecasted
financial statements
① Retained earnings (Net income –dividends) are constructed, an
analyst should
② Working Capital Items perform sensitivity
analysis for
Accounts Forecasted sales Forecasted COGS
Inventory individual
receivable DSO projected
projected 365 Inventory turnover
assumptions, or
perform analyses
with alternative
③ PP&E
assumptions
Sales
Constant (scenario analysis),
historical Assets to examine the
sensitivity of net
Forecasts may Maintenance Expansion income to changes
Separating CAPEX
be improved by CAPEX in assumptions.
Historical depreciation should be increased by the inflation rate when estimating capital expenditure for
maintenance because replacement cost can be expected to increase with inflation.

Describe the relationship between return on invested capital and competitive CFA® Preparation
advantage. www.dbf-finance.com
NOPLAT
ROIC
Invested Capital
ROIC is a return to both equity and debt and is
preferable to return on equity (ROE) in some
Tax
contexts because it allows comparisons across
NOPLAT EBIT 1 firms with different capital structures.
rate
Net
Invested Operating Operating Fixed
Working
Capital assets liabilities assets
Capital
COMPETITIVE
Firm
ROIC
> Comparables
ROIC
ADVANTAGE
likely ROCE
Pretax earnings in
the numerator

Explain how competitive factors affect prices and costs. AND: Judge the CFA® Preparation
competitive position of a company based on a Porter’s five forces analysis. www.dbf-finance.com
Porter´s five forces
① Threat of new entrants in the Industry The long term profitability of any
industry is determined by the
② Threat of substitutes
interaction of Porter´s competitive
③ Bargaining power of buyers forces
④ Bargaining power of suppliers
⑤ Rivalry among existing competitors

CFA® Preparation
INTRODUCTION: Buffet/Dorsey MOAT CONCEPT
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CAPITALISM WORKS
① Capitalism works pretty well
In the absence of MOATS
GOOD RETURNS ATRACK COMPETITORS
COMPETITION reduces HIGH returns to

average RETURNS
WARREN
BUFFET PAT
MICHAEL DORSEY,CFA
PORTER

Explain how competitive factors affect prices and costs. AND: Judge the CFA® Preparation
competitive position of a company based on a Porter’s five forces analysis. www.dbf-finance.com
HIGH Threat of substitute product LESS PRICING POWER
HIGH Intensity of Industry Rivalry LESS PRICING POWER
Undifferentiated
Low Industry concentration High fixed costs and exit barriers Slow industry growth
products
HIGH Bargaining power of suppliers Low prospects of earning growth
HIGH Bargaining power of customers LESS PRICING POWER
High customer concentration Low switching costs
HIGH Threat of New Entrants LESS PRICING POWER
BARRIERS TO ENTRY
Explain how to forecast industry and company sales and costs when they are CFA® Preparation
subject to price inflation or deflation. www.dbf-finance.com
Input costs can be significant in many No hedges nor is vertically integrated → how rapidly, and to
industries. Changes in these costs can what extent, the increase in costs can be passed on to customers,
significantly affect earnings. as well as the expected effect of price increases on sales volume
and sales revenue.
Companies with commodity-type inputs can
hedge their exposure to changes in input It may be the case that a firm can reduce the impact of an
prices through derivatives or, more simply, increase in an input price by switching to a substitute input;
fixed-price contracts for future delivery.
The effects of increasing a product’s price depend on the
Companies that are vertically integrated product’s elasticity of demand. For most firms, product
(and are in effect their own suppliers) will be demand is relatively elastic. With elastic demand, the
less subject to the effects of variations in percentage reduction in unit sales is greater than the percentage
input prices. increase in price, and a price increase will decrease total sales
revenue.

Evaluate the effects of technological developments on demand, selling prices, CFA® Preparation
costs, and margins www.dbf-finance.com
increase profit margins (at least for

Some technology advances early adopters), and, over time, increase
Robotization
decrease cost of production industry supply and unit sales as well
Other technology advances:

• New product Tablets
Skype
Disruption risk
• Improved substitutes
Modelling introduction of new Cannibalization 𝑁𝑒𝑤 𝑝𝑟𝑜𝑑𝑢𝑐𝑡 𝑠𝑎𝑙𝑒𝑠 𝑡ℎ𝑎𝑡 𝑟𝑒𝑝𝑙𝑎𝑐𝑒 𝑒𝑥𝑖𝑠𝑡𝑖𝑛𝑔 𝑠𝑎𝑙𝑒𝑠
products or new substitutes factor 𝑇𝑜𝑡𝑎𝑙 𝑛𝑒𝑤 𝑃𝑟𝑜𝑑𝑢𝑐𝑡 𝑆𝑎𝑙𝑒𝑠
This cannibalization factor can be different for different sales

channels and is likely to be lower for business customers than
for direct purchases by consumers.

CFA® Preparation
Explain considerations in the choice of an explicit forecast horizon.
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Forecast horizon Expected holding period Consider the investment strategy
Forecast horizon length Normalized Mid-cycle

with cyclical businesses Earnings earnings
When there are recent impactful events, such as acquisitions, mergers, or restructurings,
these events should be considered temporary, and the forecast horizon should be long
enough that the perceived benefits of such events can be realized (or not)

Explain an analyst’s choices in developing projections beyond the short-term CFA® Preparation
forecast horizon www.dbf-finance.com
Used multiple consistent with

Multiple approach
Terminal growth rates and required returns
Value
CF approach
① g
② Normalized CF
A difficult part of an analyst’s job is recognizing inflection points—those instances when the
future will not be like the past, due to change in a company’s or an industry’s competitive
environment or to changes in the overall economy.
Inflection points occur due to changes in:

•Overall economic environment.
•Business cycle stage.
•Government regulations.
•Technology.

CFA® Preparation
Demonstrate the development of a sales-based pro forma company model.
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Consequence of all previous

staff
REVIEW BY YOURSELF

CFA® Preparation
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-EQUITY VALUATION:
Discounted Dividend Valuation

CFA® Preparation
DDM strengths and weaknesses
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Strengths Weaknesses
① Theoretically justified ① Difficult or impossible to implement for firms

that do not currently pay dividends.
Value today= PV of future cash flows received
② Dividends are less volatile than earnings or free cash flows ② It takes the perspective of a minority
shareholder, and therefore not useful for
controlling interests
DDM appropriate if
① The company has a history of dividend payments

③ The perspective is that of a minority shareholder.
② The dividend policy is clear and related to the
earnings of the firm

CFA® Preparation
DDM strengths and weaknesses
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FCFF
FCFE
IGNORAR. MÁS
RESIDUAL INCOME TARDE A FULL

Calculate and interpret the value of a common stock using the dividend CFA® Preparation
discount model (DDM) for single and multiple holding periods. www.dbf-finance.com
One-Period DDM Multi-Period DDM
D1 P1 D1 D2 Dn Pn
V0 V0
1 r 1 r 2 n
1 r 1 r
Two-Period DDM Pepe Perez, a CFA level II candidate, is preparing the

financial forecast of a small company. He projects that
D1 D2 P2 PPP,sA will pay a dividend of $1.25 next year, $1.35 the
V0 second year, and $1.45 the third year. At the end of the
1 r 1 r
2 third year, he expects the asset to be priced at $36.50. If
the required return is 12%, what is the current value of
the shares?

Calculate and interpret the value of a common stock using the dividend CFA® Preparation
discount model (DDM) for single and multiple holding periods. www.dbf-finance.com
1.25 1.35 1.45 36.5 CF 2nd CLR WORK

V0
-0 Enter ↓
2 3
1 12% 1 12% 1 12%
1.25 Enter ↓ ↓
1.35 Enter ↓ ↓
29.20
37.95 Enter ↓ ↓
NPV 12 Enter
↓ CPT 29.2

Calculate the value of a common stock using the Gordon growth model and CFA® Preparation
explain the model’s underlying assumptions. www.dbf-finance.com
GGM Dividends increase at a constant growth eternally
The firm expects to pay a dividend in one year (D1)
g<r g > 5% unrealistic
D0 1 g D1
V0 If a stock expects to pay dividends of $2.30 per share next
r g r g year, what is the value of the stock if the required rate of
return is 12% and the expected growth rate in dividends is
4%?
2.3
V0 28.75
12% 8%

Calculate and interpret the implied growth rate of dividends using the Gordon CFA® Preparation
growth model and current stock price. www.dbf-finance.com
GGM 4 variables g D r V0
If we are given 3, we can calculate the fourth
Paco Bocatas is analyzing RQR,SL. In its most recent quarterly earnings report, RQRsaid it planned to increase its
dividend at an annual rate of 13% for the foreseeable future. Paco has an annual return target of 15.5% for RQR,SL. He
decides to use the dividend-growth rate to back out another return estimate to test against his. RQR,SL stock trades
for $55 per share and earned $3.01 per share over the last 12 months. The company paid a dividend of $2.15 per
share during the 12-month period, and its dividend-growth rate for the last five years was 9.2%.
Using the Gordon Growth model, the required annual return for RQR stock is closest to:
2.15 1 13%
55 r 17.42%
r 13%

Calculate and interpret the present value of growth opportunities (PVGO) and CFA® Preparation
the component of the leading price-to-earnings ratio (P/E) related to PVGO. www.dbf-finance.com
E1
V0 PVGO
r
A Company that has opportunities to earn returns >

required return, would benefit from retaining earnings
Present Value of (instead of paying dividends) and investing in these
Future growth opportunities.
Investment PVGO
Opportunities
Value of
Firm´s
Equity E1 Growth Companies PVGO Assets in
Value of assets in Place
place
r
Assets in
Slow-growth Place
Industries PVGO

Two analists, both CFA level II candidates,

3.64
are asked to perform an analysis of 41 PVGO
0.09
Graquitico,SL. Grac has a current market
value of $41 per share with a earnings of PVGO 0.55
$3.64. What is the present value of its
growth opportunities (PVGO) if the
required return is 9%?

Pepe and Paco are asked to perform an

1.25
analysis of Chicharro,SL. Chicharro has a 42 PVGO
0.12
current market value of $42 and a
required return of 12%. The current PVGO 31.58
dividend amounts to $1.25. All earnings
are paid-out as dividends. What is the
present value of Ambiance's growth
opportunities (PVGO)?

Calculate and interpret the justified leading and trailing P/Es using the Gordon CFA® Preparation
growth model. www.dbf-finance.com
P0 P0 D0 1 g
Leading Trailing GGM V0
P/E P/E
E1 E0 r g
D0 1 g
Justified P0 1 b
E1
Leading V0 P0
P/E E1 r g r g
D0 1 g
Justified P0 1 b 1 g
E0
Trailing V0 P0
P/E E0 r g r g

D0 1 g 0.75
1 11%
Pablo Lopez, is evaluating a firm, for a potential IPO Justified 3.5
E0
that has the following characteristics: Trailing
P/E r g 13% 11%
•Current share price $100.00.
•Current earnings $3.50.
•Current dividend $0.75. Justified
•Growth rate 11%. Trailing 11.1
•Required return 13%. P/E
Based on this information and the Gordon growth

model, what is the firm's justified trailing price to
earnings (P/E) ratio?

D1 0.75
Antonio Gonzalez is considering the purchase of Justified E1 3.5
common shares of firm Multiplera,SA, that has the leading
following characteristics: P/E r g 13% 11%

•Current earnings $3.50. Justified
•Current dividend $0.75. leading 10.7
•Growth rate 11%. P/E
•Required return 13%.
Based on this information and the Gordon growth

model, what is the firm's justified leading price to
earnings (P/E) ratio?

CFA® Preparation
Calculate the value of noncallable fixed-rate perpetual preferred stock.
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Value of perpetual
Dp
preferred shares
rp

Describe strengths and limitations of the Gordon growth model and justify its CFA® Preparation
selection to value a company’s common shares. www.dbf-finance.com
Strengths Limitations
① Is applicable to stable, mature, dividend-paying firms. Very sensitive to small changes in growth rates and
① required returns.
② Is appropriate for valuing market indices
② Not easily applied to non-dividend-paying stocks
③ Is easily communicated and explained→ straightforward
For firms which future growths rates are difficult to
④ Can be used to determine price-implied growth rates, ③ be predicted, GGM difficult to be implemented,
required rates of return, and value of growth opportunities and unreliable outcomes
⑤ Can be used to supplement other more complex valuation

methods

Explain the assumptions and justify the selection of the two-stage DDM, the H- CFA® Preparation
model, the three-stage DDM, or spreadsheet modeling to value a company’s
www.dbf-finance.com
common shares.
Two-Stage H-Model 3-Model
Growth Growth Growth
Stage 1 Stage 2 Stage 1 Stage 2 Stage Stage Stage

time time 1 2 3 time

CFA® Preparation
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GROWTH PHASE
VARIABLE
Initial Growth Transition Maturity
Earnings Growth Very High Above average but falling Stable at long run level
Capital Investment Significant Decreasing Stable at lrl
Profit Margin High Above average but falling Stable at lrl
FCFE Negative May be +, and growing Stable at lrl
ROE vs Required r ROE > r ROE approaching r ROE= r
Dividend payout Low or zero Increasing Stable at lrl
Appropriate Model Three-stage Two-stage Gordon growth

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common shares.
Two-Stage
CF 2nd CLR WORK
-0 Enter ↓
Time Period G D V CF
1.2 Enter ↓ ↓
0 - 1 - -
1.44 Enter ↓ ↓
1 20% 1.2 1.2 31.678 Enter ↓ ↓
2 20% 1.44 1.44

NPV 10 Enter
3 20% 1.728 29.95 31.678
↓ CPT 26.08
4 4% 1.7971

www.dbf-finance.com
common shares.
H-Model
N
D0 1 gl D0 2
gs gl
V0
r gl r gl
Growth
Stage 1 Stage 2
time

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common shares.
Three-Stage
Same as Two-Stage Model

CFA® Preparation
Exercises multistage models
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• DBF has organized an investing contest. CFA level TEAM-A TEAM-B TEAM-C
II candidates are asked to forecast future
dividends of a company called Dividends per share $1.5 $1.5 $1.5
EstablePagadora,SA. The pupils are organized in year 0
teams:
1. Team-A
Long term Bond 5% 5% 5%
2. Team-B Rate
3. Team-C Expected return of 12% 12% 12%
Find in the exhibit at the right, the dividend
IBEX 35
payment patterns forecast by each team. Beta of 1.4 1.4 1.4
EstablePagadora
Calculate the value of the stock today, based upon
each of the three assumptions Growth rate in Year 1; g=20% Years 1-3, Year 1-3 g=15%
dividends Year 2;g= 18% g=12.0% Then decline
Year 3;g= 16% After Year linearly to a
Year 4;g=9% 3, g=3.0% perpetual
Year 5;g=8% growth of g=3%
Year 6;g=7% in 4 years
After;g=4%

CFA® Preparation
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TEAM-AGuys
Due Diligence
• DBF has organized an investing contest. CFA level Time Period Growth Dividend Value Cash Flow CF 2nd CLR WORK
II candidates are asked to forecast future 0 1.5 1.50 0 Enter ↓

dividends of a company called 1 20% 1.80 1.80
1.8 Enter ↓ ↓
EstablePagadora,SA. The pupils are organized in 2 18% 2.12 2.12
teams: 3 16% 2.46 2.46 2.12 Enter ↓ ↓
1. Team-A 4 9% 2.69 2.69
2.46 Enter ↓ ↓
2. Team-B 5 8% 2.90 2.90
3. Team-C 6 7% 3.10 29.89 32.99 2.69 Enter ↓ ↓
7 4% 3.23 ↓ ↓
2.9 Enter
Find in the exhibit at the right, the dividend Rf 5%
payment patterns forecast by each team. EMRP 7% 32.99 Enter ↓ ↓
Beta 1.40 NPV 14.8 Enter

Calculate the value of the stock today, based upon Required Return 14.8%
each of the three assumptions ↓ CPT 22.21

CFA® Preparation
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TEAM-B
Valuations Guys
• DBF has organized an investing contest. CFA level Time Period Growth Dividend Value Cash Flow CF 2nd CLR WORK
II candidates are asked to forecast future 0 1.5 1.50 0 Enter ↓

dividends of a company called 1 12% 1.68 1.68
1.68 Enter ↓ ↓
EstablePagadora,SA. The pupils are organized in 2 12% 1.88 1.88
teams: 3 12% 2.11 18.4 20.50 1.88 Enter ↓ ↓
1. Team-A 4 3% 2.17
20.5 Enter ↓ ↓
2. Team-B Rf 5%
3. Team-C EMRP 7% NPV 14.8 Enter
Beta 1.40
↓
Find in the exhibit at the right, the dividend Required Return 14.8% CPT 16.44
payment patterns forecast by each team.
Calculate the value of the stock today, based upon

each of the three assumptions

CFA® Preparation
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TEAM-C CF 2nd CLR WORK

TEAM-C
Equities Guys
Time Period Growth Dividend Value Cash Flow 0 Enter ↓
Growth
0 1.5 1.50
1 15% 1.73 1.73 1.73 Enter ↓ ↓
2 15% 1.98 1.98
3 15% 2.28 2.28 1.98 Enter ↓ ↓
2.28+24.53 Enter ↓ ↓
NPV 14.8 Enter
↓ CPT
20.74
Stage 1 Stage 2 Stage 3

time
4
2.28 1 3% 2.28 15% 3%
V3
2
24.55
14.8% 3% 14.8% 3%

Estimate a required return based on any DDM, including the Gordon growth CFA® Preparation
model and the H-model. www.dbf-finance.com
DDM 4+x variables gn D r V0
If we are given 3+x, we can calculate the fourth
• PPP,SA just paid a dividend of $3.0 , the • Given an equity risk premium of 6.5%, a
forecasted growth is 9%, declining over four forecasted dividend yield of 2.5% on the
years to a stable 6% thereafter. The current value market index and a U.S. government bond
of PPP´s shares is $50. What is the required yield of 3.5%, what is the consensus long-term
return? earnings growth estimate?
4 D0 1 g
3 1 6% 3 9% 6% P0
2
50 r g
re 6% re 6%
D1 10% g 2.5%
r g
re 12.72% P0 g 7.5%

Estimate a required return based on any DDM, including the Gordon growth CFA® Preparation
model and the H-model. www.dbf-finance.com
DDM 4+x variables gn D r V0
If we are given 3+x, we can calculate the fourth
• Given that a firm's current dividend is $2.00, A firm pays a current dividend of $1.00 which is expected to
the forecasted growth is 7%, declining over grow at a rate of 5% indefinitely. If current value of the firm's
three years to a stable 5% thereafter, and the shares is $35.00, what is the required return applicable to
current value of the firm's shares is $45, what the investment based on the Gordon dividend discount
is the required rate of return? model (DDM)?
3
2 1 5% 2 7% 5% 1 1 5%
2
45 35
re 5% re 5% re 5%
re 8%
re 9.8%

Explain the use of spreadsheet modeling to forecast dividends and to value CFA® Preparation
common shares. www.dbf-finance.com
STUDY BY YOURSELF

Calculate and interpret the sustainable growth rate of a company and CFA® Preparation
demonstrate the use of DuPont analysis to estimate a company’s sustainable
www.dbf-finance.com
growth rate.
SGR ROE b
Retention
b 1 Dividend pay-out rate
rate
Net
Income Dividends Net Income Sales Assets
SGR
Net Income Sales Assets Equity
Beginning or average
Company´s financial decisions balance sheets?
PERFORMANCE
Evaluate whether a stock is overvalued, fairly valued, or undervalued by the CFA® Preparation
market based on a DDM estimate of value. www.dbf-finance.com
IF Market
Price > Implied Price Overvalued

CFA® Preparation
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-EQUITY VALUATION: Free cash

flow Valuation

CFA® Preparation
Flashcard 1
www.dbf-finance.com
Cara 1 Cara 2
FCFFn
V0
FCFF1
n X X ENTERPRISE
1
y 1
y VALUE
y WACC

CFA® Preparation
Flashcard 2
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Cara 1 Cara 2
FCFEn
V0
FCFE1
n X X EQUITY
1
y 1
y VALUE
y Cost of
Equity

CFA® Preparation
INTRO FCFF & FCFE www.dbf-finance.com
COMPANY-A COMPANY-B

CFA® Preparation
COMPANY-A COMPANY-B
Equity
Home Equity Home

Debt

CFA® Preparation
COMPANY-B
Equity
Home
Debt

CFA® Preparation
COMPANY-B
Equity
Home
Debt
FCFF
FCFE
CFA® Preparation
COMPANY-A COMPANY-B

CFA® Preparation
COMPANY-A COMPANY-B
Equity
Home Equity Home

Debt
ENTERPRISE VALUE
EQUITY VALUE
CFA® Preparation
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CASH FLOWS USED FOR VALUATION PURPOSES
FCFF ENTERPRISE VALUE
FCFE EQUITY VALUE

CFA® Preparation
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COMPANY-A COMPANY-B
NET INCOME 200 NET INCOME 200

(+) NON CASH CHARGES 100 (+) NON CASH CHARGES 100
(+) INTEREST (after tax) 0 (+) INTEREST (after tax) 0
(-) CAPEX -250 (-) CAPEX -250
(-) W. CAPITAL VAR 0 (-) W. CAPITAL VAR 0
FCFF 50 Enterprise Value= €500 FCFF 50 Enterprise Value= €500
Interest Paid 0 Interest Paid -10

Principal Paid 0 Principal Paid -30
FCFE 50 Equity Value= €500 FCFE 10 Equity Value= €83

CFA® Preparation
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+1 +2 +3
EBITDA
Equity
Fixed Assets Var. WC
CAPEX
IMPUESTO
Net Debt
Working Capital FCFF

CFA® Preparation
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FINANCING SOURCES
+1 +2 +3
EBITDA
Equity
CAPEX
IMPUESTO
Net Debt
Working Capital FCFF 10 11 12
ENT. VALUE 130
CAPITAL EMPLOYED

CFA® Preparation
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NET OPERATING ASSETS FINANCING SOURCES

+1 +2 +3
EBITDA
Equity
CAPEX
IMPUESTO
Net Debt
Working Capital FCFF
INTERESES
PRINCIPAL
FCFE
INVESTED CAPITAL CAPITAL EMPLOYED

CFA® Preparation
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+1 +2 +3
EBITDA
Equity
CAPEX
IMPUESTO
Net Debt
Working Capital FCFF 10 11 12
INTERESES -1 -1 -1
PRINCIPAL -3 -3 -3
FCFE 6 7 8

CFA® Preparation
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+1 +2 +3
Equity
Fixed Assets
Net Debt
Working Capital FCFE 6 7 8
EQUITY VALUE 80

A): Compare the free cash flow to the firm (FCFF) and free cash flow to equity CFA® Preparation
(FCFE) approaches to valuation. www.dbf-finance.com
Book value of
Equity Equity
Total book
Fixed Assets value of the
FIRM
Net Debt

Equity
Market Value of Equity Enterprise
Value Market Value
Equity Value Value of Debt
Enterprise
Value
Market Value of
Debt

Dividends
Equity “Share-repurchase”
Fixed Assets Interests

Debt repayments
Net Debt
New Debt issued

Required return
Market Value of on Equity
Equity (CAPM, APT, etc..)
WACC
Required return
Market Value of on Debt
Debt (Tax deductible)

Equity FCF to equity suppliers=
FCF before:
Fixed Assets - FCF to thetowhole

Payments equityfirm=
suppliers
Net Debt After
FCF before:
- Payments to/from debt
- suppliers
Payments to/from debt
suppliers
- Payments to equity
suppliers

CFA® Preparation
B): Explain the ownership perspective implicit in the FCFE approach.
www.dbf-finance.com
Control Can change DDM FCF

perspective dividend policy not appropriate appropriate
Analysts often prefer FCF rather

than DDM because:
① A lot of firms don´t pay dividends
② Dividends are paid at the discretion of the board of directors. Therefore, not representative of
the firm’s long-run profitability.
If a company is viewed as an acquisition target, free cash flow is a more appropriate
③
measure because the new owners will have discretion over its distribution (control
perspective).
④ Free cash flows may be more related to long-run profitability of the firm as compared
to dividends.

C): Explain the appropriate adjustments to net income, earnings before interest and taxes (EBIT),
earnings before interest, taxes, depreciation, and amortization (EBITDA), and cash flow from
CFA® Preparation
operations (CFO) to calculate FCFF and FCFE. www.dbf-finance.com
FCFF NI NCC Int Tax

1
rate
FCInv Δ WC
Tax
FCFF EBIT 1 Dep FCInv Δ WC
rate
Original Cambios Diferencia
FCFF CFO Int Tax Revenues 1,000,000 1,000,000 0

1 FCInv COGS -500,000 -500,000 0
rate
Gross Profit 500,000 500,000 0
GM 50% 50% 0
Tax Personnel expenses -200,000 -200,000 0
FCFF EBITDA 1 Tax
rate Dep
rate
FCInv Δ WC OPEX -100,000 -100,000 0
EBITDA 200,000 200,000 0
Depreciation and Amortization -100,000 -100,000 0
EBIT 100,000 100,000 0
Interest expense -20,000 -20,000
EBT 80,000 100,000 -20,000
Taxes -24,000 -30,000 6,000
Ni 56,000 70,000 -14,000
CAPEX 100,000 100,000 0
Working Capital 50,000 50,000 0

C): Explain the appropriate adjustments to net income, earnings before interest and taxes (EBIT),
earnings before interest, taxes, depreciation, and amortization (EBITDA), and cash flow from
CFA® Preparation
operations (CFO) to calculate FCFF and FCFE. www.dbf-finance.com
FCFE FCFF Int Tax Net

1
rate Borrowings
Net
FCFE NI NCC FCInv Δ WC Borrowings
FCFE CFO Net

FCInv
Borrowings
FCFE EBITDA Tax Tax Tax Net

1 Dep FCInv Δ WC Int 1
rate rate rate Borrowings

Non-Cash-Charges
CFA® Preparation
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Depreciation Add back Increase in

Deferred tax
Subtract
Amortization assets (not future
of intangibles Add back reversal)
Restructuring Increase in
Add back
provisions Deferred tax
liability (not Add back
Restructuring future reversal)
provisions Subtract
reversals
Amortization
of bond Add back
discount
Accretion of
bond Subtract
premium

Non-Cash-Charges→ Bond premium/ Discount
CFA® Preparation
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Amortization of
Add back ISSUER PERSPECTIVE
bond discount
MIDLAND EXERCISE KAPLAN

At the beginning of the year, Midland Corporation issued a 9% bond with a face value of $100,000 for $96,209 to yield 10%.
Year BoP Interest Amortization EoP

9,000 9,000 9,000 9,000 9,000+100,000
+ + + + 1 96,209 5 9,621
= 96,209 621 96,830
(1+10%) (1+10%)2 (1+10%)3 (1+10%)4 (1+10%)
2 96,830 9,683 683 97,513
3 97,513 9,751 751 98,264
4 98,264 9,826 826 99,091
5 99,091 9,909 909 100,000
TOTAL 3,791
CFA® Preparation
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Amortization of
Add back ISSUER PERSPECTIVE
bond discount


DEBIT CREDIT 1 96,209 9,621 621 96,830
YEAR 1 . Beginning of Year
2 96,830 9,683 683 97,513
CASH FINANCIAL DEBT
(96,209) (96,209)
3 97,513 9,751 751 98,264
YEAR 1 . End of Year
4 98,264 9,826 826 99,091
INT. EXPENSE CASH
(9,621) (9,000) 5 99,091 9,909 909 100,000
FINANCIAL DEBT
(621)
TOTAL 3,791
CFA® Preparation
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Amortization of
Subtract ISSUER PERSPECTIVE
bond premium

9,000 9,000 9,000 9,000 9,000+100,000

+ + + + = 103,993
(1+8%) (1+8%)2 (1+8%)3 (1+8%)4 Year (1+8%)
BoP
5
Interest Amortization EoP
1 103,993 8,319 (681) 103,312
2 103,312 8,265 (735) 102,577
3 102,577 8,206 (794) 101,783
4 101,783 8,143 (857) 100,926
5 100,926 8,074 (926) 100,000

CFA® Preparation
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Amortization of
Subtract ISSUER PERSPECTIVE
bond premium

DEBIT CREDIT
YEAR 1 . Beginning of Year
1 103,993 8,319 (681) 103,312
CASH FINANCIAL DEBT
(103,993) (103,993) 2 103,312 8,265 (735) 102,577
YEAR 1 . End of Year 3 102,577 8,206 (794) 101,783

4 101,783 8,143 (857) 100,926
INT. EXPENSE CASH
(8,319) (9,000) 5 100,926 8,074 (926) 100,000
FINANCIAL DEBT
(681)
Non-Cash-Charges→ Deferred Tax Assets/ Liabilities
CFA® Preparation
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Deferred Tax Liability Deferred Tax Asset
Accounting Cash
< tax
Accounting < tax
Cash Tax Tax
If no future reversal If no future reversal
Add back Subtract

CFA® Preparation
DEFERRED TAX ASSET/LIABILITY SIMPLIFICATION www.dbf-finance.com
DEBIT CREDIT
1,000 CORPORATE INCOME TAX 2,000 1,000 TAXES PAYABLE 2,000
DEFERRED TAX ASSET
DEFERRED TAX LIABILITY

CAPEX
CFA® Preparation
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Proceeds from sale of

FCInv CAPEX
l/t assets
IF
No sales of l/t Sales of l/t
assets assets
Ending Net Beginning Net Ending Net Beginning Net Gain on

FCInv FCInv PP&E PP&E Dep
PP&E PP&E Depreciation Sale
SEE EXCEL
SPREADSHEET

CAPEX
CFA® Preparation
www.dbf-finance.com
Balance Sheet
2013 2014 Income Statement
Current Assets 2014
Cash 20,000 131,500 Sales 500,000
Accounts receivable 10,000 30,000
Cost of goods sold -200,000
Inventory 5,000 5,000
Non current Assets Wages and Salaries -25,000
Land 100,000 100,000 Depreciation -35,000
Gross plant and equipment 200,000 219,000 Interest expense -2,500
Accumulated depreciation -50,000 -85,000 Income from continuing operations 237,500
Net plant and equipment 150,000 134,000
Gain from sale of equipment 14,000
Goodwill 10,000 10,000
Total Assets 295,000 410,500
Earnings before taxes 251,500
Current Liabilities Income tax -88,025
Accounts payable 100,000 50,000 Net Income 163,475
Wages payable 68,500 43,500 Common dividend declared 37,054
Interest payable 6,000 8,500
Taxes payable 3,000 31,025
Dividends payable 2,500 36,054
Noncurrent Liabilities
Bonds 15,000 20,000
Deferred taxes 20,000 20,000
Stockholders´ equity
Common stock 30,000 25,000
Retained earnings 50,000 176,421
Total liabilities and Stockholders equity 295,000 410,500
CAPEX
CFA® Preparation
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BEG. GROSS (+) (-) COST OF (=) ENDING

ASSETS PURCHASES ASSETS SOLD GROSS ASSETS
(+) AC.
(-) (=) ENDING. AC.
BEG. AC. DEPRECIATION
DEPRECIATION DEPRECIATION
DEPRECIATION OF ASSETS
COST
SOLD
BEG. NET (+) (-) (=) ENDING

(-) NBV OF
ASSETS PURCHASES DEPRECIATION NET ASSETS
ASSET SOLD
COST
(-) NBV OF (=) PROFIT FROM

(+) SALE PRICE
ASSET SOLD ASSET SALE
(+)
(-) SALE PRICE (=) NET CAPEX
PURCHASES
CAPEX
CFA® Preparation
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(-)
I BEG. NET
ASSETS
(+)
PURCHASES DEPRECIATION
COST
(-) NBV OF
ASSET SOLD
(=) ENDING
NET ASSETS
II (+) SALE PRICE

(-) NBV OF
ASSET SOLD
(=) PROFIT FROM
ASSET SALE
I
𝐵𝑒𝑔. 𝑁𝑒𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 + 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠 − 𝑆𝑎𝑙𝑒𝑠 𝑃𝑟𝑖𝑐𝑒 − 𝐷𝑒𝑝. 𝐶𝑜𝑠𝑡 = 𝐸𝑛𝑑𝑖𝑛𝑔 𝑁𝑒𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝑃𝑟𝑜𝑓𝑖𝑡 𝑓𝑟𝑜𝑚 𝐴𝑠𝑠𝑒𝑡
- + 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠 − 𝑆𝑎𝑙𝑒𝑠 𝑃𝑟𝑖𝑐𝑒 = 𝐸𝑛𝑑𝑖𝑛𝑔 𝑁𝑒𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐵𝑒𝑔. 𝑁𝑒𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 + −𝐷𝑒𝑝. 𝐶𝑜𝑠𝑡 − 𝑃𝑟𝑜𝑓𝑖𝑡 𝑓𝑟𝑜𝑚 𝐴𝑠𝑠𝑒𝑡
II
(+)
PURCHASES

CAPEX
CFA® Preparation
www.dbf-finance.com
(-)
I BEG. NET
ASSETS (150)
(+)
PURCHASES DEPRECIATION
(-) NBV OF
ASSET SOLD
(=) ENDING
NET ASSETS
COST (35) (134)
(-) NBV OF (=) PROFIT FROM

(+) SALE PRICE
ASSET SOLD ASSET SALE (14)
I
𝐵𝑒𝑔. 𝑁𝑒𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 + 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠 − 𝑆𝑎𝑙𝑒𝑠 𝑃𝑟𝑖𝑐𝑒 − 𝐷𝑒𝑝. 𝐶𝑜𝑠𝑡 = 𝐸𝑛𝑑𝑖𝑛𝑔 𝑁𝑒𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝑃𝑟𝑜𝑓𝑖𝑡 𝑓𝑟𝑜𝑚 𝐴𝑠𝑠𝑒𝑡
- + 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠 − 𝑆𝑎𝑙𝑒𝑠 𝑃𝑟𝑖𝑐𝑒 = 𝐸𝑛𝑑𝑖𝑛𝑔 𝑁𝑒𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐵𝑒𝑔. 𝑁𝑒𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 + 𝐷𝑒𝑝. 𝐶𝑜𝑠𝑡 − 𝑃𝑟𝑜𝑓𝑖𝑡 𝑓𝑟𝑜𝑚 𝐴𝑠𝑠𝑒𝑡
II + 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠 − 𝑆𝑎𝑙𝑒𝑠 𝑃𝑟𝑖𝑐𝑒 = 134 − 150 + 35 − 14 = 5
(+)
PURCHASES
Working Capital
CFA® Preparation
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Increase in
Working CASH OUT
Capital
Decrease in
Working CASH IN
Capital

Free Cash Flow With Preferred Stock
CFA® Preparation
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Treat preferred
Not Tax Deductible
stock just like debt
Add preferred Assumes that the Net Income used

dividends to FCFF is after preferred dividends
Revise WACC

E): Describe approaches for forecasting FCFF and FCFE.
CFA® Preparation
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FCFF
Net
FCFE NI NCC FCInv Δ WC Borrowings
① Growth rate to FCFF0
② Forecast underlying components of FCFF

separately
FCFE
Equity
Fixed Assets
SAME as FCFF but
Assumptions about leverage need to be done

Net Debt
FCFE NI 1 DR FCInv 1
Working Capital
Dep DR Δ WC
DR Target Debt to Asset Ratio

CFA® Preparation
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FCFE I
FCFE II

CFA® Preparation
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𝐷
𝐷𝑅 =
𝐴
CFA® Preparation
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4 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = 200
𝐷𝑅 =
5
YEAR-1 YEAR-2
Net Income= 1,000 Net Income= 1,000
Equity Equity
Fixed Assets Fixed Assets
(1,000) (1,100)
Net Debt Net Debt

Working Capital (1,200) Working Capital (1,360)
(500) (600)

CFA® Preparation
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YEAR-1 YEAR-2 YEAR-1 YEAR-2
Equity Equity
(1,000) (1,100)
Net Debt Net Debt

Working Capital (1,200) (1,360)
(500) Working Capital
(600)
CASH OUT CASH IN

CFA® Preparation
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𝐹𝐶𝐹𝐸 𝑌𝑒𝑎𝑟 − 2 = 1,000 + 200 − 300 − 100 + 160 = 960 𝐹𝐶𝐹𝐸 𝑌𝑒𝑎𝑟 − 2 = 1,000 − [20% 𝑥 300 − 200 ] − 20% 𝑥 100 = 960
YEAR-1 YEAR-2
4
Net Income= 1,000 𝐷𝑅 = Net Income= 1,000
5
Equity Equity
(1,000) (1,100)
Net Debt Net Debt

Working Capital (1,200) Working Capital (1,360)
(500) (600)

Exercises FCFF FCFE
CFA® Preparation
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Calculate the FCFF in 20x1 starting from Net

Income, given the data below. No sale of assets
during 20X0 and 20X1.Tax rate. 30%
Income Statement Balance Sheet

20X0 20X1 20X0 20X1
Cash 7.5 15
Sales 375 450
Account receivable 22.5 45
COGS -150 -180 Inventory 45 60
Gross Profit 225 270 Current assets 75 120
SG&A -45 -52.5 Gross PP&E 450 600
EBITDA 180 217.5 Accumulated Depreciation -210 -285
Depreciation -60 -75 Total Assets 315 435
EBIT 120 142.5
Accounts Payable 30 30
Interest expense -15 -22.5
Short-term debt 15 30
EBT 105 120 Current liabilities 45 60
Taxes -31.5 -36 Long term debt 150 171
Net Income 73.5 84 Common Stock 75 75
Retained earnings 45 129
Total liabilities and equity 315 435

Exercises FCFF FCFE
CFA® Preparation
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Calculate the FCFF in 20x1 starting from Net

Income, given the data below. No sale of assets FCFF NI NCC Int Tax
1
rate
FCInv Δ WC
during 20X0 and 20X1.Tax rate. 30%
Working Capital FCInv

Balance Sheet
20X0 20X1 20X0 20X1 Increase
Cash 7.5 15 Account receivable 22.5 45 Ending Net PP&E 315
Account receivable 22.5 45 Inventory 45 60 (-) Beginning Net PP&E 240
Inventory 45 60 Accounts Payable 30 30 (+) Depreciation 75
Current assets 75 120 Net 37.5 75 37.5 (=)FCInv 150
Gross PP&E 450 600
Accumulated Depreciation -210 -285
Total Assets 315 435 FCFF 84 75 22.5 1 30% 150 37.5 -12.75
Current liabilities 45 60
Long term debt 150 171
Common Stock 75 75
Retained earnings 45 129

Exercises FCFF FCFE
CFA® Preparation
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Calculate the FCFE in 20x1 starting from EBIT, given

the data below. Assets with a net book value of $50
were sold for $80 during 20X1 .Tax rate. 30%
Balance Sheet
Income Statement 20X0 20X1
20X0 20X1 Cash 6 12
Sales 300 360 Account receivable 18 36
Inventory 36 48
COGS (120) (144)
Current assets 60 96
Gross Profit 180 216 Gross PP&E 360 480
SG&A (36) (42) Accumulated Depreciation -168 -228
EBITDA 144 174 Total Assets 252 348
Depreciation (48) (60)
EBIT 96 114
Interest Expense (12) (18) Current liabilities 36 48
Gain from sale of Asset 30
PBT 84 126 Long term debt 120 136.8
CIT (25) (38) Common Stock 60 60
Retained earnings 36 103.2
Net Income 59 88
Exercises FCFF FCFE
CFA® Preparation
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Calculate the FCFE in 20x1 starting
from EBIT, given the data below. FCFE EBIT Tax Tax Net
1 Dep FCInv Δ WC Int 1
Assets with a net book value of $50 rate rate Borrowings
were sold for $80 during 20X1 .Tax
rate. 30%
Balance Sheet
20X0 20X1 Working Capital FCInv
Cash 6 12 20X0 20X1 Increase
Account receivable 18 36 Account receivable 18 36
Ending Net PP&E 252
Inventory 36 48 Inventory 36 48
Accounts Payable 24 24 (-) Beginning Net PP&E 192
Current assets 60 96
Gross PP&E 360 480 Net 30 60 30 (+) Depreciation 60
Accumulated Depreciation -168 -228 (-) Gain on sale 30
Total Assets 252 348 (=)FCInv 90
Accounts Payable 24 24 FCFE 114 1 30% 60 90 30 18 1 30% 28.8

Current liabilities 36 48
36
Long term debt 120 136.8

Common Stock 60 60
Retained earnings 36 103.2
Exercises FCFF FCFE projections
CFA® Preparation
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Calculate the value of the stock of
Company, Valorando,SA, given the FCFE NI 1 DR FCInv Dep 1 DR Δ WC
following data:
DR Target Debt to Asset Ratio
EPS last year 1
FCInv last year 1 D/E
2
DR
2
40%
Dep last year 0.5 3 5
Increase in WC last year 0.25

FCFE0 1 1 40% 1 1
Target D/E 66.67% 0.5 40% 0.25 0.55
Required return on Equity 14%

WACC 10% Value of 0.55 1 4%
equity
5.72
g 4% 14% 4%

F): Compare the FCFE model and dividend discount models.
CFA® Preparation
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Control Recognition of value

FCFE should be inmediate
Perspective
Minority Value not realized until the

DDM dividend policy reflects
Perspective
firms long term
profitability

G: Explain how dividends, share repurchases, share issues, and changes in leverage may affect CFA® Preparation
future FCFF and FCFE. www.dbf-finance.com
No Effect in No Effect in
Dividends
FCFF FCFE
Share No Effect in No Effect in

repurchase FCFF FCFE
No Effect in No Effect in
Share issues
FCFF FCFE
Changes in No Effect in Minor Effect

Leverage FCFF in
FCFE

H: Evaluate the use of net income and EBITDA as proxies for cash flow in valuation.
CFA® Preparation
www.dbf-finance.com
Poor proxy
Net Income
of FCFE Includes NCC
Ignores CFs that don´t appear in NI:

• CAPEX
Net • Working Capital
FCFE NI NCC Capex Δ WC Borrowings • Net borrowings
Poor proxy
EBITDA
of FCFF
Ignores:
Tax Tax
FCFF EBITDA 1 Dep Capex Δ WC • Taxes
rate rate • Working Capital
• CAPEX

I: Explain the single-stage (stable-growth), two-stage, and three-stage FCFF and FCFE models and CFA® Preparation
select and justify the appropriate model given a company’s characteristics. www.dbf-finance.com
Single Stage FCFF model Single Stage FCFE model
Value of FCFF1 FCFF0 1 g Value of FCFE1 FCFE0 1 g

the firm equity
WACC g WACC g Re g Re g

Exercises FCFF FCFE
CFA® Preparation
www.dbf-finance.com
FFFF,SA made $40 million before interest and taxes on revenues of $100 million last year. Investment in fixed capital was 12% of
revenues, and depreciation was 10% of revenues. Working capital investment was 4% of revenues. FFFF expects revenues to
grow 12% annually during the next five years and afterwards grow 4% annually eternally. EBIT, investment in fixed and working
capital, depreciation, are expected to represent the same % of revenues as the last year during the next five years. After five
years, investments in fixed capital and depreciation will offset each other, and EBIT margin and working capital investment will
continue to represent the same percentage of revenues as in the last year. FFFF’s tax rate is 40%. Suppose that the weighted
average cost of capital (WACC) is 12% during the high growth stage and 10% during the stable stage. Calculate the Enterprise
Value of the firm today.
Year-0 Year-1 Year-2 Year-3 Year-4 Year-5 Year-6

Sales 100.00 112.00 125.44 140.49 157.35 176.23 183.28
EBIT 40.00 44.80 50.18 56.20 62.94 70.49 73.31
EBIT (1-tax) 24.00 26.88 30.11 33.72 37.76 42.30 43.99
FCInv 12.00 13.44 15.05 16.86 18.88 21.15 -
WC Inv 4.00 4.48 5.02 5.62 6.29 7.05 7.33
Depreciation 10.00 11.20 12.54 14.05 15.74 17.62 -
FCFF 20.16 22.58 25.29 28.32 31.72 36.66
610.95
FCFF 20.16 22.58 25.29 28.32 642.67
Discount factor 1.12 1.25 1.40 1.57 1.76
Discounted Value 18.00 18.00 18.00 18.00 364.67

Enterprise Value 436.67
Exercises FCFF FCFE
CFA® Preparation
www.dbf-finance.com
EEE. earned $2.0 per share last year. Investment in fixed capital was $1.0 per share, and depreciation was $0.5. Investment in
working capital was $0.30 per share. EEE expects earnings to grow at 12% per year for the next five years and that investment in
fixed capital, depreciation, and investment in working capital will grow at the same rate. After five years, the growth in earnings and
working capital requirements will decline to a stable 4% per year, and investment in fixed capital and depreciation will offset each
other (i.e., they will be equal). EEE’s target debt to equity ratio is 25%. WACC is 12% during the high-growth stage and 8% during
the stable stage. The shareholders require a return of 15% on their investment during the high-growth stage and a return of 10% on
their investment during the stable stage. The FCFE in Year 6 and the value per share of EEE’s common stock are closest to:
Year-0 Year-1 Year-2 Year-3 Year-4 Year-5 Year-6

EPS 2.00 2.24 2.51 2.81 3.15 3.52 3.67
FCInv 1.00 1.12 1.25 1.40 1.57 1.76
WC Inv 0.30 0.34 0.38 0.42 0.47 0.53 0.55
Depreciation 0.50 0.56 0.63 0.70 0.79 0.88
DR 20% 20% 20% 20% 20% 20% 20%
FCFE 1.52 1.71 1.91 2.14 2.40 3.23

53.76
FCFE 1.52 1.71 1.91 2.14 56.16
Discount factor 1.15 1.32 1.52 1.75 2.01
Discounted Value 1.32 1.29 1.26 1.22 27.92

Equity Value 33.02
Exercises FCFF FCFE
CFA® Preparation
www.dbf-finance.com
Given the data below, calculate: FCFE
1) FCFE N.I 100
2) FCFF
3) Enterprise Value
DR 20%
4) Equity Value Investment in Working Capital -25
Investment in Fixed Assets -80
Net income 100
Investment in Working Capital 25 Depreciation 40
Investment in Fixed Assets 80
Depreciation 40
Net
FCFFBorrowings 13
Target Debt Ratio 20% FCFE
N.I 100 48
Tax Rate 40%
Long term growth rate FCFF 2.5% (+) Interest (1-tax) 9.6
Long term growth rate FCFE 1.5%
(+) Preferred Stock 49
Securities
Before tax
(+) Depreciation 40
Security Type Market Value required return (-) Inv Working Capital -25
Preferred Stock 700 7%
Bonds 200 8.00% (-) Investment in Fixed Assets -80
Common Stock 900 13%
FCFF 93.6
Exercises FCFF FCFE
CFA® Preparation
www.dbf-finance.com
Given the data below, calculate:
1) FCFE
2) FCFF Equity Preferred W Debt WACC
3) Enterprise Value
4) Equity Value
Weight 50% 39% 11%
After tax 13.0% 7.0% 4.8%
Net income 100
Investment in Working Capital 25 6.50% 2.72% 0.53% 9.76%
Investment in Fixed Assets 80
Depreciation 40 Enterprise Value 1,322
Target Debt Ratio 20%
Tax Rate 40% (-) Bonds -200
Long term growth rate FCFF 2.5% (-) Preferred Stock -700
Long term growth rate FCFE 1.5%
Equity Value 422
Securities
Before tax
Security Type
Preferred Stock
Market Value required return
700 7%
Value of equity 424
Bonds 200 8.00%
Common Stock 900 13%

Exercises FCFF FCFE- Non cash Charges (1 of 2)
CFA® Preparation
www.dbf-finance.com
① Reported amortization of a software developed internally by the firm 5 years ago totaling -50
+ 50
② Deferred tax liability increased by 50, and is expected to reverse in the future.
No effect
③ Amortization of bond premium totaling 10.
- 10
④ Restructuring charge totaling 30
+ 30

Exercises FCFF FCFE- Non cash Charges (2 of 2)
CFA® Preparation
www.dbf-finance.com
① Reversal of a past restructuring charge totaling 5
- 5
② Deferred tax asset increased by 50, and is not expected to reverse in the future.
- 50
③ Amortization of bond discount totaling 5.
+ 5

K: Explain the use of sensitivity analysis in FCFF and FCFE valuations.
CFA® Preparation
www.dbf-finance.com
Sensitivity Shows how sensitive is a valuation to changes in model´s inputs

analysis
Major sources of error in valuations:
① Future growth
② Chosen base years

L: Describe approaches for calculating the terminal value in a multistage valuation model.
CFA® Preparation
www.dbf-finance.com
① Single stage model
② Multiple Approach
Terminal
value in Trailing
Earnings year n
year n P/E
Terminal
value in leading
Earnings year n+1
year n P/E

M: Evaluate whether a stock is overvalued, fairly valued, or undervalued based CFA® Preparation
on a free cash flow valuation model. www.dbf-finance.com
IF Market
Price > Implied Price Overvalued

CFA® Preparation
www.dbf-finance.com
-EQUITY VALUATION:
Market-Based Valuation: Price
and Enterprise Value Multiples

LOS 36.a: Distinguish between the method of comparables and the method based on forecasted
fundamentals as approaches to using price multiples in valuation, and explain economic
CFA® Preparation
rationales for each approach. www.dbf-finance.com
① Method of comparables
Value of a stock based on average price multiple of stock of comparable companies.
② Method of forecasted fundamentals
Value of a stock based upon a ratio of justified value to a fundamental variable
① ② Expected
Median trailing Pay-out ratio
growth rate 4% 30%
P/E of 18 Company A
Company A
comparable
companies Required
14%
Expected EPS 5.5 return stock A
EPS Company A
5
Company A 30%
Justified Value of
leading P/E 3 5.5 3 17
Value of 5 18 90 Company A
Company A 14% 4%

CFA® Preparation
www.dbf-finance.com
LOS 36.b: Calculate and interpret a justified price multiple.
LOS 36.c: Describe rationales for and possible drawbacks to using alternative price multiples and dividend
yield in valuation
LOS 36.d: Calculate and interpret alternative price multiples and dividend yield.

CFA® Preparation
P/E ratio www.dbf-finance.com
Formula Exercise
Market price per share PARAPA,S.A:
Trailing • Reported Earnings current fiscal year:$100 million
P/E • EPS forecast next year: $3
EPS LTM
• Shares outstanding: 25 million. Market Price: 100 $ per share
• Calculate trailing and leading P/E
Market price per share
Leading
P/E 100 100
Trailing Leading
EPS next twelve
P/E P/E
months 4 3
① Earnings power (EPS proxy) →primary determinant of investment value ① Earnings can be negative
② The P/E ratio is very popular. ② Earnings are volatile. Therefore, interpretation of P/Es difficult for
analysts.
Empirical research shows that P/E differences are significantly

Management discretion within allowed accounting practices can
③ related to long-run average stock returns. ③ distort reported earnings.

CFA® Preparation
P/B ratio www.dbf-finance.com
Formula Exercise
market value of equity Market price per share BARABA,S.A:
P/B • Book Value of Equity 20X5: $60 million
ratio • Sales 20X5: $10 million
book value of equity Book value per share
• Calculate P/B ratio
Strengths 300
P/B
Book value→ cumulative amount→ usually +, even → (-)EPS. ratio
① 60
Book value is more stable than EPS, so it may be more useful than P/E
② when EPS is particularly high, low, or volatile. Weaknesses
Book value→ appropriate measure of net asset value for firms that ① P/Bs do not reflect the value of intangible economic assets, such as
③ primarily hold liquid assets (i.e. finance, investment, insurance, and human capital.
banking firms.
② P/Bs can be misleading when there are significant differences in the
④ P/B useful in valuing companies that are expected to go out of business. asset size of the firms under consideration because in some cases the
firm’s business model dictates the size of its asset base. (i.e. outsourcing)
Empirical research shows that P/Bs help explain differences in long-run
⑤
average stock returns. Different accounting conventions can obscure the true investment in the
③ firm made by shareholders, which reduces the comparability of P/Bs
across firms and countries. (i.e. R&D)

CFA® Preparation
P/S ratio www.dbf-finance.com
Formula Exercise
market value of equity Market price per share BARABA,S.A:
P/S • Book Value of Equity 20X5: $200 million
ratio • Sales 20X5: $100 million
Total sales Sales per share
• Calculate P/S ratio
Strengths 300
P/S
Sales always (+). Thus, meaningful even for distressed companies. ratio
① 100
② Sales less easy to manipulate than EPS and Book Value

Weaknesses
P/S ratios are less volatile than P/E multiples. This may make P/S ratios
③ more reliable in valuation analysis when earnings for a particular year are ① High growth in sales does not necessarily indicate high operating profits
very high or very low relative to the long-run average. as measured by earnings and cash flow.
Appropriate for valuing stocks in mature or cyclical industries and start-up ② P/S ratios do not capture differences in cost structures across companies.
④ companies with no record of earnings. It is also often used to value
investment management companies and partnerships While less subject to distortion, revenue recognition practices can still
③
distort sales forecasts.(i.e. bill and hold, etc)
Empirical research shows that P/Ss help explain differences in long-run

⑤ average stock returns.

CFA® Preparation
P/CF ratio www.dbf-finance.com
Formula
P/CF market value of equity Market price per share

ratio
Total CF CF per share
Strengths
① Price to cash flow is more stable than price to earnings.
② CF less easy to manipulate than EPS and Book Value

Weaknesses
Reliance on cash flow rather than earnings handles the problem of
③ differences in the quality of reported earnings, which is a problem for P/E. ① Items affecting actual cash flow from operations are ignored when the
EPS plus noncash charges estimate is used. (i.e. working capital and
CAPEX).
Empirical research shows that P/CFs help explain differences in long-run
④ average stock returns.
② FCFE is preferable to operating cash flow. But FCFE is more volatile than
operating cash flow, so it is not necessarily more informative.

CFA® Preparation
Dividend Yield www.dbf-finance.com
Formula Exercise
BARABA,S.A:
Trailing 4 x most recent quarterly dividend • Just paid a dividend totaling: $1 per share
D/P • Consensus forecast of dividends over the next four quarters: 1.1, 1, 1.2
Market price per share and 1
• Current market price is $80
Forecast dividend over next four quarters • Calculate leading and trailing dividend yield
Leading
D/P 4 4.3
Market price per share Trailing Leading
D/P 80 D/P 80
① Dividend yield contributes to total investment return. ① it ignores capital appreciation.
Dividends are not as risky as the capital appreciation component of total ② The dividend displacement of earnings concept argues that dividends
② return. paid now displace future earnings, which implies a trade-off between
current and future cash flows.

LOS 36.e: Calculate and interpret underlying earnings, explain methods of normalizing earnings CFA® Preparation
per share (EPS), and calculate normalized EPS www.dbf-finance.com
Normalized Earnings
Underlying earnings Estimate of EPS in the middle of the business cycle
Persistent, continuing, recurring, or core earnings Methods
Excluding nonrecurring components
Average EPS over a recent period.
① Historical average EPS
(period = proxy of business cycle)
② Average ROE Average ROE over a recent period. (period =

proxy of business cycle) x BVPS
Average ROE preferred. EPS ignores size effect
Using the data in the following table, calculate normalized earnings using the
method of historical average EPS and the method of average return on Average EPS 2.75
equity
20X1 20X2 20X3 20X4

Average ROE 13%
EPS 3 3 2.5 2.5 BVPS 18
BVPS 25 25 18 18 Normalized EPS 2.34
ROE 14% 12% 12% 14%
LOS 36.f: Explain and justify the use of earnings yield (E/P).
CFA® Preparation
www.dbf-finance.com
If earnings are negative P/E ratio not meaningful Normalized EPS Restate as E/P
High Earnings / Price Cheap security
Low Earnings / Price Expensive security
PRICE EARNINGS P/E E/P

Stock-1 2 -2 -1 -1
Stock-2 2 2 1 1
CFA® Preparation
www.dbf-finance.com
LOS 36.g: Describe fundamental factors that influence alternative price

multiples and dividend yield.
LOS 36.h: Calculate and interpret the justified price-to-earnings ratio (P/E),
price-to-book ratio (P/B), and price-to-sales ratio (P/S) for a stock, based on
forecasted fundamentals.

CFA® Preparation
Justified P/E ratio www.dbf-finance.com
Formula
D0 1 g
Justified P0 1 b
E1
Leading V0 P0
P/E E1 r g r g
D0 1 g
Justified P0 1 b 1 g
E0
Trailing V0 P0
P/E E0 r g r g
Justified Positively related to g

P/E
Negatively related to r

CFA® Preparation
Justified P/E ratio www.dbf-finance.com
D0 1 g 0.75
1 11%
Pablo Garcia Torrent, is evaluating a firm, for a Justified 3.5
E0
potential IPO that has the following characteristics: Trailing
P/E r g 13% 11%
•Current earnings $3.50.
•Current dividend $0.75. Justified
•Growth rate 11%. Trailing 11.9
•Required return 13%. P/E
Based on this information and the Gordon growth D1 0.75

model, what is the firm's justified trailing and leadind Justified E1 3.5
price to earnings (P/E) ratio? leading
P/E r g 13% 11%
Justified
leading 10.7
P/E

CFA® Preparation
Justified P/B ratio www.dbf-finance.com
Formula
D1 E
ROE g P0 1 b
B B ROE 1 b
V0
r g
B r g r g r g
ROE ROE b ROE g
r g r g
Justified Increases as ROE increases
P/B
The larger the spread
D E 1
between ROE and Re, the
b
larger the P/B

CFA® Preparation
Justified P/B ratio- Exercise www.dbf-finance.com
Calculate the justified P/B given the following data
ROE 12%
Re 10%
Justified P/B 1.3
g 3%
b 25%
D0 0.25
E0 1

CFA® Preparation
Justified P/S ratio www.dbf-finance.com
Formula
D1 E0
1 b 1 g
P0 S S0
S r g r g
Justified Increases as Profit Margin increases

P/S
Earnings growth rate increases

CFA® Preparation
Justified P/S ratio- exercise www.dbf-finance.com
Calculate the justified P/S given the following data:
Retention Ratio 70%

ROE 12%
EPS 5
Sales per Share 100
Re 10%
g 8.4%
E/S Payout g (Re-g)

5% 30% 8.4% 1.600%
Justified P/S 1.01625

CFA® Preparation
Justified P/CF www.dbf-finance.com
FCFE0 1 g
V 0
r g
Justified Growth rate increases

P/CF
Required return decreases

CFA® Preparation
Justified Dividend Yield www.dbf-finance.com
D0 1 g 1 r g D0 r g
P0
r g P0 D0 1 g P0 1 g
Dividend yield
Positively related to Required return
Negatively related to growth rate in

Dividends

LOS 36.i: Calculate and interpret a predicted P/E, given a cross-sectional regression on CFA® Preparation
fundamentals, and explain limitations to the cross-sectional regression methodology. www.dbf-finance.com
Predicted P/E Linear regression of historical P/E Over its fundamental variables
Expected Growth
Risk
Limitations
① The predictive power of the estimated P/E regression for a different time period and/or sample of stocks is uncertain.
② The relationships between P/E and the fundamental variables examined may change over time.
③ Multicollinearity is often a problem in these time series regressions, which makes it difficult to interpret individual regression coefficients

Damodaran Regression
CFA® Preparation
www.dbf-finance.com

LOS 36.j: Evaluate a stock by the method of comparables and explain the importance of
fundamentals in using the method of comparables. LOS 36.r: Evaluate whether a stock is
CFA® Preparation
overvalued, fairly valued, or undervalued based on comparisons of multiples. www.dbf-finance.com
Steps Frequently Used P/E benchmarks
① Select and calculate the multiple that will be used ① P/E of another company’s stock in a similar industry with similar
operating characteristics.
② Select the benchmark and calculate the mean or median of its
② Average or median P/E of peer group within the company’s industry.
multiple over the group of comparable stocks.
③ Compare the stock’s multiple to the benchmark. ③ Average or median P/E for the industry
Examine whether observed differences between the multiples of the

④ stock and the benchmark are explained by the underlying ④ P/E of an equity index.
determinants of the multiple.
⑤ Average historical P/E for the stock.

LOS 36.j: Evaluate a stock by the method of comparables and explain the importance of
fundamentals in using the method of comparables. LOS 36.r: Evaluate whether a stock is
CFA® Preparation
overvalued, fairly valued, or undervalued based on comparisons of multiples. www.dbf-finance.com
Evaluate whether Due, Valuation and Equities are under,

IF over or fairly valued
Trailing P/E. Exercise
Firm P/E Multiple
< Benchmark Multiple
Leading P/E
5-year Expected
Growth rate Beta
Three possibilities Due Team 22 3% 1.5
Valuation Team 10 5% 1
Equities Team 22 8% 0.8
① The stock is undervalued. Peer Median 15 5% 1
② The stock is properly valued, but the stock has a lower expected
growth rate than the benchmark, which leads to a lower P/E.
③ The stock is properly valued, but it has a higher

required rate of return (higher risk)
than the benchmark, which leads to a lower P/E.

Fed and Yardeni Models
CFA® Preparation
www.dbf-finance.com
STUDY BY
YOURSELVES

LOS 36.k: Calculate and interpret the P/E-to-growth ratio (PEG) and explain its use in relative CFA® Preparation
valuation. www.dbf-finance.com
Calculate the PEG of stock A and evaluate whether it

appears to be undervalued, overvalued or fairly valued
P/E ratio
PEG
ratio
g
P/E ratio of stock A 15
PEG of peers 5
5 year consensus growth rate of stock A 5.0%
All else equal, the lower the PEG, the more attractive
the stock
PEG drawbacks
PEG of A 3.00
Appears to be undervalued
① The relationship between P/E and g is not linear, which makes
comparisons difficult.
② The PEG ratio still doesn’t account for risk.
③ The PEG ratio doesn’t reflect the duration of the high-growth period
for a multistage valuation model, especially if the analyst uses a
short-term high-growth forecast.

LOS 36.l: Calculate and explain the use of price multiples in determining terminal value in a CFA® Preparation
multistage discounted cash flow (DCF) model www.dbf-finance.com
Based on Fundamentals Based on Comparables
Justified leading Terminal Value Benchmark

Terminal Value EPS EPS
P/E ratio in Year n leading
in Year n Year n+1 Year n+1
P/E ratio
Terminal Value Justified trailing EPS
in Year n P/E ratio Year n
Terminal Value Benchmark EPS
in Year n leading Year n
P/E ratio
Strength Weakness
𝑃0 It uses market data only. If benchmark is mispriced→

Lea𝑑𝑖𝑛𝑔 𝑃/𝐸 = Bad Terminal Value
𝐸1

LOS 36.m: Explain alternative definitions of cash flow used in price and enterprise value (EV) CFA® Preparation
multiples and describe limitations of each definition. www.dbf-finance.com
① Earnings-plus-non-cash-charges
CF Net Income Depreciation Amortization
It ignores some cash items (working capital and CAPEX)
② CFO Often adjusted for Non Recurrent Items.
Adjusted Net Cash

CFO (1- tax rate)
CFO Interest
③ FCFE
④ EBITDA

LOS 36.n: Calculate and interpret EV multiples and evaluate the use of EV/ EBITDA.
CFA® Preparation
www.dbf-finance.com
Market value Minority

EV Market value of
common stock
Market value of
preferred equity of debt interest
Cash and
Investments
EV/EBITDA Enterprise Value

ratio
EBITDA
① The ratio may be more useful than P/E when comparing firms with
different degrees of financial leverage. If working capital is growing, EBITDA will overstate CFO. Further, the
① measure ignores how different revenue recognition policies affect CFO.
② EBITDA is useful for valuing capital-intensive businesses with high levels of

depreciation and amortization.
Because FCFF captures the amount of capital expenditures, it is more
EBITDA is usually positive even when EPS is not. ② strongly linked with valuation theory than EBITDA. EBITDA will be an
③ adequate measure if capital expenses equal depreciation expenses.

EV/ EBITDA. EXERCISE
CFA® Preparation
www.dbf-finance.com
Enterprise Value
Calculate the EV/EBITDA given the following data (+) Market Cap 1,000
(+) Market value of debt 300
(+) Minority interests 20
(+) Preferred stock 15
Data (-) Cash and marketable securities -50
Share price today 10 (-) Investments -250
Shares outstanding (millions) 100 Enterprise Value 1,035
Market value of debt 300
Cash and marketable securities 50
Investments 250
EBITDa
Minority interests 20
(+) Net Income 100
Preferred stock 15
(+) Interest expense 10
Net Income 100
(+) Taxes 40
Interest expense 10
(+) Depreciation and Amortization 15
Depreciation and Amortization 15
EBITDA 165
Taxes 40

LOS 36.o: Explain sources of differences in cross-border valuation comparisons.
CFA® Preparation
www.dbf-finance.com
Differences in
The use of relative Challenging in Accounting standards
Use of comparable
valuation methods international
firms
context Growth opportunities
Risk
Difficulties in
P/E dispersion Cultures
Benchmarks
More affected Less affected

Differences in
Accounting standards P/E
P/Adjusted CFO
Goodwill treatment P/B
P/FCFE
R&D EV/EBITDA
Pension expense
Tangible asset revaluation

LOS 36.q: Explain the use of the arithmetic mean, the harmonic mean, the weighted harmonic CFA® Preparation
mean, and the median to describe the central tendency of a group of multiples www.dbf-finance.com
mean or weighted mean of Portfolio of two stocks:

P/E multiple for
the P/Es of the portfolio • A) Price:15. Earnings:1.
a stock index
stocks. P/E = 15
• B) Price:50. Earnings 10.
P/E = 5
Actual P/E of Portfolio:

=(15+50)/(1+11)=5.9
Weighted 1
Arithmetic Mean: 5.9
(15+5)/2= 10 Harmonic Mean
15 1 50 1
Weighted Arithmetic Mean: 65 15 65 5

(15/65)* 15+(50/65)* 5= 7.3
Harmonic Mean:
2/((1/15)+(1/5)) = 7.49

CFA® Preparation
www.dbf-finance.com
Return Concepts

A) Distinguish among realized holding period return, expected holding period return, required return,
CFA® Preparation
return from convergence of price to intrinsic value, discount rate, and internal rate of return. www.dbf-finance.com
Holding Period
Increase in price of an asset, plus any cash flow received divided by the initial price of the asset
Return
P1 P0 CF1
Holding period
Assumes that Cash Flow is received at the end of the period
return
P0
CF1 P1 P0
Holding period
return
P0 P0
Interest earned on
CF1 If CF received before the end of the period CF1 CF
reinvestment
Cash Flow Yield
P0
P1 P0
Return from Price
Appreciation
P0

CFA® Preparation
Realized Return Actual historical return based on past observed prices and cash flows.
Expected based on forecasts of future prices and cash flows. Expectations can
Return result from elaborate models or subjective opinions.
Required minimum return an investor requires given the asset’s risk.

Return
The riskier the asset, the higher the higher required return.
Required return is also called the opportunity cost for investing in the
asset
IF Expected
return > Required return Undervalued

CFA® Preparation
Return from V0 P0
convergence of
price to
intrinsic value P0
V0 P0
Expected Required
return return
P0
Discount Rate used to find the Present Value of an

rate investment
Discount rate that makes the

IRR For publicly traded securities value of discounted cash
flows = Current Price

CFA® Preparation
INTRO ERP, RFR, Required return, RISKS, etc
www.dbf-finance.com
r = r + β ( r - r)
a f a m f

CFA® Preparation
www.dbf-finance.com
Risk Return Trade-off Appropriate

measure of
Risk
Systematic
Interest rates,
risk Risks that cannot be diversified away recessions, wars
TOTAL Entrance of a new

RISK
competitor, a
Unsystematic Specific risk, that can be diversified. regulatory
risk change, change
of management

CFA® Preparation
www.dbf-finance.com
CAPM Systematic risk β
F-F Asset specific Size, P/B, value/growth

P-S
Unanticipated changes in
Macroeconomic Inflation, Interest rates,
macroeconomic variables
investor confidence, real
business activity, others
Build-up
method

B) Calculate and interpret an equity risk premium using historical and forward-looking estimation
CFA® Preparation
approaches. www.dbf-finance.com
Equity risk Required return Risk free

Premium on equity index rates
Steps for calculating a future Equity Risk Premium based on historical information
① Select an equity index
② Select a time period
③ Calculate the mean return on the index
④ Select a proxy for the risk-free rate
The risk-free return Consistent with the time horizon for the investment

B) Calculate and interpret an equity risk premium using historical and forward-looking estimation
CFA® Preparation
approaches. www.dbf-finance.com
After calculating the Equity Risk Premium It can be used to calculate the required return of individual stocks
CAPM model General Model
Required Risk-free
return of return βi Equity risk premium Used in
Build-up Valuation of private businesses
stock i method
βi Level of systematic risk in the stock i

Does not consider systematic risk
Systematic Systematic risk of
IF
risk of stock i the market βi 1
Required Other risk
Risk-free Equity risk
return of Premia/discounts
return
IF
Systematic
risk of stock i > Systematic risk of
the market βi > 1 stock i premium
appropriate for i
Systematic Systematic risk of

IF
risk of stock i the market βi 1

CFA® Preparation
Estimates of Equity Risk Premium www.dbf-finance.com
Difference between the historical mean return of a broad-based
① Historical Estimates index and the risk free rate during a given period of time
Assumes that mean and variance are constant over time
① Objectivity
② Simplicity Premium actually is countercyclical:

• Low during good times
• High during bad times
Sample Period influences outcome

③ If investors are rational→ Unbiased historical estimates
Survivorship Bias
Geometric Arithmetic
Other
Considerations
① Method to calculate the mean mean ≤ mean
Longer term Lower

② Risk free Rate IF Bond Yield curve Upward Sloping
bonds ERP

CFA® Preparation
② Forward-Looking Estimates
① Gordon Growth Based
② Supply-side models
③ Estimates from surveys

CFA® Preparation
.
② ① Gordon Growth Based Dividend discount
model
• Firms with stable growth rates
• Dividends ≈ FCFE
• Firms with stable leverage
Reasonable when:
D 1
① Applied to developed economies and markets
P 0 =
Ample sources of reliable forecasts for data such as
② dividends and growth rates (k- g)
P0 = Price of stock today
D1 = Expected dividends next year
k= Required return on equities
g= Growth rate in dividends for ever
GGM One year forecast Consensus long term

Equity risk dividend yield on earnings growth rate Long-term government
premium market index bond yield

CFA® Preparation
.
② ① Gordon Growth Based
Weaknesses
① Forward looking estimates will change over time

and therefore need to be updated
During expansion phases→ Low dividend yield, high expected growth rates
During recession phases→ High dividend yield, low expected growth rates
② Assumes stable growth rates in dividends

CFA® Preparation
.
② ② Supply-side estimates→ Macroeconomic models
Based on the relationships between
Macroeconomic Financial
AND
variables variables
The use of proven models Estimates are only appropriate for developed countries
The use of current information
Public entities represent a large proportion of the economy
Reasonable to believe there is a relationship between

macroeconomic variables and asset prices

CFA® Preparation
.
Ibbotson-Chen
Equity risk
premium
Ibbotson-Chen D1
Equity risk 1 1 Real growth rate Expected changes
Expected inflation 1 1 Rf
premium in EPS in P/E P0

CFA® Preparation
.
Expected YTM of 20-Year T-Bonds YTM of 20-Year TIPS

inflation
Expected
Real
Real GDP growth Labour productivity Labour supply
Growth
growth rate growth rate
Rate
Expected
Market P/E expected to
changes IF
in P/E overvalued decrease
Market P/E expected to

IF
undervalued increase

CFA® Preparation
.
② ③ Survey estimates
Consensus of the opinions from a sample of people
Sample is usually restricted to experts in valuations
Surveys are easy to obtain Usually wide disparity of opinions

C) Estimate the required return on an equity investment using the capital asset pricing model, the CFA® Preparation
Fama–French model, the Pastor–Stambaugh model, macro-economic multifactor models, and the
build-up method (e.g., bond yield plus risk premium). www.dbf-finance.com
① CAPM
Required return
on stock i Risk-free-rate Equity risk premium βi
Calculate the required return on equity of a stock, if the current risk free rate
is 2.5%, the equity risk premium 6.5%, and beta of the stock is 1.3
Required return
on stock i 2.5% 6.5% 1.3 10.95%

② Multifactor Models
Required return
on stock i Risk-free-rate Risk premium 1 β1 Risk premium 2 β2 Risk premium n βn

Fama-French Model
Required return
on stock i RF β mkt,i Rmkt RF β SMB,i Rsmall RBig β HML,i RHBM RLBM
Market Size Value
• Efficient market Hypothesis→ excess risk

• Inefficient market Hypothesis→ Mispricing

Pastor-Stambaugh Model
Required
R less R
return on Fama-French Model β Liquidity,i Liquid
more
Liquid
stock i

Macroeconomic Multifactor Models
Systematic risk Unanticipated changes in Macroeconomic Factors
Factors:
Return of risky Return of riskless
Unanticipated changes in investors´ willingness to corporate government bonds
① Confidence risk undertake risks bonds
Unanticipated changes in investors´ desired time Return of long-term Return of treasury

② Time Horizon risk government bonds bills
to payouts
③ Inflation risk Unanticipated change in inflation Actual inflation Expected inflation
④ Business Cycle risk Unanticipated change in the level or real activity End of period Beginning of
expected period expected
activity index activity index
⑤ Market timing risk Not explained by 1 to 4

Build-up method Usually applied to closely held companies were betas are not readily obtainable
Bond yield plus Risk Premium Method

Required
Equity risk Size Specific company
return on RF
premium premium premium Appropriate for companies with publicly traded debt
stock i
Controlling vs Required
Minority interest return on YTM long term bonds Risk Premium
Usually adjusted directly from the stock i
market value, not through the
Marketability required return
YTM long term Inflation Leverage Sensitivity to
bonds business cycle
Risk Premium Added risk of holding equity of the

company
3%-5%

D) Explain beta estimation for public companies, thinly traded public companies, and nonpublic
CFA® Preparation
companies. www.dbf-finance.com
① Public Companies
Regressing the returns of the company´s stock on the returns of the overall market
Which index to use
Length of the sampled period Five years of monthly data Two years of weekly data (Bloomberg)
Adjusting for Beta Drift
Based on the tendency of the Beta to revert to 1 over time
Adjusted Regression
2/3 1/3 1
Beta Beta

Calculate and interpret beta;
CFA® Preparation
www.dbf-finance.com
STEPS
𝛽𝑙𝑒𝑣𝑒𝑟𝑒𝑑
𝑅𝑝𝑝
𝛽𝑢𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑
1 Calculate the 𝛽 of the comparable company
2 Unlever to adjust for differences in leverage
3 Relever with the target structure of the subject company
4 Use the Beta in #3 to calculate the Cost of Equity
5 Use the 𝑘𝑒 in #4 to calculate the WACC
𝑅𝑚

CFA® Preparation
② Thinly traded stocks and Non-public Companies

• Calculate the β of Tereforrica, given the following data:
① Identity a comparable company that is publicly traded
• Levered Beta of Porrafon (comparable company): 1.3
• Debt to equity ratio of Porrafone :1/2
② Estimate the Beta of the Comparable Company • Debt to equity ratio of Tereforrica : 2/1
③ Unlever the Beta of the Comparable Company 1

Unlevered
1.3 0.8667
1 Beta
Unlevered 1
Beta 1
Beta
Debt comparable 2
1
Equity comparable
④ Lever up Estimated
0.8667
2
Beta 1 2.6
1
Estimated Debt company
Unlevered 1
Beta
Beta Equity company

CFA® Preparation
CAPM
Very simple→ Just one factor Difficulty of choosing the appropriate factor
Low explanatory power in some cases
Multifactor
Models
Higher explanatory power (not always) More Complex and more expensive
Build-up
Very simple Models
Can be applied to closely Use of historical values that may not be
held companies meaningful anymore.

CFA® Preparation
F) Explain international considerations in required return estimation.
www.dbf-finance.com
Exchange rate risk Required

Information risk→ Data issues
return home Risk Premia
currency
Country Spread Model Country Risk Rating Model
Required
Yield of bonds Yield of bonds in Regression Model
return
developed in the emerging the developed
country market market
Y X
Equity Risk Premium Risk ratings
for developed countries (institutional
investor)
SEE EXCEL SPREADSHEET→ DAMODARAN

and Institutional Investor

CFA® Preparation
G) Explain and calculate the weighted average cost of capital for a company.
www.dbf-finance.com
Market Value of Debt Market Value of Equity

WACC Rd 1 Tax rate Re
Market Value of Debt Market Value of Debt
and Equity and Equity
• Calculate the WACC of XYZL,SA, given the

Tax rate Marginal Tax rate following data:
TOTAL • Market debt to equity ratio:2/3

WACC FCFF ENTERPRISE • Target debt to equity ratio:1/2
VALUE • Required return on XYLZ´s debt: 6%
• Required return on XYLZ´s equity:10%
WACC • XYLZ´s effective tax rate 20X5: 18%
Market value weights Target weights of • XYLZ´s marginal tax rate 20X5: 30%
Assumes
of debt and equity debt and equity
Market value weights Target weights of Target weights of

IF
of debt and equity debt and equity debt and equity

CFA® Preparation
www.dbf-finance.com
RESIDUAL INCOME
Francisco Parga Valle,CFA

A: Calculate
and interpret residual income, economic value CFA® Preparation
added, and market value added. www.dbf-finance.com
RESIDUAL net income of a firm less a charge that measures

INCOME stockholders’ opportunity cost of capital
RATIONALE FOR RESIDUAL INCOME It recognizes the cost of equity capital in the measurement of income.
Residual Income = 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 − (𝐸𝑞𝑢𝑖𝑡𝑦 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑥 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦)

A: Calculate
EVA measures the value added for shareholders by

management during a given year.
EVA = NOPAT − ( WACC × total capital )

Adjustments to be made by analysts (if applicable):
• Capitalize and amortize R&D charges (rather than expense them), and add them back to earnings to
calculate NOPAT.
• Add back charges on strategic investments that will generate returns in the future
• Eliminate deferred taxes and consider only cash taxes as an expense
• Treat operating leases as capital leases and adjust nonrecurring items.
• Add LIFO reserve to invested capital and add back change in LIFO reserve to NOPAT

A: Calculate
difference between the market value of a firm’s long-term debt and equity and the book
MVA value of invested capital supplied by investors. It measures the value created by
management’s decisions since the firm’s inception
MVA = MARKET VALUE − total capital

A: Calculate
Given the data below, calculate economic value added and market value added
NOPAT 3,000
WACC 10%
Invested Capital Beginning of Period 32,000
Invested Capital End of Period 35,000
Share price ($) 200
nº of shares outstanding 400
Market Value of Long term Debt 15,000
EVA NOPAT Capital Charge
EVA - 200,00 3.000 3.200,00
MVA Market Value Book Value of Capital

MVA 60.000 95.000 35.000

b: Describe the uses of residual income models. CFA® Preparation
www.dbf-finance.com
EVA and MVA, usually apply the concept of residual income to the measurement
of managerial effectiveness and executive compensation.
Residual income models have also been proposed as a method

to measure goodwill impairment.

c: Calculate the intrinsic value of a common stock using the residual income model and compare value CFA® Preparation
recognition in residual income and other present value models.
www.dbf-finance.com
𝑅𝐼𝑡 = 𝐸𝑡 − (𝑟 𝑥 𝐵𝑉𝑡−1 )
𝑅𝐼𝑡 = 𝑅𝑂𝐸 − 𝑟 𝑥 𝐵𝑉𝑡−1

www.dbf-finance.com
Given the data below, calculate residual income for 2019 and 2020
Book Value per share (31st December 2018) 20 2019 2020

Consensus EPS estimates
ROE 25,0% 26,7%
EPS 2019 5
EPS 2020 6 RI 2,60 2,93
BV EoP 22,50
Dividend Payout ratio 2019& 2020 50%
Cost of Equity 12,0%

www.dbf-finance.com
𝑅𝐼1 𝑅𝐼2 𝑅𝐼𝑛

𝑉0 = 𝐵0 + 1
+ 2
+ ⋯ + 𝑛
)
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟)
𝑅𝑂𝐸 − 𝑟 𝐵0
𝑉0 = 𝐵0 +
(𝑟 − 𝑔)

d) Explain fundamental determinants of residual income. CFA® Preparation
www.dbf-finance.com
𝑉0 = 𝐵0 +
(𝑟 − 𝑔)

f: Calculate and interpret the intrinsic value of a common stock using CFA® Preparation
single-stage (constant-growth) and multistage residual income models. www.dbf-finance.com
Given the data below, calculate the value of the shares today, using the
residual income approach
Book Value Per Share 30 ROE RR g

ROE 20%
g 20% 30% 6,0%
Required Return on Equity 12%
Dividend Pay-out ratio 70%
𝑉0 = 𝐵0 +
(𝑟 − 𝑔)
70,0
h: Explain continuing residual income and justify an estimate of continuing CFA® Preparation
residual income at the forecast horizon, given company and industry prospects. www.dbf-finance.com
STUDY BY YOURSELVES

I: Explain continuing residual income and justify an estimate of continuing residual CFA® Preparation
income at the forecast horizon, given company and industry prospects. www.dbf-finance.com
DDM and FCFE models measure value by discounting a stream of expected cash flows
The residual income model starts with a book value and adds to this the present value of
the expected stream of residual income.
Theoretically, the intrinsic value derived using expected dividends, expected free
cash flow to equity, or book value plus expected residual income should be
identical if the underlying assumptions used to make the necessary forecasts are the
same.

J: Explain strengths and weaknesses of residual income models and justify the CFA® Preparation
selection of a residual income model to value a company’s common stock www.dbf-finance.com
① Terminal value does not dominate the intrinsic value estimate, ① The models rely on accounting data that can be manipulated by
management.
② Residual income models use accounting data, which is usually easy to find.
The models are applicable to firms that do not pay dividends or that do Reliance on accounting data requires numerous and significant
③ not have positive expected free cash flows in the short run
② adjustments.
The models assume that the clean surplus relation holds or that its
④ The models are applicable even when cash flows are ③ failure to hold has been properly taken into account.
volatile.
The models focus on economic profitability rather than

⑤
just on accounting profitability.

CFA® Preparation
www.dbf-finance.com
¡GRACIAS!

CFA® Preparation
www.dbf-finance.com
-EQUITY VALUATION: The Five

Competitive Forces That Shape
Strategy

LOS 31.a: Distinguish among the five competitive forces and explain how they CFA® Preparation
drive industry profitability in the medium and long run www.dbf-finance.com
Porter´s five forces
① Threat of new entrants in the Industry The long term profitability of any
industry is determined by the
② Threat of substitutes
interaction of Porter´s competitive
③ Bargaining power of buyers forces
④ Bargaining power of suppliers
⑤ Rivalry among existing competitors

CFA® Preparation
INTRODUCTION: Buffet/Dorsey MOAT CONCEPT
www.dbf-finance.com
CAPITALISM WORKS
① Capitalism works pretty well
In the absence of MOATS
GOOD RETURNS ATRACK COMPETITORS
COMPETITION reduces HIGH returns to

average RETURNS
WARREN
BUFFET PAT
MICHAEL DORSEY,CFA
PORTER

CFA® Preparation
Force 1. Threat of new entrants in the industry
www.dbf-finance.com
KEY ISSUE Factors affecting this force
Probability of new entrants to the industry that can alter ① Economies of scale
the competitive landscape reducing the share of the value-
added realized by the incumbents ② Product differentiation and Brand identity
③ Switching costs
④ Capital requirements to produce facilities

CONCLUSSION
The probability of new entrants depends upon the size ⑤ Access to distribution channels
(and existence) of BARRIERS TO ENTRY
⑥ Government approvals or requirements
The higher the BARRIERS, the WEAKER THE THREAT Cost and quality advantages enjoyed by
⑦
incumbent firms

CFA® Preparation
Force 2. Threat of substitutes
www.dbf-finance.com
Currently available or prospective alternative products ① Relative Price Performance of Substitutes

limit the price buyers are willing to pay for the current
products of the industry. ② Buyer propensity to substitute.
③ Switching costs
CONCLUSSION (Porter). Productores de aislantes de fibra en invierno

de 1978 en USA.
This force is not only affected by existing potential
substitutes, but also those that could become available in (Dorsey) Propensity→ Aircraft suppliers industry, y Alestis
the future
(Dorsey) Switching costs → Oracle, SAP
Buffet: Evolutionary vs Revolutionary

CFA® Preparation
Force 3. Bargaining power of Buyers
www.dbf-finance.com
① Switching costs
How strong is the negotiation power of buyers→ Impact in
the distribution of value ② Availability of substitute products
③ Brand identity
④ Product differentiation
⑤ Profitability of the buyer
CONCLUSSION
⑥ Price relative to Total Purchases
Mainly dependent upon two factors:
(Porter). Ejemplo de Chrysler,GM y Ford con sus
Bargaining leverage proveedores.
(Porter) Customer concentration.
Buyer´s price sensitivity
(Dorsey) Cost:Benefit ratio

CFA® Preparation
Force 4. Bargaining power of Suppliers
www.dbf-finance.com
① Available options
Strength of the position of suppliers and their impact on
the distribution of the value added in the industry ② Presence of substitutes
③ Degree of supplier concentration

④ Importance of volume to supplier
CONCLUSSION ⑤ Threat of forward integration
The stronger the bargaining position of suppliers, the ⑥ Switching costs

greater their ability to increase their share of the value
added with higher prices of inputs
Labour are also suppliers

CFA® Preparation
Force 5. Degree of rivalry among existing competitors
www.dbf-finance.com
Factors affecting this force
KEY ISSUE
① Number of competitors: Equality of force?
Existing firms in the industry will compete through price
wars and higher costs? ② Industry growth→ The higher, the lower risk
③ High degree of operating and financial leverage

High fixed costs and/or storage costs
④ Participant´s commitment to business→ Strategic
⑤ Product differentiation
⑥ Product shelf life

⑦ Existence of barriers to exit:
• Collective dismissals; Dismantling
• Government restrictions (FIAT Italy)
⑧ Informational complexity
LOS 31.b: Describe why industry growth rate, technology and innovation, government, and
complementary products and services are fleeting factors rather than forces shaping industry
CFA® Preparation
structure www.dbf-finance.com
① Industry Growth Rate

High growth rate, CP, reduces rivalry among existing
players
But in the absence of barriers to entry, attracts new Affect an industry temporarily
players
② Innovation and technology

Improved technology does no mean higher profits if
Not determine l/t industry
attracts new competitors profitability
Also threat of substitutes
③ Government Policies
④ Complementary products

LOS 31.c: Identify changes in industry structure and forecast their effects on the industry´s CFA® Preparation
profit potential www.dbf-finance.com
Industry structure Changes over time

① Changes in Threat of new entrants ② Changes in power of suppliers and buyers
Increase in capacity of distributors Consolidation of suppliers/ buyers in the industry
Erosion of Brand Identity
Changes in Government regulations
③ Changes in the Threat from Substitutes ④ Changes in Rivalry
Changes in technology Changes in the number of competitors
Changes in the use of leverage

Internet- Skype against TELCOM
Internet- E-mail against courier Passage of time→ More mature

industries usually more rivalry
Internet- Newspaper industry

LOS 31.d: Explain how positioning a Company, exploiting industry change, and shaping industry CFA® Preparation
structure may be used to achieve a competitive advantage www.dbf-finance.com
Porter Rationale for comprehension purposes: ① Positioning the Company, reducing
1. Assume the industry structure will not change→ Positioning Customer power→
2. Assume the industry can change→ Capitalising on Changes in Supplier power→ Use of standardized parts, outsourcing labour
Industry
3. Assume I can change the industry structure→ Creating Substitutes→ Differentiating, increasing product features
changes in the Industry Structure Threat of entry→ Raising fixed costs (R&D, mechanization, network,
advertising)
② Capitalizing on Changes in the Industry Rivalry→ Avoid price wars, focus on price differentiation, search of
niches
Forward / backward integration
③ Creating changes in the industry
Improvements in a substitute
Increasing industry value added overall → Improving distribution channel
Sudden changes in technology Redistributing the value added in its favour→ Increase prices after reducing
bargaining power of buyers through switching costs
DON’T MISTAKE WITH SHORT TERM Strategies such us price discounting

Steps in using the Forces and Industry Analysis
CFA® Preparation
www.dbf-finance.com
① Define the industry ④ Determine the industry structure
Products/services sold How the five forces influence:
② Identify the participants Pricing Cost Structure
Competitors Buyers Suppliers Distinguish cause and effect
Potential entrants Substitutes Switching costs Reduction of bargaining

power of buyers
③ Determine the strength or weakness of each force
⑤ Assess current and potential shifts in each force
What drives it Why
⑥ Decide what forces can be changed in ways that

affect the value of the industry or firm

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CFA® Preparation

Francisco Parga, CFA

EQUITY VALUATION: APPLICATIONS AND PROCESSES I ½ 31 de Enero

Francisco Parga, CFA

Francisco Parga, CFA

valuation of an asset or security by someone who

② Forecast Company performance IV analyst Price IV actual Price IV analyst IV

④ Convert the forecasts into valuation model 10 20

Francisco Parga, CFA

Going assuming that a company will continue to operate

It cannot be assumed that the business will survive

Francisco Parga, CFA

valuation of an asset or security by someone

Analysts should know the

the price at which a hypothetical willing, AUDIT

Francisco Parga, CFA

VALUATION estimating the value of an asset

① Understand the business

② Forecast Company performance

③ Select the appropriate valuation model

④ Convert the forecasts into valuation model

⑤ Apply the valuation conclussions

Francisco Parga, CFA

VALUATION estimating the value of an asset

① Stock selection ⑥ Communication with analysts and investors

② Interpretation of the market ⑦ Valuation of private business

④ Fairness Opinions Planning Defining investment objectives & constraints

⑤ Planning and Consulting Executing

Francisco Parga, CFA

Michael Porter five elements of industry structure→ Five Forces

5 forces Generic Strategies

① Threat of new entrants in the industry. ① Cost leadership→ Low-cost Producer

② Threat of substitutes. ② Product differentiation

③ Bargaining power of buyers. ③ Focus

④ Bargaining power of suppliers. Segmentation→ Focused on a Group

Francisco Parga, CFA

Quality of Financial Statement Information Assessment

① Accelerating or premature recognition of income

② Reclassifying gains and nonoperating income

⑤ Off-Balance-sheet issues SPEs, operating leases, etc…

Francisco Parga, CFA

Absolute valuation models Relative valuation models

Dividend discount models IF P/E company > P/E comparables Relatively

Free cash flow approach

Residual Income Approach

Asset Based Models

Francisco Parga, CFA

Sum-of-the-parts value Conglomerate Discount

Investors “should” apply a markdown to the value of a

Conglomerate discount is the difference between market

③ Incorrect Measurement: Poor Research

Francisco Parga, CFA

② Is appropriated based upon the quality and availability of input data

Francisco Parga, CFA

-EQUITY VALUATION: Industry

Francisco Parga, CFA

Bottom-up Top-Down HYBRID

Historical revenue growth Expected GDP growth Most common type

Francisco Parga, CFA

Growth relative to GDP growth Market Growth and Market Share

GDP Growth X% Estimate of the Estimate of the

Francisco Parga, CFA

average cost of production decreases as industry sales increase