Reading 42 – Free Cash Flow Valuation

LOS A: Define and interpret free cash flow to the firm (FCFF) and free cash flow to equity (FCFE):
 FCFF is the cash available to the firm’s suppliers of capital after all operating expenses (including taxes) have
been paid and necessary investments in working capital and fixed capital have been made. Typically, FCFF is
calculated as CFO minus capital expenditures.
 FCFE is the cash flow available to the company’s shareholders after all operating expenses, interest, and
principal payments have been paid and all working capital and fixed capital needs have been met. Typically,
FCFE is the cash flow from operations, minus capital expenditures minus payments to (and receipts from)
debtholders.


LOS B: Describe the FCFF and FCFE approaches to valuation, and contrast the appropriate discount rates for
each model and explain the strengths and limitations of the FCFE model:
The value of the firm is the present value of the expected future FCFF discounted at the WACC:
Firm value = FCFF discounted at the WACC
The value of the firm’s equity is the present value of the expected future FCFE discounted at the required return on
equity:
Equity value = FCFE discounted at the required return on equity
 FCFF and FCFE approaches:
o FCFF is the after-tax cash flow going to all investors in the firm. Therefore to value this we would want
to discount future cash flows at the firm’s WACC. We typically use a target WACC because an individual
firm’s capital structure may fluctuate over time. With this model, if we value the firm and then deduct
the market value of debt we can back our way into the value of equity. Remember that this method
only values the firm as an operating entity. If the firm has substantial cash, marketable securities or
land held for investment purposes the value of these assets should be added in to arrive at a total firm
value.
o FCFE on the other hand is the cash flow that flows through to the firm’s common equity holders. It is
riskier relative to entity-wide cash flows and therefore should be discounted at a higher discount rate—
the required return on equity.
 FCFF and FCFE discount rates:
o For the FCFF model, use the WACC and ensure you use the market value of debt and equity and not
book values. Because a company’s capital structure can change over time we need to be sensitive to
the debt and equity weights we plug into the CAPM. Because of this analysts will often use a target
capital structure. Finally, remember when utilizing the WACC that the cost of debt is derived from the
company’s YTM on outstanding debt (reflected after taxes) and the cost of equity is estimated using
CAPM, APT, or a build-up model.
 o For the FCFE model use the required return on equity.
 FCFF versus FCFE: FCFE is more straightforward to use in cases where the company’s capital structure is not
particularly volatile. On the other hand, if a company has negative FCFE and significant debt outstanding than
FCFF is generally the better valuation model choice.
LOS C: Contrast the ownership perspective implicit in the FCFE approach to the ownership perspective
implicit in the dividend discount approach:
The ownership perspective in the free cash flow approach is that of an acquirer who can change the firm’s dividend
policy, which is a control perspective. The ownership perspective implicit in the dividend discount approach is that of a
minority owner who has no direct control over the firm’s dividend policy. If investors are willing to pay a premium for
control of the firm, there may be a difference between the values of the same firm derived using the two models.
Analysts often prefer to use free cash flow rather than dividend-based valuation for the following reasons:
 Many firms pay no, or low, cash dividends.
 Dividends are paid at the discretion of the board of directors. It may, consequently, poorly reflect the firm’s
long-run profitability.
 If a company is viewed as an acquisition target, free cash flow is a more appropriate measure because the new
owners will have discretion over its distribution.
LOS D: Discuss the appropriate adjustments to net income, earnings before interest and taxes (EBIT),
earnings before interest, taxes, depreciation, and amortization (EBITDA), or cash flow from operations
(CFO) to calculate FCFF and FCFE:
FCFF and FCFE may be calculated starting either from net income, cash flows from operations, EBIT, or EBITDA.

 For Net Income:

o
o Investments in fixed and working capital are necessary to ensure that the firm’s productive capacity is
maintained.
o When finding the net increase in working capital we exclude cash and cash equivalents as well as notes
payable and the current portion of long term debt (they are debt instruments). Cash is excluded
because a change in cash is what we are trying to assess. Notes payable and the current portion of long
term debt are excluded because they are liabilities with explicit interest costs which makes them a
financing and not an operating cash flow.
o Non-cash charges:
 o

o
Adjustment to NI
Noncash Item to Arrive at FCFF
Depreciation Added Back
Amortization of Intangibles Added Back
Restructuring Charges (Expense) Added Back

Restructuring Charges
(Income Resulting From Reversal) Subtracted
Losses Added Back
Gains Subtracted
Amortization of Long-Term
Bond Discounts Added Back
Amortization of Long-Term
Bond Premiums Subtracted
Added Back But
Warrants Special
o Deferred Taxes Attention
 Be on the lookout for the inclusion of gains on asset sales in the financial statements. This will reflect the
difference between the sales price and book value of the asset sold and is not a cash flow. The actual cash
flow is the value for which the asset is sold and it will be reflected in the cash flow from investing section.
o In summary, whether an adjustment for a non-cash charge is needed depends on where in the income
statement it has been deducted and whether the non-cash charge is a tax-deductible expense.
 For interest, it was expensed on the income statement but it represents a financing cash flow to bondholders
that is available to the firm before it makes any payments to its capital suppliers. Therefore we have to add it
back. However, we don’t add back the entire interest expense but only the after-tax interest expense because
paying reduces our tax bill.
 For CFO and for FCFE to FCFF:
 Remember that CFO already adjusts for noncash expenses as well as net investment in working capital

o
 Here, we have to add back to CFO the interest expense to get to the FCFF because interest expense (and the
resulting tax shield) was reflected on the income statement to arrive at net income. The company, by
 incorporating debt in its capital structure, reduces its tax bill by its marginal tax rate times the
interest payment.
 For EBIT and EBITDA

o
o Summary of the equation derivations:


 


LOS E: Calculate FCF and FCFE given a company’s financial statements prepared according to U.S. GAAP or
IAS.

Income Statement Millions ($) Statement of Cash Flows Millions ($)

Revenue 3,000 Net Income 240
Operating Expenses (2,200) Depreciation 300
EBITDA 800 WC adj. A/R (40)
Depreciation (300) Inventories (30)
EBIT 500 A/P 15
Interest Expense (100) Accrued Taxes 10
EBT 400 Cash Flow from Operations (CFO) 495
Taxes @ 40% (160) Investing Activities:
Net Income 240 Purchase of fixed assets 400
 Financing Activities:
Notes payable (50)
Long-term financing issuances (25)
Beginning with Net Income:
FCFF = NI + NCC + Int (1 – tax rate) – FCInv – WCInv
FCFF = 240 + 300 + (100)(1-0.40) – 400 – (40 + 30 – 15 – 10) = $155
FCFE = NI + NCC – FCInv – WCInv + Net Borrowing
FCFE = 240 + 300 – 400 – (40 + 30 – 15 – 10) + (25 + 50) = $170
Alternatively,
FCFE = FCFF – Int (1 - tax rate) + Net Borrowing
FCFE = 155 – (100)(1 - 0.40) + (25 + 50) = $170
Beginning with CFO:
FCFF = CFO + Int Exp (1 – tax rate) – FCInv
FCFF = 495 + (100)(1 – 0.40) – 400 = $155
FCFE = CFO – FCInv + Net Borrowings
FCFE = 495 – 400 + (50 + 25) = $170
LOS F: Discuss approaches for forecasting FCFF and FCFE:
 There are basically two approaches here. Either you can forecast free cash flow and then apply a generic
growth rate. Or, the more realistic and complicated method involves forecasting the underlying components of
free cash flow separately.


LOS G: Contrast the recognition of value in the FCFE model to the recognition of value in dividend discount
models:
The free cash flow to equity approach takes a control perspective which assumes that recognition of value should be
immediate. Dividend discount models take a minority perspective, under which value may not be realized until the
dividend policy accurately reflects the firm’s long-run profitability.
There are two conditions when the valuation derived from the FCFE valuation model will be the same as the value from
the Dividend Discount Model Valuation. First, if dividends are identical to FCFE. Second, if FCFE is larger than the
dividends yet the excess cash (FCFE minus dividends) is invested in projects with a NPV equal to 0. When the FCFE is
greater than the dividends and excess cash (FCFE minus dividends) are invested in projects with a positive NPV, the
FCFE model will obtain a greater value than the dividend discount model. Typically, the value produced by the FCFE
model exceeds the value produced by the dividend discount model with the difference considered to be the value in
controlling the firm’s dividend policy.
LOS H: Explain how dividends, share repurchases, share issues, and changes in leverage may affect FCFF
and FCFE:
 Dividends, share repurchases and share issues do not affect FCFF and FCFE. This is because cash flow methods
attempt to forecast cash flow available to investors and these are uses of cash flow.
 Changes in leverage, such as shifting your capital structure towards a higher debt will not affect FCFF. An
increase in debt, however, will affect FCFE in two ways: first, it will increase FCFE in the year that the debt is
issued. It will then reduce FCFE in subsequent years because of the higher interest expense.
 When a firm adds leverage, its value may increase due to the tax shields on interest expense and the generally
lower cost of debt. In theory, there is an optimal capital structure. If the amount of debt employed is greater
than the optimal, the costs associated with risk of bankruptcy or financial distress begin to outweigh the
advantage of interest tax shields.
LOS I: Critique the use of net income and EBITDA as proxies for cash flows in valuation:
 Net income is a poor proxy for FCFE. Net income includes noncash charges like depreciation that have to be
added back to arrive at FCFE. In addition, it ignores cash flows that don’t appear on the income statement,
such as investments in working capital and fixed assets as well as net borrowings. This can be seen by simply
examining the formula for FCFE in terms of NI:
FCFE = NI + NCC − FCInv − WCInv + net borrowing
 EBITDA is a poor proxy for FCFF. The following equation makes this point clear:
FCFF = EBITDA (1 − tax rate) + (Dep × tax rate) − FCInv − WCInv
 EBITDA doesn’t reflect the cash taxes paid by the firm, and it ignores the cash flow effects of the investments in
working capital and fixed capital.
LOS J: Discuss the single-stage (stable growth), two-stage, and three-stage FCFF and FCFE models
(including assumptions), and explain the company characteristics that would justify the use of each model:
 Single stage FCFF, FCFE model:


The two-stage model is similar to the two-stage DDM. The model assumes that there are two stages of growth:
a first stage with a high-growth rate for n years and a second stage with a lower, constant growth rate forever.
The two-stage model is also best suited to analyzing firms in a high growth phase that will maintain that growth
for a specific period, such as firms with patents or firms in an industry with significant barriers to entry or firms that are
growing at a rate significantly higher than the overall economy. Companies growing at a rate similar to or less than the
nominal growth rate of the economy are best suited for the Stable Growth FCFE Model. Companies in high growth
industries correspond to the E-Model (Three-Stage FCFE Model). A firm that pays out all of its earnings as dividends will
have a growth rate of zero (remember g = RR × ROE) and would not be valued using the two-stage FCFE model.

The three-stage model:

 Assumes a constant growth rate in each of the three stages.
 Projects constant growth rates in stages 1 and 3, but a declining growth rate in stage 2.
 Growth could be dependent on sales, profits, or could by applied directly to FCFF or FCFE.
Keep in mind that the simple idea is the growth rate pattern corresponds to the assumptions of the model.
Multi-stage FCF model selection: basically, select a model that matches the growth rate of the underlying
firm. If growth is expected to be high and then stable then select a two-stage growth model etc.
A firm that is in a stable growth phase should have growth rate close to that of the economy, and the cost of
equity should approximate the required rate of return on the market. In addition, the capital expenditures should not be
disproportionately large relative to the depreciation expense.
LOS K: Calculate the value of a company using the single-stage, two-stage, and three-stage FCFF and FCFE
models:
Example (1-Stage): The Range Co. currently has FCFF of $600,000. They are currently operating at their target debt
ratio of 30%. The market value of the firm's debt is $3,530,000 and Range has 500,000 shares of common stock
outstanding. The firm's tax rate is 40%, the shareholders require a return of 14% on their investment, the firm's cost of
debt is 9%, and the expected growth rate in FCFF is 6%. Calculate the value of the firm.
Since we are given FCFF in the most recent year (FCFF0), we need to increase FCFF at the growth rate by one year to
get FCFF1. Next, we calculate WACC.
WACC = (0.70 × 0.14) + [0.30 × 0.09 × (1 − 0.40)] = 11.4%

Value per share = $11,777,778 / 500,000 = $23.56

Example (2-Stage): Assume the following FCFF values for periods 0 - 6, respectively. $5.90, $6.49, $7.13, $7.84,
$8.63, $9.50, and $8.28. After year 6 growth falls to 5%. Calculate the value of the firm and its equity if the WACC is
17% during years 1-5 and 15% thereafter. The firm has 1 million shares of common stock outstanding and its long term
debt is trading at its par value of $32 million.
The terminal value as of year 5 is $8.28 / (0.15 − 0.05) = $82.80
Given that the value of the firm's debt is $32 per share, the value of equity per share = $62.36 − $32.00 = $30.36
Example (3-Stage): The Hermsen Co. is expected to experience growth in three distinct stages in the future. The most
recent FCFE is $0.84 per share.
High growth period: Duration = 4 years, FCFE growth rate = 40%, and required return = 25%
Transitional period: Duration = 3 years, FCFE growth will decline by 12% a year down to the indicated stable growth
rate, required return = 18%
Stable growth period: FCFE growth rate = 4%, required return = 12%
High-growth
1 2 3 4
period
Growth rate 40% 40% 40% 40%
FCFE $1.176 $1.646 $2.305 $3.227
PV $0.941 $1.053 $1.180 $1.322

Transitional period 5 6 7
Growth rate 28% 16% 4%
FCFE $4.130 $4.791 $4.983
PV $1.433 $1.409 $1.242
Calculate the value of the firm's equity using the 3-stage FCFE model.
Terminal value as of year 7 = $5.182 / (0.12 − 0.04) = $64.775
Value per share = 0.941 + 1.053 + 1.180 + 1.322 + 1.433 + 1.409 + 1.242 + [(64.775 / (1.254 × 1.183)] = $24.728
LOS L: Explain how sensitivity analysis can be used in FCFF and FCFE valuations:
Sensitivity analysis shows how sensitive an analyst’s valuation results are to changes in each of a model’s inputs. The
importance of various forecasting errors can be assessed through a full sensitivity analysis. There are two major sources
of error in valuation analysis:
 Estimating the future growth in FCFF and FCFE: Growth forecasts depend on a firm’s future profitability,
which in turn depends on sales growth, changes in profit margin, position in the life cycle, its competitive
strategy, and the overall profitability of the industry.
 The chosen base years for the FCFF or FCFE growth forecasts: A representative base year must be chosen,
or all of the subsequent analysis and valuation will be flawed.
LOS M: Discuss the approaches for calculating the terminal value in a multi-stage valuation model:
There are two basic approaches for calculating terminal value: using a single-stage model or a multiple approach. Using
the first approach, we forecast an FCFF or FCFE at the point in time at which cash flows begin to grow at the long-term,
stable growth rate, and then we estimate terminal value using a single-stage model.
The other way to do this is to use valuation multiples (like P/E ratios) to estimate terminal value. The terminal value in
year n in terms of P/E, for example, would be expressed as:
terminal value in year n = (trailing P/E) × (earnings in year n)
terminal value in year n = (leading P/E) × (forecasted earnings in year n + 1)
LOS N: Describe the characteristics of companies for which the FCFF model is preferred to the FCFE model:
Depending on the company being analyzed, an analyst may have reasons to prefer using FCFF or FCFE. If the
company’s capital structure is relatively stable, FCFE is more direct and simpler to use than FCFF. In the case of a
levered company with negative FCFE, using FCFF to value a stock may be easier.
With cash flow valuation models always remember that what we are trying to do is forecast the cash that a company is
able to produce into its future and reflect these cash flows in the present.

US GAAP IAS
Interest Received Operating Operating or Investing
Interest Paid Operating Operating or Financing
Dividends Received Operating Operating or Investing
Dividends Paid Financing Financing or Operating
If a firm has significant non-operating assets such as excess cash, marketable securities, or land held for investment,
then analysts often calculate the value of the firm as the value of its operating assets plus the value of its non-operating
assets.
Reading 43 – Market-Based Valuation: Price Multiples
LOS A: Distinguish between the method of comparables and the method based on forecasted fundamentals
as approaches to using price multiples in valuation, and discuss the economic rationales for each approach:
The justified price multiple for the method of comparables is an average multiple of similar stocks in the same
peer group. The economic rationale for the method of comparables is the Law of One price, which asserts that two
similar assets should sell at comparable prices (i.e., multiples). It’s a relative valuation method, so we can only assert
that a stock is relatively over or undervalued relative to some benchmark.
The justified price multiple for the method of forecasted fundamentals is the ratio of the value of the stock
from a discounted cash flow (DCF) valuation model divided by some fundamental variable (e.g., earnings per share).
The economic rationale for the method of forecasted fundamentals is that the value used in the numerator of the
justified price multiple is derived from a DCF model that is based on the most basic concept in finance: value is equal to
the present value of expected future cash flows discounted at the appropriate risk-adjusted rate of return.
LOS B: Define a justified price multiple:
Price multiples are ratios of a common stock’s market price to some fundamental variable. The most common
example is the price-to-earnings (P/E) ratio. A justified price multiple (warranted/intrinsic price multiple) is what the
multiple should be if the stock is fairly valued. If the actual multiple is greater than the justified price multiple, the stock
is overvalued; if the actual multiple is less than the justified multiple, the stock is undervalued (all else equal).
LOS C: Discuss rationales for using each price multiple and dividend yield in valuation, discuss possible
drawbacks to the use of each price multiple and dividend yield, and calculate each price multiple and
dividend yield:
P/E Ratio
1. Earnings power, as measured by earnings per share (EPS), is the primary determinant of investment value.
2. The P/E ratio is popular in the investment community.
3. Empirical research shows that P/E differences are significantly related to long-run average stock returns.
 Earnings can be negative, which produces a useless P/E ratio.
 The volatile, transitory portion of earnings makes the interpretation of P/Es difficult for analysts.
 trailing P/E = market price per share / EPS over previous 12 months
leading P/E = market price per share / forecasted EPS over next 12 months
P/B Ratio
1. Book value is a cumulative amount that is usually positive, even when the firm reports a loss and EPS is negative.
Thus, a P/B can typically be used when P/E cannot.
2. Book value is more stable than EPS, so it may be more useful than P/E when EPS is particularly high, low, or
volatile.
3. Book value is an appropriate measure of net asset value for firms that primarily hold liquid assets. Examples
include finance, investment, insurance, and banking firms.
4. P/B can be useful in valuing companies that are expected to go out of business.
5. Empirical research shows that P/Bs help explain differences in long-run average stock returns.
 P/Bs do not recognize the value of nonphysical assets, such as human capital.
 P/Bs can be misleading when there are significant differences in the asset size of the firms under consideration.
 P/B = market value of equity / book value of equity = market price per share / BV per share
where: book value of equity = common shareholders' equity = (total asset - total liabilities) - preferred stock
P/S Ratio
1. P/S is meaningful even for distressed firms, since sales revenue is always positive. This is not the case for P/E and
P/B ratios, which can be negative.
2. Sales revenue is not as easy to manipulate or distort as EPS and book value, which are significantly affected by
accounting conventions.
3. P/S ratios are not as volatile as P/E multiples. This may make P/S ratios more reliable in valuation analysis.
4. P/S ratios are particularly appropriate for valuing stocks in mature or cyclical industries and start-up companies
with no record of earnings.
5. Like P/E and P/B ratios, empirical research finds that differences in P/S are significantly related to differences in
long-run average stock returns.
 High growth in sales does not necessarily indicate operating profits as measured by earnings and cash flow.
 P/S ratios do not capture differences in cost structures across companies.
 P/S = market value of equity / total sales = market price per share / sales per share
P/CF Ratio
1. Cash flow is harder for managers to manipulate than earnings.
2. Price to cash flow is more stable than price to earnings.
3. Reliance on cash flow rather than earnings handles the problem of differences in the quality of reported earnings,
which is a problem for P/E.
4. Empirical evidence indicates that differences in price to cash flow are significantly related to differences in long-run
average stock returns.
 Items affecting actual CFO are ignored when the EPS plus noncash charges estimate is used.
 From theoretical perspective, FCFE is preferable to cash flow but is more volatile than straight cash flow.
 P/CF = market value of equity / CF = market price per share / cash flow per share
where: cash flow = CF, adjusted CFO, FCFE, or EBITDA
LOS D: Calculate underlying earnings given EPS and nonrecurring items in the income statement and
discuss methods of normalizing EPS, and calculate normalized EPS by each method:
 Basically, analysts want to focus on underlying earnings which is also known as persistent, continuing, or
core-earnings. Underlying earnings is an earnings measure that excludes nonrecurring components, such as
gains and losses from asset sales, asset write-downs, provisions for future losses, and changes in accounting
estimates.
Example: Calculate underlying earnings.
Qtr. ending Stock price Reported EPS Gain on asset sales Extraordinary expense
Dec 2006 $42 $1.25 $0.25
Mar 2007 $56 $1.25
June 2007 $62 $1.50
Sept 2007 $60 $1.25 $1.00
Answer:
12-month EPS = 1.25 + 1.25 + 1.50 + 1.25 = $5.25 Underlying earnings = 5.25 − 0.25 + 1.00 = $6.00
 There is a countercyclical tendency to have high P/Es due to lower EPS at the bottom of a cycle and low P/Es
due to high EPS at the top of a cycle. This effect is known as the Molodovsky effect. Analysts will adjust P/Es
for cyclicality by estimating normalized EPS which is an estimate of EPS during the middle of the business cycle
(thereby MINIMIZING the effect discussed). There are basically two methods to accomplish this:
o Method of historical EPS: simply take an average of EPS over an appropriate business cycle.
o Method of average ROE: simply take an average ROE over a business cycle times BVPS.
Example: The following table is data for Gunderson Consulting. Calculate normalized EPS using both methods.
Year 2004 2005 2006 2007
EPS $4.00 $3.80 $5.25 $4.50
BVPS $25 $26 $26 $28
ROE 15% 15% 21% 16%
Answer:
Historical average EPS method: $4.39 Average ROE method: Average ROE × BVPS2007 = 0.1675 × $28.00 = $4.69
LOS E: Explain and justify the use of earnings yield (E/P):
Negative earnings render P/E ratios meaningless. In such cases, it is common to use normalized EPS and/or restate the
ratio as the earnings yield (E/P) because price is never negative.
 A high E/P suggests a cheap security.
 A low E/P suggests an expensive E/P.
This permits securities to be ranked from cheap to expensive based on E/P ratios. Beware look-ahead bias.
LOS F: Discuss the fundamental factors that influence price multiples and dividend yield:
 Justified P/E increases as g increases or r decreases.
 Justified P/B increases as ROE increases or the spread between ROE and r increases.
 Justified P/S increases as profit margin increases or g increases.
 Justified P/CF increases as g increases or r decreases.
LOS G: Calculate the justified P/E, P/B, P/S ratios for a stock based on forecasted fundamentals:
 Justified P/E Multiple:

o By looking at the above formula we can conclude that the factors that affect P/E are expected growth
and required return. The justified P/E is positively related to the growth rate of cash flows (dividends or
FCF) and inversely related to the stock’s required rate of return.
 Justified P/B Multiple:


o By examining the formula above we can conclude that the P/B ratio increase with ROE (all else equal),
the larger the spread between ROE and r the higher the ratio (this makes sense because the larger the
spread, all else equal, the more value the firm is creating through its investments and hence investors
should be willing to pay more for this).
 Justified P/S Multiple:


o By looking at the equation above we can deduce that the P/S ratio will increase, all else equal, if the
profit margin increases or the earnings growth rate increases.
 Justified P/CF multiple: calculate this by calculating price based on a FCF valuation methodology and then
dividing this price by your chosen proxy for cash flow. The ratio will increase if the required return decreases or
your assumed growth rate increases.
  Justified EV/EBITDA multiple: this is simply the enterprise value based on a forecast of fundamentals divided
by EBITDA forecast based on fundamentals. The ratio is positively related to the growth rate FCFF and EBITDA
and negatively related the firm’s overall risk level and WACC.
 Justified dividend yield:


 The dividend yield is positively related to the required rate of return and negatively related to the forecasted
growth rate in dividends. This implies that choosing high dividend yield stocks reflects a value rather
than a growth strategy.
LOS H: Calculate a predicted P/E, given a cross-section regression on fundamentals, and explain limitations
to the cross-section regression methodology:
 A predicted P/E can be estimated from a linear regression of historical P/Es on its fundamental variables,
including expected growth and risk.


Example:
An analyst is valuing a public utility with a dividend payout ratio of 0.50, a beta of 0.95, and an expected earnings
growth rate of 0.06. A regression on other public utilities produces the following regression equation:
Predicted P/E = 6.75 + (4.00 × dividend payout) + (12.35 × growth) – (0.5 × beta)
The firm’s P/E ratio is 12.0. Calculate the predicted P/E on the basis of the values of the explanatory variables for the
company, and determine whether the stock is over- or underpriced.
Answer:
6.75 + (4.00 × 0.50) + (12.35 × 0.06) – (0.50 × 0.95) = 9.02
Actual P/E is greater than predicted P/E, so the firm is overpriced.
LOS I: Define the benchmark value of a multiple:
The method of comparables approach to valuation compares a stock’s price multiple to a benchmark of the multiple
using the following steps:
1. Select and calculate the multiple that will be used.
2. Select the benchmark stock and calculate the mean or median of its multiple over the group of comparable
stocks.
3. Compare the stock’s multiple to the benchmark.
4. Examine whether any observed difference between the multiples of the stock and the benchmark are explained
by the underlying determinants of the multiple, and make appropriate valuation adjustments.
Frequently encountered P/E benchmarks include:
 P/E of another stock of a company in a similar industry with similar operating characteristics.
 Average or median P/E of peer group within the company’s industry.
 Average/median P/E for the industry. Median P/E does not reflect the impact of outliers, while the mean does.
 P/E of an equity index.
 Average historical P/E for the stock.
Equity index benchmarks: the FED model suggests that the market is overvalued when the market’s current earnings
yield is less than the 10-year treasury yield. The Yardeni model relates the current earnings yield on the market to
both the current yield on A-rated corporate bonds and the consensus 5-year earnings growth rate, which is absent in
the FED model.
LOS J: Evaluate a stock by the method of comparables using each of the price multiples and explain the
importance in fundamentals in using the method of comparables:
The basic idea of the method of comparables is to compare a stock’s price multiple to the benchmark. Firms with
multiples below the benchmark are undervalued, and firms with multiples above the benchmark are overvalued.
However, the fundamentals of the stock should be similar to the fundamentals of the benchmark before we can
make direct comparisons and draw any conclusions about whether the stock is overvalued or undervalued. In other
words, we have to ensure that we’re comparing apples to apples. That is why the fundamental variables (i.e., the
fundamentals) that affect each multiple are important in applying the method of comparables.
Let’s use the P/E ratio as an example. Remember that justified P/E is positively related to growth rates and negatively
related to expected return and risk. Suppose we determine that the P/E of our stock is less than the benchmark. There
are (at least) three possible explanations for this:
 The stock is undervalued.
 The stock is properly valued, but the stock has a lower expected growth rate than the benchmark, which leads
to a lower P/E.
 The stock is properly valued, but it has a higher expected return (higher risk) than the benchmark, which leads
to a lower P/E.
In order to conclude that the stock is truly undervalued, we have to make sure that the stock is comparable to
the benchmark: it should have similar expected growth and similar risk and return.
 The major difference between the approaches in comparing P/E and P/B values to a benchmark is that P/B ratios
are not widely disseminated and therefore analysts will use a trailing P/B figure.
Example:
You are valuing Housing Products, Inc., which is a building construction materials company, using the trailing P/E metric.
Specifically, you are using the median trailing P/E of a group of companies as a benchmark. Housing Products has a
trailing P/E of 22.78, while the median peer group P/E is 16.25. Assuming that there are no differences in the
fundamentals (i.e., growth rates and risk levels) among the peer firms and Housing Products, evaluate the pricing of
Housing Products common stock.
Answer:
The stock of Housing Products appears to be overvalued. Its trailing P/E is 22.78, compared with the benchmark of only
16.25.
LOS K: Calculate the PEG ratio and explain its use in relative valuation:
The PEG ratio captures the relationship between earnings growth and P/E.

 Remember, the PEG ratio has the following drawbacks:

o The relationship between P/E and g is not linear thereby making comparisons difficult
o The PEG ratio does not account for risk
o The PEG ratio doesn’t reflect the duration of the high-growth period for a multi-stage valuation model,
especially if the analyst uses a short-term high-growth forecast.
Example: Med-Ready Inc. has a leading P/E of 28.75 and a 5-year consensus growth rate forecast of 14.5%. The
median PEG for a group of companies comparable in risk to Med-Ready Inc. is 2.34. Calculate the firm’s PEG and explain
whether the stock appears to be correctly valued, overvalued, or undervalued.
Answer:

Given the comparable group median PEG of 2.34, it appears that Med-Ready Inc. may be undervalued. However,
it is important for the analyst to determine whether the peer group PEG is also based on leading P/Es, and
whether the comparable firms are similar in expected return and risk.
LOS L: Calculate and explain the use of price multiples in determining terminal value in a multi-stage
discounted cash flow (DCF) model:
 A terminal value that is projected as of the end of an investment horizon should reflect an earnings growth rate
that the firm can sustain over the long-run. Basically, analysts use a price multiple, multiply this by the
fundamental variable (e.g. EPS and then calculate a terminal value.)
 
 The strength of the comparables approach is that it uses market data exclusively. The weakness is that if the
comparable is mispriced we will have errors in our terminal value estimation.
Example:
An analyst estimates the EPS of Polar Technology in five years to be $2.10, the EPS in six years to be $2.32, and the
median trailing industry P/E to be 35. Calculate the terminal value in year 5.
Answer: Terminal value in year 5 = (benchmark trailing P/E ratio) × (forecasted earnings in year 5) = 35 ×
$2.10 = $73.50
LOS M: Discuss alternative definitions of cash flow used in price multiples, and explain the limitations of
each definition.
There are at least four definitions for cash flow:
1. Earnings-plus-non-cash-charges (CF) is equal to net income + depreciation + amortization. A limitation of
this measure is that it ignores some items that affect cash flow.
2. Cash flow from operations (CFO) is often adjusted by adding back after-tax interest costs, because CFO by
itself includes items related to financing and investing activities.
Adjusted CFO = CFO + [(net cash interest outflow) × (1 − tax rate)]
3. Free cash flow to equity (FCFE) is the preferred way, but is more volatile than straight cash flow.
FCFE = CFO − FCInv + net borrowing
4. Earnings before interest, taxes, depreciations, and amortization (EBITDA) is better suited as an
indicator for total company value rather than just equity value.
 EV/EBITDA ratio: because EBITDA is a flow to both equity and debt it should be related to a numerator that
measures total company value. EV is equal to:

o
o EV/EBITDA is useful in a number of situations:
 The ratio may be more useful than P/E when comparing firms with different degrees of financial
leverage.
 EBITDA is useful for valuing capital intensive businesses with high levels of depreciation and
amortization.
 EBITDA is usually positive when EPS is not.
o EV/EBITDA has a number of drawbacks, however:
  If working capital is growing, EBITDA will overstate CFO. Further, the measure ignores how
different revenue recognition policies affect CFO.
 Because FCFF captures the amount of capital expenditures it more strongly linked with valuation
theory than EBITDA. EBITDA will be an adequate measure if capital expenses equal depreciation
expenses.


 Dividend Yield: the advantages of the dividend yield approach are that dividend yield contributes to total
investment return and dividends are not as risky as the capital appreciation component of total return. The
disadvantages of the dividend yield approach are that the focus on dividend yield is incomplete because it
ignores capital appreciation.


LOS N: Discuss the sources of differences in cross-border valuation comparisons:
 Using a comparables approach across borders is difficult because of differences in culture, growth, accounting
and risk. Further, benchmarking is difficult because P/Es for individual firms in the same industry vary widely
internationally and country market P/Es can vary significantly.
 The least affected metrics are price/adjusted cash flow and price/FCFE. The most affected are P/B, P/E,
EV/EBITDA because of management’s choice with regards to accounting assumptions.
LOS O: Describe the main types of momentum indicators and their use in valuation:
Momentum indicators relate either the market price or a fundamental variable like EPS to the time series of historical
or expected value. Common momentum indicators include earnings surprise, standardized unexpected earnings, and
relative strength.
 The unexpected earnings surprise is the difference between reported earnings and expected earnings.
 The standardized unexpected earnings (SUE) is measured as earnings surprise / standard deviation of
earnings surprise.
 Relative strength indicators compare a stock's price or return performance during a given time period with
its own historical performance or with some group of peer stocks.
A given size forecast error is more (less) meaningful the smaller (larger) the historical size of forecast errors.
Reading 44 – U.S. Portfolio Strategy: Seeking Value— Anatomy of Valuation
LOS A: Explain why an analyst would use a ten-year moving average as a benchmark in the valuation
process:
 A ten-year moving average provides a near-time historic benchmark against which current valuations can be
measured.
 You need to be careful with the approach, however. If a stock receives a downgrade in their growth prospects
then the stock may appear cheap relative to its high valuation during the period when its growth prospects were
more favorable.
LOS B: Determine the importance of correlation analysis when using a multi-matrix valuation approach:
This topic review covers a study conducted by Goldman Sachs Research. In this study a multi-matrix valuation
approach was used to identify cheap (low priced) and expensive (high priced) equity securities contained in the S&P 500.
The study investigates the valuation of the S&P 500 as a whole and the various sectors within the S&P 500.
Seven valuation metrics are used:
1. enterprise value / sales (EV/sales)
2. enterprise value / EBITA (EV/EBITA)
3. price / book
4. free cash flow yield (FCF)
5. price / earnings (P/E)
6. P/E-long-term growth (PEG)
7. implied growth (derived from the dividend discount model)
Whenever multiple variables (metrics) are used to measure the same financial characteristic, it is important that
their coefficients be positive. This provides some assurance that the various measures will tend to generate the same
over/under valuation signal, so the analyst can have more confidence in the interpretation of each stock’s overall
average score. The correlation coefficients among the seven valuation metrics used in the Goldman Sachs study are all
positive and range from 0.1 to 0.9.
LOS C: Illustrate why the PEG valuation technique must be used with care:
The PEG ratio is a valuation metric that is used to determine the relative trade-off between P/E and the
dividend growth rate. A low PEG ratio indicates a stock that is undervalued (cheap) and a high ratio indicates an
overvalued (expensive) stock. The general rule is that PEG ratios fall in the range of one to two. As the PEG ratio gets
close to two or higher, the stock is generally considered to be expensive. The validity of the PEG ratio is highly
questionable when it is used with low-growth companies. For example, suppose a low-growth company has a growth
rate of 1% and a P/E of 3, so its PEG ratio is also 3. According to the PEG ratio, the stock is overvalued, but it is unlikely
that a stock with a P/E of 3 is actually overvalued.
Furthermore, companies with zero expected growth have a PEG ratio that is undefined (division by zero), and
companies with negative growth have a negative PEG ratio, which renders it meaningless. For these reasons, PEG
ratios are usually only applied to companies with normal or high earnings growth.
LOS D: Indicate the impact of discount rate sensitivity in valuation models:
Whenever a valuation model employs the discounting of future cash flows, the resultant value estimate is highly
sensitive to the assumed discount rate. For example, the constant growth dividend discount model (DDM) is commonly
expressed as:

In the DDM, value is extremely sensitive to changes in the quantity r – g (the effective discount rate).
Small changes in the spread between r and g can lead to relatively large changes in the model’s estimate of value.
Reading 45 – Residual Income Valuation
LOS A: Calculate and interpret residual income and describe and calculate alternative measures of residual
earnings (e.g. EVA and market valued added):
 Residual income looks at a firm’s economic profit, or net income after the firm’s opportunity cost of capital
(charge that measures stockholders' opportunity cost in generating that income) is taken into account.
Example: Fiber Line Access (FLA) builds optical fiber rings in large U.S. cities. The book value of its assets is $1.4 billion,
which is financed with $800 million in equity and $600 million in debt. Its before-tax cost of debt is 3.33%, and its
relevant tax rate is 34%. FLA has a cost of equity of 12.3%.
EBIT $142,000,000
Less: interest expense (20,000,000)
Pre-tax income 122,000,000
Less: income tax expense (41,480,000)
Net income $80,520,000
RI is calculated as Net income – Equity charge
Equity charge = equity capital × cost of equity = $800 million × 0.123 = $98,400,000
RI = $80,520,000 – $98,400,000 = -$17,880,000
 Accounting income includes a cost of debt (i.e. interest expense) but does not reflect dividends or other equity
capital related funding costs. This means that accounting income may overstate returns from the perspective of
equity investors. Residual income explicitly deducts all equity capital costs.
 EVA: this simply measures the value added for shareholders by management during a given year.


 An analyst should make the following adjustments before calculating NOPAT:
o Capitalize and amortize research and development charges (rather than expense them) and add them
back to earnings to calculate NOPAT.
o Add back charges on strategic investments that will generate returns in the future.
o Capitalize (but do not amortize) goodwill, add amortization expense back to invested capital. This is
important if statements are formed under IAS— under the new laws of GAAP goodwill is not amortized
but it is subject to an impairment test.
o Eliminate deferred taxes and consider only cash taxes as an expense.
o Treat operating leases as capital leases and adjust non-recurring items.
 MVA: this is simply the difference between a firm’s market value and its total invested capital where EVA is the
difference between after-tax operating income and charge for total capital.
LOS B: Discuss the uses of residual models:
Residual income-based valuation models, like EVA and MVA, usually apply the concept of residual income to the
measurement of managerial effectiveness and executive compensation. However, for the exam we’re most interested in
the equity valuation applications of residual income models. Residual income models have also been proposed as a
method to measure goodwill impairment.
LOS C(1): Calculate future values of residual income, given current book value, consensus earnings growth
estimates, and an assumed dividend payout ratio, and calculate the intrinsic value of a share of common
stock using the residual income model:

Example: Laura Kraft, CFA, was assigned the task of forecasting the RI for Delilah Cosmetics, Inc. over the next two
years. To accomplish this task, Kraft assembled the information provided below. Kraft assumed a required rate of return
of 11%.
Current market price = € 24.00, BVPS = € 18.00, Annual EPS estimates for January 2008 and 2009 are respectively,
€ 2.05 and € 2.22. The dividend payout ratio for both years is 65%. Forecast Delilah’s residual income for 2008 and 2009.
FY 2008 FY 2009
BV0 € 18.00 € 18.72
Earnings per share forecast 2.05 2.22
Dividend forecast 1.33 1.44
Forecast book value per share 18.72 19.50
Equity charge per share 1.98 2.06
Per share RI € 0.07 € 0.16
Example: Expert Systems has a beginning book value per share of $7.00, an expected growth rate of 15%, this year's
forecasted earnings per share of $1.25, and a required rate of return of 17. Assuming that the dividend remains
constant at $0.75 per share, what is next year’s expected residual income per share?
EPS next year = 1.25 × 1.15 = $1.44. Forecast book value per share = BV0 + EPS – D = 7.00 + 1.25 – 0.75 = $7.5.
The per share equity charge is 7.5 × 0.17 = $1.28. Thus, residual income is expected to be 1.44 – 1.28 = $0.16.
 The residual income valuation model breaks the intrinsic value of a stock into two elements: the current book
value of equity and the present value of expected future residual income:

Example: Vista Concepts has a required rate of return of 12%. Over the next three years, Vista has the expected
financial data as shown below. Residual income for years 2011 and beyond is assumed to be zero. Calculate the value of
Vista's stock.
2008 2009 2010
Beginning book value per share (BV0) $8.00 $9.20 $10.85
Per share RI (Eforecast – equity charge) $1.04 $1.65 $2.95
  All this equation is trying to communicate is that the value of a stock is equal to its current BVPS and the
present value of all of its expected future residual income which is the difference between end-of-period EPS and
a charge for using the firm’s equity capital.
LOS C(2): Contrast the recognition of value in the residual income model to value recognition in other
present value models, discuss the strengths and weaknesses of the residual income model, and justify the
choice of the residual income model for equity valuation, given characteristics of the company being valued:
 Because DDM and FCF models derive a lot of their value from your terminal value assumptions (which are highly
uncertain due to terminal value’s sensitivity to the r and g terms), they will underestimate value relative to the
residual income models which derive a large portion of their intrinsic value from current book value.


LOS D: Discuss the fundamental determinants or drivers of residual income:
 The general residual income models make no assumptions regarding the long-term future earnings or dividend
growth. However, if we make the simplifying assumption of a constant dividend and earnings growth rate we
can develop a residual income model that highlights the fundamental drivers of residual income with a model
known as the single stage residual income valuation model:

 If ROE is equal to the required return on equity, the justified market value of a share of stock is equal to its
book value. When ROE is higher than the required return on equity, the firm will have positive RI and will be
valued at more than book value.

 is the additional value generated by a firm's ability to produce returns in excess of the cost of
equity, and consequently, is the present value of a firm's expected economic profits (i.e., residual income).
LOS E: Explain the relationship between residual income valuation and the justified price-to-book ratio
based on forecasted fundamentals:
As with the DDM and FCFE models, RI models can be used to establish justifiable market multiples. Among the
various market multiples, the RI model is most closely related to the stock's price-to-book value (P/B) ratio because a
stock's justified P/B is directly linked to expect future RI. This can be seen by observing the single stage RI model,
where P0/B0 is expressed in terms of the ROE, the required rate of return, and the constant dividend growth rate. If ROE
is greater than the required return on equity, the present value of RI will be positive, the market value will be greater
than book value, and the justified P/B ratio will be greater than one.
P0/B0 = 1 + (ROE-r) / (r-g) = (ROE-g) / (r-g)
LOS F: Calculate and interpret the intrinsic value of a share of common stock using a single-stage residual
income model:
Example: Calculating value with a single-stage residual income model:
Western Atlantic Railroad has a book value of $23.00 per share. The company’s return on new investments (ROE) is
14%, and its required return on equity is 12%. The dividend payout ratio is 60%. Calculate the value of the shares
using a single-stage residual income model.
Answer:
First calculate the growth rate: g = retention ratio × ROE = (1 – 0.6) × 0.14 = 0.056 = 5.6%
Then calculate intrinsic value using the single-stage model:

The present value of the firm’s expected economic profits is $7.19.

LOS G: Calculate an implied growth rate in residual income, given the market price-to-book ratio and an
estimate of the required rate of return on equity:

Example: You are considering the purchase of Tellis Telecommunications, Inc., which has a P/B ratio of 2.50. ROE is
expected to be 13%, current book value per share is € 8.00, and the cost of equity is 11%. Calculate the growth rate
implied by the current P/B ratio.
Answer:
The P/B ratio of 2.50 and the current book value per share of € 8.00 imply a current market price of € 20.00(8 × 2.50).
This implies a growth rate of:

LOS H (1): Define continuing residual income and list the common assumptions regarding continuing
residual income:
Continuing residual income is the residual income that is expected over the long term— which is a function of
industry outlook and competitive advantage. The projected rate at which residual income is expected to fade over the
life cycle of the firm is captured by a persistence factor, w, which is between zero and one.
To simplify the model, we typically make one of the following assumptions about continuing residual income at
the end of the short-term period:
 Residual income is expected to persist at its current level forever.
 Residual income is expected to drop immediately to zero.
 Residual income is expected to decline to a long-run average level consistent with a mature industry.
 Residual income is expected to decline over time as ROE falls to the cost of equity (in which case residual
income is eventually zero).
LOS H (2): Justify an estimate of continuing residual income at the earnings forecast horizon, given
company and industry prospects:
An analysis of the firm’s position in its industry and the structure of the industry will be necessary to justify
these assumptions. The assumption that RI is expected to decline to a long-run average level consistent with a mature
industry is the most realistic if we assume that over time industry competition reduces economic profits to the point at
which firms begin to leave the industry and ROE stabilizes at a long-run normal level. The strength of the persistence
factor will depend partly on the sustainability of the firm’s competitive advantage and the structure of the industry: the
more sustainable the competitive advantage and the better the industry prospects, the higher the persistence factor.
Higher persistence factors will be associated with:
 Low dividend payouts.
 Historically high residual income persistence in the industry.
Lower persistence factors will be associated with:
 High return on equity.
 Significant levels of nonrecurring items.
 High accounting accruals.
LOS I: Calculate and interpret the intrinsic value of a share of common stock using a multi-stage residual
income model, given the required rate of return, forecasted earnings per share over a finite horizon, and
forecasted continuing residual earnings:
For multi-stage residual income models, first forecast residual income over a short-term horizon, and then make some
simplifying assumptions about the pattern of residual income growth over the long term. Continuing residual income is
the residual income that is expected over the long-term. The present value of continuing residual income in year T – 1 is
equal to:

 If residual income is expected to persist at the current level forever, w = 1.

 If residual income is expected to drop immediately to zero, w = 0.
 If residual income is expected to decline over time after year T as ROE falls to the cost of equity capital, then
the persistence factor, w, is between zero and one.
Another way to estimate continuing residual income without using the persistence factor is to assume residual income is
expected to decline to a normal long-run level consistent with a mature industry. Then the premium over book value
(PT – BT) is equal to the present value of continuing residual income in year T, and the present value of continuing
residual income in year T – 1 is:

LOS J: Explain the relationship of the residual income model to the DDM and the FCFE model:
 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 future residual
income.
 Theoretically, the intrinsic value derived using expected dividends, FCFE, or book value plus expected residual
income should be identical if the underlying assumptions used to make the necessary forecasts are the same.
In reality, however, it is rarely possible to forecast all of the common inputs with the same degree of accuracy
and the different models yield different results.

LOS k: Discuss the strengths and weaknesses of the residual income model.
Strengths
 Terminal value does not dominate the intrinsic value estimate, as is the case with dividend discount and free
cash flow valuation models.
 RI models use available accounting data.
 The models are applicable to firms that do not pay dividends or that do not have positive expected free cash
flows in the short run.
 The models are applicable even when cash flows are highly volatile.
 The models focus on economic rather than just accounting profitability.
Weaknesses
 The models rely on accounting data that can be manipulated.
 Reliance on accounting data requires numerous and significant adjustments.
 The models assume that the clean surplus relation holds or that its failure to hold has been properly taken into
account.
LOS l: Justify the selection of the residual income model for equity valuation, given characteristics of the company
being valued.
RI models are appropriate under the following circumstances:
 A firm does not pay dividends, or the stream of payments is too volatile to be sufficiently predictable.
 Expected free cash flows are negative for the foreseeable future.
 The terminal value forecast is highly uncertain, which makes dividend discount or free cash flow models less
useful.
RI models are not appropriate under the following circumstances:
 The clean surplus accounting relation is violated significantly.
 There is significant uncertainty concerning the estimates of book value and return on equity.
LOS M: Discuss the major accounting issues in applying residual income models:
1 Violations of the clean surplus relationship:
o One of the major assumptions of the residual income model is the clean surplus relationship (i.e. ending
book value = beg book value + earnings – dividends). This assumption may not hold, however, if some
items flow directly to shareholder’s equity and bypass the income statement. Some items that can
bypass it are:
o Foreign currency translation gains and losses that flow directly to retained earnings under the all-current
method.
o The minimum liability adjustment in pension accounting.
o Changes in the market value of debt and equity securities classified as available for sale)
o The effect of violating the clean surplus relationship assumption is that net income is not correct, but
book value is still correct. The risk in applying the residual income model when the clean
surplus relation doesn’t hold is that the ROE forecast will not be accurate if the clean surplus
violations are not expected to offset in future years.
2 Balance sheet adjustments to fair value:

3 Intangible assets:
o Goodwill reported on the balance sheet that results from an acquisition in which the buyer paid fair value
should be included for purposes of calculating book value of equity. In addition, the effect of any
amortization of goodwill should be excluded from the estimate of ROE.
o For R&D we can make the general statement that the ROE estimate for a mature company should reflect
the long-term productivity of the company’s R&D expenditures: productive R&D expenditures increase
ROE and residual income and unproductive expenditures reduce ROE and residual income.
4 Nonrecurring items and other aggressive accounting practices:
o Nonrecurring items should not be included in residual income forecasts because they represent items
that are not expected to continue in the future.
o Firms may adopt other types of aggressive accounting practices that overstate the book value of assets
and earnings by, for example, accelerating revenue recognition in the current period and/or deferring
expenses to later periods.
5 Aggressive accounting practices - firms making aggressive (conservative) accounting decisions will report higher
(lower) book values and lower (higher) future earnings.
6 International accounting differences.
o Availability of reliable earnings forecasts.
o Systematic violations of the clean surplus assumption.
o Poor quality accounting rules that result in delayed recognition of value changes.