(CFA) (2015) (L2) 20150314-15+20150321-22 - 权益和其他类投资分析 - 李斯克3

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TopicWeightingsinCFALevelII
Session NO. Content Weightings
Study Session 1-2 Ethics & Professional Standards 10-15
Study Session 3 Quantitative Methods 5-10
Study Session 4 Economic Analysis 5-10
Study Session 5-7 Financial Statement Analysis 15-20
Study Session 8-9 Corporate Finance 5-15
Study Session 10-12 Equity Analysis 15-25
Study Session 13 Alternative Investments 5-10
Study Session 14-15 Fixed Income Analysis 10-20
Study Session 16-17 Derivative Investments 5-15
Study Session 18 Portfolio Management and Wealth Planning 5-10
Total: 100
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SummaryofReadingsandFramework
SS10
¾ R30EquityValuation:ApplicationsandProcesses
¾ R31ReturnConcepts
SS11
¾ R32TheFiveCompetitiveForcesthatShapeStrategy
¾ R33YourStrategyNeedsaStrategy
¾ R34IndustryandCompanyAnalysis
¾ R35DiscountedDividendValuation
SS12
¾ R36FreeCashFlowValuation
¾ R37MarketBasedValuation:PriceandEnterpriseValueMultiples
¾ R38ResidualIncomeValuation
¾ R39PrivateCompanyValuation
3-248
ValuationandIntrinsicValue
¾ Valuationistheprocessofestimatingthevalueofanassetby:
z Usingamodelbasedonvariablestheanalysisbelievesinfluencethe
fundamentalvalueoftheasset
z Comparingittotheobservablemarketvalueof“similar”assets
¾ Generalstepsintheequityvaluationprocess:
z Understandthebusiness.
z Forecastcompanyperformance.
z Selecttheappropriatevaluationmodel.
z Converttheforecastsintoavaluation.
z Applythevaluationconclusions.
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DifferentKindsofValues&Valuation
¾ Intrinsicvalue(IV):thevaluationofanassetorsecuritybysomeonewho
hascompleteunderstandingofthecharacteristicsoftheassetorissuing
firm.
IVanalyst price ( IVactual price) ( IVanalyst IVactual )
¾ Fairmarketvalue:thepriceatwhichahypotheticalwilling,informed,
andablesellerwouldtradeanassettoawilling,informed,andable
buyer.
¾ Investmentvalue:valueofastocktoaparticularbuyer.
¾ Liquidationvalue:valuewhencompanywillnotcontinuetooperate.
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ApplicationsofEquityValuation
¾ Objectives
z Stockselection:toguidethepurchase,holding,orsaleofstocks.
z Readingthemarket:currentmarketpricesimplicitlycontaininvestor’s
expectationsaboutthefuturevalueofthevariablesthatinfluencethe
stock’sprice.
z Projectingthevalueofcorporateactions:usevaluationtechniquesto
determinethevalue ofproposedcorporatemergers,acquisitions,
divestitures,MBO,andrecapitalizationefforts.
z Fairnessopinions:tosupportprofessionalopinions.
z Planningandconsulting:toevaluatetheeffectsofproposedcorporate
strategiesonthefirm’sstockprice,pursuingonlythosethathavethe
greatestvaluetoshareholders.
z Communicationwithanalystsandinvestors:valuationapproachprovides
acommonbasisuponwhichtodiscussandevaluatethecompany.
z Valuationofprivatebusiness:valueofthefirmorholdingsinfirmsthat
arenotpubliclytraded.
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ApplicationsofEquityValuation
z Portfoliomanagement
9 planning,execuonandfeedback3stepsintheporolio
managementprocess(valuationismostcloselyassociatedwiththe
planningandexecutionsteps).
1. Planning
9 identificationandspecificationtheinvestmentobjectivesand
constraintswringdetailontheinvestmentstrategyof
securitiesselection
9 ValuationonindividualsecurityisnotapplytoIndexingstrategy
butactivemanagement.
2. Execution
9 Portfolioselection
9 Portfolioimplementation
3. Feedback
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ValuationProcess
¾ Valuationprocess
1. Understandingthebusiness
z Elementsofindustrystructure(Porter’sfiveforces)
9 Threatofnewentrantsintheindustry;
9 Threatofsubstitutes;
9 Bargainingpowerofbuyers;
9 Bargainingpowerofsuppliers;
9 Rivalryamongexistingcompetitors.
z Threegenericstrategies:
9 Costleadership;
9 Productdifferentiation;
9 Focus.
2. Forecastingcompanyperformance
z Topdownforecastingapproach
z Bottomupforecastingapproach
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ValuationProcess
z Detailedexaminationofthefootnotesaccompanyingthe
financialreports:
9 Acceleratingorprematurerecognitionofincome.
9 Reclassifyinggainsandnonoperatingincome.
9 Expenserecognitionandlosses.
9 Amortization,depreciation,anddiscountrates.
9 Offbalancesheetissues.
3. Selectingtheappropriatevaluationmodel
z Absolutionvaluationmodel;
9 DDM,FCFM,residualincomeapproach,assetbasedmodel
z Relativevaluationmodel.
9 Multiples,suchasP/E,P/B,P/CF,etc.
4. Convertingforecaststoavaluation
5. Makingtheinvestmentdecision
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QuantitativeandQualitativefactorsinvaluation
¾ Quantitativefactors
z keysourcefromcompany’saccountinginformationandfinancial
disclosures
z Including:balancesheet,incomestatement,cashflowstatement,
aswellasthefootnotes
¾ Qualitativefactors
z Purpose:tomeasureindustryperformance,suchaslegaland
regulatoryenvironment
z Including:
9 qualityofthefirm’smanagementteam;
9 thetransparencyofitsperformance;
9 theanalyst’sconfidenceinthefirm’s;
9 industry’saccountingpractices
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Qualityofinputs
¾ Qualityofinputs
z Analystscanforecastfirm’sfutureeconomicvaluebasedon
currentfacts
¾ Requirement
z Thefinancialfactorsmustbedisclosedinsufficientdetailand
accuracy
z Theinvestigationofissuesrelatingtoaccuracyisoftenbroadly
referredtoasqualityofearningsanalysis,namelythescrutinyofall
financialstatements
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Footnotesofaccountingstatementsandotherdisclosures
¾ Indicatorsofselectedqualityofearnings
Category Observation Example
Accelerating or premature
Revenues and Recognizing revenue recognition of income
gains early Reclassifying gains and non-
operating income
Expense recognition and losses
Expenses and Delay of Recognition of
Amortization, depreciation, and
Losses Expenses
discount rates
Balance Sheet
Off-balance-sheet issues SPEs
Issues
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IntrinsicValueandAlpha
¾ Intrinsicvalue isthevalueofanassetgiveahypotheticallycomplete
understandingoftheassets’investmentcharacteristics.Valuationisa
partoftheactivemanager’sattempttoproductionpositiveexcess
return
z Alpha,anexcessriskadjustedreturn,alsocalledanabnormalreturn
¾ Formula:
z exantealpha=expectedholdingperiodreturn– requiredreturn
z expostalpha=actualholdingperiodreturn– contemporaneous
requiredreturn
¾ thedierencebetweenintrinsicvalue(V)andmarketvalue(P)
perceivemispricingbecomespartofthemanager’sforecastof
expectedreturninuencethetotalreturnontheassetnamely
influencealpha
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GoingConcernAssumption
¾ Acompanyhasonevalueifitisimmediatelydissolved,andanother
valueifitcontinuesinoperation.
¾ Goingconcernassumption
z Itisbasedontheassumptionthatthecompanywillmaintainits
businessactivitiesintotheforeseeablefuture.
z goingconcernvalueofthecompanyisthevalueunderagoing
concernassumption
¾ Nongoingconcernassumption
z Nongoingconcernvalueisbasedontheassumptionthatthe
companywillfinishoperatingandallassetswillbesoldout.
z Alsocalledliquidationvalueduetoliquidationshouldbeconcerned
inthisassumption
¾ goingconcernvalueϊ ϊ liquidationvalue
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Typesofvaluationmodels
¾ Thetwoboardtypesofgoingconcernmodelsofvaluationare:
z Absolutevaluationmodels
z Relativevaluationmodels
¾ Absolutevaluationmodels
z themodelthatspecifiesanasset’sintrinsicvaluewhichisinordertobe
comparedwiththeasset’smarketprice(doesnotneedconsideraboutthe
valueofotherfirms).
z Twotypes:
9 Presentvaluemodelordiscountedcashflowmodel
DDM
FCFmodel
Residualincomemodel
9 Assetbasedmodel:sometimeisusedtovaluethecompanythatown
orcontrolnaturalresources,suchasoilfields,coaldepositsandother
mineralclaims
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Typesofvaluationmodels
¾ Relativevaluationmodels(methodofcomparable)
z themodelthatspecifiesanasset’svaluerelativetothatofanother
asset
z Itistypicallyimplementedusingpricemultiples
z Forexample:P/E rm<P/Emarketstockisrelavelyundervalued
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Sumofthepartsvaluation&conglomeratediscount
¾ Sumofthepartsvaluation
z Sumofthepartsvaluation(breakupvalueorprivatemarketvalue):an
analystcanvalueindividualpartsofthefirmandaddthemuptodetermine
thevalueforthecompanyasawhole.
¾ Conglomeratediscount
z Investorsapplyamarkdown tothevalueofacompanythatoperatesin
multipleunrelatedindustries,comparedtothevalueacompanythathasa
singleindustryfocus.Itistheamountbywhichmarketvalueunder
representssumofthepartsvalue.
z Threeexplanationsforconglomeratediscountsare:
9 Internalcapitalinefficiency:allocationofcapitalnotbasedonsound
decisions.
9 Endogenous(internal)factors:pursuedunrelatedbusinessacquisitions
tohidepooroperatingperformance.
9 Researchmeasurementerrors:conglomeratediscountsarearesultof
incorrectmeasurement.
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BroadCriteriaforChoosingAppropriateApproach
¾ Whenselectinganapproachforvaluingagivencompany,ananalyst
shouldconsiderwhetherthemodel:
z Fitsthecharacteristicsofthecompany.
z Isappropriatebasedonthequalityandavailability ofinputdata.
z Issuitablegiventhepurposeoftheanalysis.
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SummaryofReadingsandFramework
SS10
¾ R30EquityValuation:ApplicationsandProcesses
¾ R31ReturnConcepts
SS11
¾ R32TheFiveCompetitiveForcesthatShapeStrategy
¾ R33YourStrategyNeedsaStrategy
¾ R34IndustryandCompanyAnalysis
¾ R35DiscountedDividendValuation
SS12
¾ R34FreeCashFlowValuation
¾ R35MarketBasedValuation:PriceandEnterpriseValueMultiples
¾ R36ResidualIncomeValuation
¾ R37PrivateCompanyValuation
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1.Returnconcepts
¾ Holdingperiodreturn
z Holdingperiodreturnisthereturnearnedfrominvestinganasset
overaspecifiedtimeperiod.
z Theformula:
P1 P 0 D1 D1 P1
r 1 dividend yield price appreciation return
P0 P0
zAnnualizedHPR.
9 Forexample:ifthereturnforonemonthis1%thenthe
annualizedHPRis(1+0.01)121=12.68%
¾ Realized&expectedreturn
z Realizedreturn:isthesamewithHPR.Itisbackwardlookingcontext.
z Expectedreturn:Inforwardlooking,aninvestorcanforman
expectationconcerningthedividendandsellingprice.
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1.Returnconcepts
¾ Requiredreturn(opportunitycost)
z theminimumlevelofexpectedreturnthataninvestorrequiresin
ordertoinvestintheassetoveraspecifictimeperiod,giventhe
assets’riskiness.
z Itrepresents:
9Athresholdvalueforbeingfairlycompensatedfortheriskofthe
asset.
9Ifinvestor’sexpectedreturn>requiredreturn,theassetis
undervalued;andviceversa.
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1.Returnconcepts
¾ Expectedreturn
z Whenaassetismispriced,priceofassetsconvergestoitsintrinsic
valueinaperiodtime.
z Theinvestor’sexpectedrateofreturncomprises:
9 Requiredreturn;and
9 Areturnfromconvergenceofpricetovalue.
V 0 P0
E ( R ) | rT
P0
Where,
V0,thereintrinsicvalueofthestock;
P0,thecurrentpriceofthestock
rT,requiredreturnduringtheconvergencetimeperiod
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1.Returnconcepts
¾ Discountrate
z ItisarateusedinfindingthePVoffuturecashflows;
z Usedtodeterminetheintrinsicvaluedependsonthecharacteristics
oftheinvestment ratherthanthatofpurchaser;
¾ Internalrateofreturn(IRR)
z IRRisamarketdeterminedrate.Itistheratethatequatesthevalue
ofthediscountedcashflowsthecurrentprice ofthesecurity.
z Ifthemarketsareefficient,thentheIRRrepresentstherequired
return.
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2.Equityriskpremium
¾ Theequityriskpremiumistheincrementalreturn(premium)thatinvestors
requireforholdingequitiesratherthanariskfreeasset.
z Equityriskpremium=Requiredreturnonequityindex– riskfreerate
¾ CAPM
z Requiredreturnonsharei =Currentexpectedriskfreereturn+ i
(Equityriskpremium)
¾ BuildupMethod
z Requiredreturnonshare i =Currentexpectedriskfreereturn
+Equityriskpremium
sOtherriskpremium/discounts
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2.Equityriskpremium
¾ Historicalestimate
z Equityriskpremium:consistsofthedifferencebetweenthehistoricalmean
returnforabroadbasedequitymarketindex andarisk–freerate overa
giventimeperiod.
z Issuesinhistoricalestimate
9 Selectanappropriateindex.Anindexisfrequentlyadjusted.Indriving
thereturn,itshouldbestationary.
9 Timeperiod.Thelongertheperiodused,themoreprecisethe
estimate.
9 Arithmeticmeanorgeometricmean (lower)inestimatingthereturn;
9 Longtermbondorshorttermbill isaproxyfortheriskfreeassets.
z Issues
9 Survivorshipbias.Thatresultstheoverestimatereturnonindexand
theERP.Downwardadjustmentisusedtooffsetthebias.
9 Riskpremiumwillbelower whengeometricmeanisusedorusedof
longertermbondsratherthanshortertermbondstoestimatethe
riskfreerate.
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2.Equityriskpremium
¾ Forward-looking (Ex ante) estimate – conceptual framework

z ERP is based on expectations for economic and financial variables from
the present going forward. It is logical to estimate ERP directly based on
current information and expectation.
z It is not subject to the issues such as non-stationary or data series in
historical estimate. But it is subject to potential errors related to models
and behavioral bias.
z 3 approaches
9 Gordon growth model (GGM) estimate;
9 Macroeconomics model estimate; and
9 Survey estimate.
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2. Equity risk premium

¾ GGM
z GGM equity risk premium estimate = Dividend yield on the index based on
year-ahead aggregate forecasted dividends and aggregate market value +
Consensus long-term earnings growth rate – Current long-term government
bond yield
z A simple way to understand the equation:
D1
ERP r RFR g RFR
P0
z The above equation assumes growth rate is constant.
z An analyst may make adjustment to reflect P/E boom or bust.
z Another method to solve these problems:
Equity Index Price PVrapid (r)+PVtransition (r)+PVmature (r)
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¾ Supply-Side Estimates (Macroeconomic Model)
^ ^ ^ ^ ^
ERP [1 i ] u [1 rEg ] u [1 PEg ] 1 Y RF
Expected changes in the P/E ratio Expected risk-free rate
Expected inflation Expected real growth in GDP Expected yield on the index
z Expected inflation: iˆ (YTM of 20-year T-bonds)-(YTM of 20-year TIPS)

TIPS: Treasury Inflation Protected Securities
z Expected real growth in GDP:
ˆ
rEG=real GDP growth
ˆ
rEG=labor productivity growth rate + labor supply growth rate
¾ Forward-looking (Ex ante) estimate – survey
z Use the consensus of the opinions from a sample of people.
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¾ Comparison
Estimates Strength Weakness
precision issues (due to the

a familiar and popular choice (if reduced/divided length of data)
reliable long-term records are difficult-to-maintain stationary
available) assumption (if the series starting
Historical
unbiased estimate (if no point extended to the distant past)
Estimates
systematic errors has been made) empirically countercyclical expected
objective quality (grounded in equity risk premium
data) survivorship bias and
positive/negative surprises
available (direct based on current
often subject to other potential errors
Forward- info. and expectations concerning
related to financial/economic models
looking such variables)
and behavioral biases in forecasting.
Estimates not subject to the issue of non-
subjective
stationarity or data biases
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¾ Comparison
Estimates Strength Weakness
Popular method; Change through time and need

Reasonable when applied to to be updated;
GGM
developed economies and markets; Assumption of a stable growth
Typically sample sources. rate.
Supply-Side Proven models; Only appropriate for developed

Estimates Current information; countries;
Wide disparity from different

Survey Estimates Easy to obtain
groups
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3. Required return on equity
¾ In estimating the required return on equity, the analyst can choose

following models:
z CAPM;
z Multifactor models;
9 Fama-French Model (FFM);
9 Pastor-Stambaugh model (PSM);
9 Macroeconomic Multifactor models;
z Build-up method
9 Bond Yield Plus Risk Premium Method
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CAPM model
Required return on share i = Current expected risk-free return
+ i (Equity risk premium)
¾ It’s an equilibrium model based on key assumptions:
z Investors are risk aversion;
z Investors make investment decision base on the mean return and
variance of return of their portfolio.
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CAPM model—Beta Estimates for Public Companies

¾ Estimating Beta for public company
z The choice of index: the S&P 500 and the NYSE composite.
z The length and frequency of sample data:
9most common choice is 5 years of monthly data;
9Two years of weekly data for fast grow market.
¾ Adjusted Beta for Public Companies
z Adjusted beta = (2/3) (Unadjusted beta) + (1/3) (1.0)
z Beta drift refers to the observed tendency of an estimated beta to
revert to a value of 1.0 over time.
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Estimating Beta for tiny traded stock or nonpublic companies:

zStep 1: Selecting benchmark company(comparable)
9 Use the public companies’ information in the same industry;
zStep 2: Estimate the benchmark’s beta (similar with previous section);
zStep 3: Unlevered benchmark’sª beta: º
E E
1
| «« »
»
¬1 D / E
U « » E
¼
zStep 4: lever up the unlevered beta for tiny traded stock or nonpublic
E D/E E
' ª ' ' º
| ««1 »
companies: E ¬ ¼» U
34-248

Multifactor model
¾ The beta in CAPM does not describe the risk completely. Multifactor
models are develop to account for the risks more completely.
Required Return=RF RP1 RP2 RPn

RPi factor sensitivityi u factor risk premiumi
z Factor sensitivity is also called the factor beta, it is the asset’s

sensitivity to a particular factor, and zero sensitivity to all other
factors.
35-248

Multifactor model
¾ Fama-French Model Vs. Pastor - Stambaugh model (PSM)
Required Return RF E mkt,j u ( Rmkt RF )

Small/large cap E SMB,j u ( Rsmall Rbig ) FFM
High/low book-to- PSM
market
E HML,j u ( RHBM RLBM )
E iliq (R LL-R HL)
E SMB,j ! 0, small-cap
E HML,j ! 0, value-oriented
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Example: Fama-French Model
The estimated factor sensitivities of TerraNova Energy to Fama—French factors
and the risk premium associated with those factors are given in the table below:
Factor Sensitivity Risk Premium(%)
Market Factor 1.20 4.5
Size Factor -0.50 2.7
Value Factor -0.15 4.3
A. Based on the Fama-french model, calculate the required return for TerraNova
Energy using theses estimates. Assume that the Treasure bill rate is 4.7
percent.
B. Describe the expected style characteristics of TerraNova based on its factor
sensitivities.
Answer:
A. r = 4.7%+(1.20x4.5%)+(-0.50x2.7%)+(-0.15x4.3%) = 4.7% + 5.4% - 1.35% -
0.645% = 8.1%
B. TerraNova Energy appears to be a large-cap, growth-oriented, high market risk
stock as indicated by its negative size beta, negative value beta, and market
beta above 1.0.
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Macroeconomic Multi-factor models
z Macroeconomic Multifactor models use factors associated with economic
variables. Burmerster, Roll, and Ross model incorporates the following five
factors:
9 Confidence risk: unexpected change in the difference between return of
risky corporate bonds and government bonds.
9 Time horizon risk: unexpected change in the difference between the return
of long-term government bonds and treasury bills.
9 Inflation risk: unexpected change in the inflation rate.
9 Business-cycle risk: unexpected change in the level of real business
activity.
9 Market timing risk: the equity market return that is not explained by the
other four factors.
38-248

Build-up method
z The basic idea for the required return on equity is
ri = Risk-free rate + Equity risk premium s One or more premium (discounts)
z For private business valuation
ri = Risk-free rate + Equity risk premium + Size premium
+ Specific-company premium
z Bond Yield Plus Risk Premium Method
BYPRP cost of equity = YTM on the company’s long-term debt + Risk premium
z Tips: Paying careful attention to whether there is a positive or negative sign
attached to the component----and work through it logically.
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Comparison of the methods
Methods Strength Weakness
Choosing the appropriate factor.

Very simple in that it uses
CAPM low explanatory power in some
only one factor
cases
higher explanatory power

Multifactor more complexity and expensive
(not assured)
Simple
Historical values may not be
Build-up Can apply to closely held
relevant to current market conditions
companies.
40-248

Summary of calculations:
¾ Calculate ERP (Equity Risk Premium)
z Historical estimate
z Forward-looking estimate
9 GGM estimate
9 Macroeconomic model estimate
9 Survey estimate
41-248
Summary of calculations:
¾ Calculate required rate of return
z CAPM
9 Actively traded public company
9 Adjusted Beta
9 Tiny traded or nonpublic company
zMultifactor model
9 Fama-French model (FFM)
9 Pastor-Stambaugh model (PSM)
9 Macroeconomic Multifactor models
zBuild-up method
9 Bond Yield + Risk Premium
42-248
4. International Consideration
International Consideration
¾ Exchange rate risk
z The volatility of exchange rate influences the return on foreign investment in
term of home currency;
Equity risk premium = Equity risk premium for a developed market
+ Country premium
z Country Spread Model: use a corresponding developed market as a
benchmark and add a premium for the emerging market.
9 One premium is the difference between the yield on bonds
z Country Risk Rating Model: risk ratings (published by Institutional Investor) for
those countries as the independent variable.
¾Data and model issues in emerging markets
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5. WACC
¾ The cost of capital is most commonly estimated using the company’s
after-tax weighted average cost of capital, or weighted average cost of
capital (WACC) for short.
z A weighted average of required rates of return for the component
sources of capital
MVD MVCE
WACC rd 1 Tax rate rce
MVD MVCE MVD MVCE
¾ The changes in capital structure results in changes in WACC. Eliminate
the impact from frequent changes of capital structure in estimating
WACC, the target capital structure is used to estimate the WACC.
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6. Discount rate selection in relation to cash flow
¾ Being used as discount rates in valuation, required returns need to be

defined appropriately relative to the cash flows to be discounted.
z Cash flow to equity Æ the required return on equity
z Cash flow to the firm Æ the firm’s cost of capital (after-tax weighted
average cost of capital )
¾ When cash flows are stated in real terms, amounts reflect offsets made
for actual or anticipated changes in the purchasing power of money
z Nominal cash flows Æ Nominal discount rates
z Real cash flows Æ Real discount rates
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Summary of Readings and Framework
SS 10
¾ R30 Equity Valuation: Applications and Processes
¾ R31 Return Concepts
SS 11
¾ R32 The Five Competitive Forces that Shape Strategy
¾ R33 Your Strategy Needs a Strategy
¾ R34 Industry and Company Analysis
¾ R35 Discounted Dividend Valuation
SS 12
¾ R34 Free Cash Flow Valuation
¾ R35 Market-Based Valuation: Price and Enterprise Value Multiples
¾ R36 Residual Income Valuation
¾ R37 Private Company Valuation
46-248
Equity Valuation: The framework

¾ Security Valuation and Investment Decision
Estimated Dollar Amount
Expected Cash Flow
Estimated Timing Scheme
(Discounted by Req. Rate of Return)
Present Value
> Market Value < Market Value
Buy Sell / Short Sell
¾ Valuation Process
z The Top-Down, Three-Step Approach
z The Bottom-Up Stock Valuation, Stock Picking Approach
47-248
Step 1: Global & Country

Analysis
48-248
Step 2: Industry Analysis
49-248
Industry Analysis
¾ Two central questions provide the basis for the firm’s choice of a
competitive strategy:
z Industry attractiveness: is the industry attractive in the terms of
long-term profit potential?
z Competitive advantage: How does the firm create value for buyers
(in excess of the cost of creating it), relative to other players in the
industry.
50-248
Industry Analysis: Porter's Five-Forces
Threat of New
Entrants In
The Industry
Rivalry
Among Threat of
Existing Substitutes
Competitors
Bargaining Bargaining
Power of Power of
Suppliers Buyers
51-248
¾ 1.Threat of new entrants in the industry

཰ Economiesofscale
ཱ Productdifferencesandbrandidentity
ི Switchingcosts
ཱི Capitalrequirements
ུ Accesstodistributionchannels
ཱུ Governmentpolicy
ྲྀ Costand/orqualityadvantages
52-248
¾ 2.ThethreatofSubstituteProducts:
཰ Therelativepriceperformanceofsubstitutes;
ཱ Buyerpropensitytosubstitute;
ི Switchingcosts
¾Differentiatedindustryproductsthatarevaluedbycustomersreducethis
threat.
53-248

¾ 3.BargainingPowerofBuyer:
཰Bargainingleverage:relatescloselytofactors
affectingtheotherforces,suchaslowswitching
costsandreadilyavailablesubstitutesenhance
thebargainingpowerofbuyers.
ཱThebuyer’spricesensitivitydependsupon
qualitativefactors.
54-248
¾ 4. Bargaining Power of Supplier:
཰Differentiation of inputs that are acceptable to the industry;
ཱPresence of substitute inputs is closely related to
the differentiation of inputs.
ིSupplier concentration.
ཱིImportance of volume to the supplier.
ུThe threat of forward integration.
ཱུSwitching costs.
55-248

¾ 5. The Degree of Rivalry Among Existing Competitors
཰Number of competitors.
ཱIndustry growth.
ིA high degree of operating or financial leverage.
ཱིParticipant’s commitment.
ུProduct differences.
ཱུProduct shelf life.
ྲྀThe existence of exit barriers.
ཷThe amount of informational complexity.
56-248
Factors Affect an Industry on Temporary Basis
¾ Various factors may affect an industry on a temporary basis but not

determine industry profitability and structure in the long term:
z Industry Growth Rate, a common mistake is to assume that fast-
growing industries are always attractive.
z Technology and Innovation, improved technology does not improve
profits if it attracts competitors.
z Government, these can be good or bad and are prone to change
through time.
z Complementary Products, these are products that are used in
conjunction with the firm’s products (like hot dogs and buns), and
these can have a positive or negative effect. Some complements can
create or increase barriers to entry and reduce the treat of substitutes.
57-248
Changes in Industry Structure on Long-Term
¾ Five forces drive an industry’s structural attractiveness and long-term

profitability.
z Changes in Threat of New Entrants
z Changes in Power of Suppliers and Buyers
z Changes in Threat from Substitutes
z Changes in Rivalry
z Strategic Alternatives
9 Alert for fundamental changes that can affect the strength or
weakness of the five forces.
58-248
Positioning a company
¾ Altering the Firm’s Existing Position
z Customer power.
z Supplier power.
z Substitutes.
z Threat of entry.
z Rivalry.
¾ Capitalizing on Changes in the Industry
z Forward or backward integration
z External forces
z Sudden and dramatic change
¾ Creating Changes in the Industry Structure
z Value-added overall
z Redistribution the value-added in favor of industry participants
z A firm can move the entire industry in directions that improve industry
attractiveness, it should try to move the industry.
59-248
Positioning a company
¾Steps in Using the Forces in an Industry
z Step 1: Define the industry
z Step 2: Identify the participants
z Step 3: Determine strength or weakness of each force
z Step 4: Determine industry structure
z Step 5: Assess current and potential shifts in each force
z Step 6: Decide which will affect the value of the industry or firm
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Example: Analyzing the Competitive Forces for WAL-Mart
¾ Synopsis
Wal-Mart is the world's largest retailer, selling a wide range of products targeted to
consumers and small businesses. The firm serves approximately 150 million customers per
week in the Americas, Asia, and the United Kingdom.
Wal-Mart is widely viewed as having the lowest prices on a broad variety of frequently-
purchased consumer products.
Principal competitors include other broad-based discount stores, grocery stores, as well
as small retailers operating in its geographic region. The smaller specialty retailers and
single-location boutiques compete with Wal-Mart in limited product lines.
Wal-Mart has a reputation as a formidable competitor, and many retailers have been
forced to change their business models in order to stay profitable once Wal-Mart enters
their markets.
A major development in recent years at Wal-Mart has been the deterioration in its market
image because of accusations of unfair labor practices. The firm is currently defending
several lawsuits involving its employment practices, and these have generated significant
and damaging press coverage.
61-248
Example: Analyzing the Competitive Forces for WAL-Mart

¾ Competitive Forces and Wal-Mart
z Threat of new entrants.
z Threat of substitutes.
z Bargaining power of buyers.
z Bargaining power of suppliers.
z Rivalry among existing competitors.
¾ Conclusion
Wal-Mart drives its competitive strategy through its enormous scale, which
provides significant barriers to entry, low supplier bargaining power, and low
buyer bargaining power. Substitutes are available for all products Wal-Mart sells
but usually at higher prices. Wal-Mart's scale has historically enabled it to enjoy
high profits for its industry.
A principal threat to Wal-Mart's long-term profitability is the increase in
supplier power in the form of the influence of its suppliers of labor on the court
system, the press, and public opinion. Wal-Mart should take action to reduce the
impact of these labor difficulties on the firm. In fact, it has made steps to improve
its public relations through actions such as increased and more visible charitable
giving.
62-248
Step 3: Stock Analysis
63-248
Equity Valuation: Quantitative Methods
¾ General Methods:
z Absolute methods:
9Discounted Dividend Valuation
9Free Cash Flow Valuation
9Residual Income Valuation
z Relative methods
9Market-Based Valuation: Price Multiple
¾ Special cases
z Private Company Valuation
64-248
Compare: dividends, free cash flow, and residual income
Advantages Disadvantages Suitability

• The company has a history of dividend
• theoretically payments.
• difficult for firms don't
justified • The dividend policy is clear and related to
Dividends currently pay dividends
• less volatile than the earnings of the firm.
• perspective of minority
other measures • The perspective is that of a minority
shareholder.
• Firms that do not have dividend histories
or have a dividend payment history that is
not clearly and appropriately related to
• regardless of
Free Cash earnings.
dividend policies or • very difficult
Flow • For firms with free cash flow that
capital structures
corresponds with their profitability.
• When the valuation perspective is that of
a controlling shareholder.
• Firms that do not have dividend histories.
• firms with negative
• Firms that have negative free cash flow
free cash flow and
Residual for the foreseeable future (usually due to
to dividend- and • more difficult to apply
income capital demands).
non-dividend-
• Firms with transparent financial reporting
paying
and high quality earnings.
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SS 10
SS 11
SS 12
66-248
Factors in assessing an industry
¾ Predictability: how accurately and how far into the future a company can
forecast factors, such as
z Industry demand
z Corporate performance
z Market expectations
¾ Malleability: extent to which a company and its competitors can
influence these industry factors.
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67-248
Strategy formulation styles

¾ There are four possible strategy formulation styles based on
predictability and malleability
Less Predictable More Predictable
Less Malleable Adaptive Classical
More Malleable Shaping Visionary
68-248
¾ Classical: appropriate when a company faces an environment that

is highly predictable and that cannot be easily changed.
z Example: Oil company strategist
z Entails identification of a company’s unique abilities and resources
z Formulation of a plan to achieve the most favorable market position
z Multiple rounds of methodical planning and quantitative prediction
tools are used to generate long-term forecasts.
z One of the goal is to optimize efficiency.
z Analysis of an industry based on Porter’s five forces is an example of
the classical style.
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¾ Adaptive: appropriate when a company faces an environment that is
highly unpredictable and not easily changed
z Example: Specialty fashion retailing
z Require company to react quickly to change by ensuring the company
has:
9 Willingness to constantly refine long-term goals in response to a
changing environment
9 The ability to quickly redistribute or acquire resources to meet
changing conditions
9 A goal of maximizing flexibility rather than efficiency
9 A short-term or continuous planning processes based on a
hypothesis rather than a rigid plan
9 Strategies that are closely linked to operational processes, to capture
signals for change and minimize information loss.
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¾ Shaping: appropriate when the underlying business environment is
less predictable but more malleable
z Example: software industry
z Entails a short or continuous planning cycle with a high degree of
flexibility
z Seek to influence the unpredictable business environment to further
their business interests by:
9 Building a network of committed customers, suppliers, and
partners
9 Defining new markets, technologies, and business practices
9 Promoting its interests through marketing, lobbying, and strategic
partnerships.
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¾ Visionary: appropriate when the business environment is both more

predictable and more malleable
z Example: Satellite radio firms
z Seeks to alter the environment to further the company’s interest.
z Entail high risk and can be disruptive, involving a so-called ‘build it
and they will come’ approach
z Business should:
9 Have adequate resources to commit
9 Stay focused on a long-term goal rather than constantly changing
strategy
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¾ Survival Style: a company faces severe restrictions on its access to

capital or other important resources
z The company should defensively focus on shoring up capital, cutting
expenses, restructuring, etc., in order to be ready when the business
environment improves and a longer-term strategy can be formulated.
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Pitfalls in Strategy formulation

¾ Focusing only on a predicable environment
z Most companies explicitly or implicitly assume that their business
environment is fairly predictable and use only classical or visionary
styles as a result.
¾ Inaccuracy in gauging the dimensions
z Executives often overestimate the predictability of the business
environment and their ability to affect it
¾ Relying on predefined timetables
z Use structured(e.g., annual) planning cycles even though the
business environment may change more rapidly.
z Does not take into account the dynamism of the business
environment
74-248
Pitfalls in Strategy formulation

¾ Having a cultural mismatch
z Difficult to implement an adaptive style when the corporate culture
does not support it
¾ Relying on a single style for diverse divisions of a company
z A single style would be poor fit for the company that operates in many
different industries or geographical regions.
¾ A style that does not evolve with changes in industry life cycle
z Strategy formulation style may need to change as an industry evolves
over its life cycle.
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SS 10
SS 11
SS 12
76-248
Approaches for equity valuation models

¾ Bottom-up analysis starts with analysis of an individual company or its
reportable segments.
z E.g. revenue projections based on historical revenue growth
¾ Top-down analysis begins with expectations about a macroeconomic
variable (expected growth rate of nominal GDP).
z E.g. revenue projections that are derived from an estimate of GDP
growth and an expected relationship between GDP growth and
company sales
¾ Hybrid analysis incorporates elements of both top-down and bottom-up
analysis.
z Hybrid analysis is the most common type
z Highlight any inconsistencies in assumptions between the top-down
and bottom-up approaches.
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Revenue forecast approaches
¾ Growth relative to GDP growth

z “GDP growth plus x%” or “to increase at the growth rate of GDP times 1+x%”.
gGDP+x% or gGDP *(1+x%)
¾ Market growth and market share

z Begins with an estimate of industry sales (market growth)
z Company revenue is estimated as a percentage of industry sales
z Market share times estimated industry sales provide the estimate of
company revenues.
Note that different business or geographic segments may have significantly different
relationship between GDP growth and revenue growth
78-248
Economies of scale
¾ Characteristics of economies of scale
z Higher operating margins (lower average cost) as production volume
increases
z Sales volume and margins will tend to be positively correlated
¾ Economies of scale may appear
z When larger companies(i.e. companies with higher sales) in an
industry have larger margins
z Ones way to evaluate is to look at common-size income statements
9 Evidence of economies of scale in COGS: lower COGS as a
proportion of sales for larger companies
9 Evidence of economies of scale in SG&A: Lower SG&A as a
proportion of sales for larger companies
79-248
Forecast COGS
¾ Forecast of gross margin should consider the probability that increasing or
decreasing trend of a company’s gross margin might continue
¾ Examine competitors gross margin to check the reasonableness of future gross
margin
z Differences between firms’ business models may be the underlying reasons
for differences in gross margin
z Investigate any remaining differences
¾ Closer examination of the volume and price of a firm’s inputs may improve the
quality of a forecast of COGS, especially in the short run.
z Fuel cost can be volatile and will have a significant impact on an airline’s
COGS, gross margin and net margins
z Firms using forward contract or other derivative securities to hedge their
future input costs
9 A hedge protects the firm’s gross margins from declining when input
prices rise
9 Protect the firm’s gross margins from increasing when input prices fall
¾ Estimate of a firm’s COGS may also be improved by forecasting COGS for the
firm’s various product categories and business segments separately
forecast COGS = (historical COGS/ revenue) u (estimate of future revenue)
forecast COGS = (1 gross margin) u estimate of future revenue)
80-248
Forecast Selling General and Administrative Costs(SG&A)
¾ SG&A operating expenses are less sensitive to changes in sales volume

than COGS
z Fixed component: greater than variable cost component
9 R&D expenditures
set by management over a near-term horizon
uncorrelated with revenue.
9 Expenses for corporate headquarters expenses, management
salaries, IT operations.
Grow gradually as the firm grows rather than being driven by
changes in firm sales in the current period
z Variable component: directly related to sales volumes
9 selling and distribution costs
¾ If segment information for SG&A is provided as a percentage of revenue,
SG&A for each segment can be forecasted to produce better estimates of
segment operating margins going forward
81-248
Forecast Financing cost
¾ Financial structure includes both debt and equity financing

z Net debt: gross debt minus cash, cash equivalents, and short-term
securities
z Gross interest expense: level of (gross) debt and market interest rates.
z Net interest expense: gross interest expense minus interest income on
cash and short-term debt securities.
¾ Analyst should also use any planned debt issuance or retirement and the
maturity structure of existing debt (disclosed in footnotes to financial
statements) to improve the forecasts of future financing cost.
82-248
Example: Calculating gross and net interest rates

¾ Atwood Inc. provided the following information:
$(000s) 20x1 20x2 Average*
*URVVGHEW 3,200 3,600 3,400
&DVK67 VHFXULWLHV 800 700 750
1HWGHEW 2,400 2,900 2,650
*URVVLQWHUHVWH[SHQVHIRU 220
[
,QWHUHVWLQFRPHIRU[ 8
1HWLQWHUHVWH[SHQVH[ 212
*average values=(beginning value + ending value)/2
¾ Calculate Atwood’s 20x2 interest expense on average gross and average net
debt and the yield on average cash balances.
83-248
Example: Calculating gross and net interest rates
¾ Answer
z Gross interest expense rate is 220/3,400 = 6.47%
z Net interest expense rate is 212/2,650 = 8.00%
z Yield on average cash balance is 8/750 = 1.07%
84-248
Forecast Income tax expense
¾ There are three primary tax used in analysis

z Statutory rate: the percentage tax charged in the country where the firm is
domiciled
z Effective tax rate: income tax expense as a percentage of pretax income on
the income statement
z Cash tax rate: cash taxes paid as a percentage of pretax income
¾Changes in deferred tax items account for the difference between income tax
expense and cash taxes due.
z Income tax expense= cash tax due + changes in deferred tax liabilities —
changes in deferred tax assets
85-248
Comparisons among income tax expense

¾ Statutory and effective tax rates
z Differ because there are expenses recognized in the income statement
that are not deductible for tax purposes (a permanent difference)
z A reconciliation of theses two rates is contained in the footnotes to
financial statements
9 Provide information about one-time events as well as tax rates for the
various tax jurisdictions the firm operates in.
z The effective tax rate for a corporation that has taxable income in several
countries will be a weighted average of the effective tax rates in each
country
9 Effective tax rate will increase if a company has relatively
higher(lower) earnings growth in a high tax country
¾ Analyst should pay special attention to estimates of tax rates for companies
that consistently report an effective tax rate that is less than the statutory rate
(or consistently less than that of comparable peer companies)
86-248
Forecasting balance sheet items

¾ Many balance sheet items flow from the forecasted income statement items
z net income less dividend declared flow through to retained earing
¾ Working capital items: forecast based on their historical relationship with income
statement items
z Inventory= forecasted annual COGS/ Inventory turnover ratio
z Projected accounts receivable=(days sales outstanding)h(forecasted
sales/365)
z Estimate derived in this way preserve working capital items’ relationship with
income statement items
z Absent any complicating factors, working capital items will increase at the same
rate as revenue
¾ PP&E: determined by depreciation and capital expenditure(capex)
z Assume PP&E will equal to its historical average proportion of sales(PP&E
grows at the same rate as revenue)
9 Analyst can make more accurate projections of a company’s future capital
needs by incorporating the information of company’s operations and future
plans into the model.
z Forecasts may be improved by analyzing capital expenditures for
maintenance separately from capital expenditures for growth
9 Historical depreciation should be increased by inflation rate when
estimating capital expenditure for maintenance.(replacement cost can be
expected to increase with inflation)
87-248
Forecasting balance sheet items
¾ Sensitivity analysis
z Once the forecasted financial statement are constructed, an analyst should
perform sensitivity analysis for individual assumptions, or perform analyses
with alternative assumptions(scenario analysis), to examine the sensitivity of
net income to changes in assumptions.
88-248
Return on invested capital (ROIC)
¾ The return on invested capital (ROIC) can be calculated once financial

projections are completed.
¾ Invested capital: operating assets minus operating liabilities
¾ ROIC=Net operating profit adjusted for taxes(NOPLAT)/ invested capital
z ROIC is a return to both equity and debt and is preferable to ROE because it
allows comparisons across firms with different capital structures.
z Firms with higher ROIC (relative to their peers) are likely exploiting some
competitive advantage in the production and /or sale of their products.
¾ Return on capital employed: similar to ROIC but uses pretax operating
earnings in the numerator to facilitate comparison between companies that face
different tax rate.
89-248
Competitive position based on a Porter’s five forces
¾ Companies have less (more)pricing power when the threat of substitute

products is high(low) and switching costs are low (high)
¾ Companies have less(more) pricing power when the intensity of industry
rivalry is high (low).
z Pricing power is low when industry concentration is less, fixed costs and
exit barriers are high, industry growth is slow or negative, and when products
are not differentiated to a significant degree.
¾ Company prospects for earnings growth are lower when the bargaining power
of suppliers is high.
z Few suppliers are able to extract a larger portion of any value added.
z Companies have less pricing power when the bargaining power of customers
are high
z Companies have more pricing power and better prospects for earnings
growth when the threat of new entrants is low.
90-248
Forecast sales and costs subject to price inflation and deflation
¾ Analyst should understand company’s hedging and vertical integration

z Hedge their exposure to changes in input prices through derivatives
z Make fixed-price contract for future delivery
z Switch to a substitute input. E.g. rising oil prices may lead power
generation firms to switch from oil to natural gas.
¾ For a company that neither hedges input price exposure nor is vertically
integrated, analyst should determine.
z how rapidly, and to what extent, the increase in costs can be passed on
to customers
z expected effect of price increases on sales volume and sales revenue
91-248
¾ Analyst should monitor input prices change

z Focus on significant factors affecting input prices
9 weather, the characteristics of input markets
9 Governmental regulation and taxation, tariffs
¾ Analyst should estimate the effects of an increase in input prices
z Make assumptions on the company’s pricing strategy
9 To preserve operating margins,company may cut other costs if the
increase on input prices is temporary, which is not appropriate for
long-term increases
z The effects of price increases on unit sales
9 Depend on the product’s elasticity of demand
92-248
¾ Product’s elasticity of demand

z With elastic demand, the percentage reduction in unit sales is greater than
the percentage increase in price, a price increase will decrease total sales
revenue
z Price increase with cost per unit and unit sales do not decrease(this is
unlikely), the operating profit is unchanged but gross margins, operating
margins and net margins will fall.
z Firms that are too quick to increase prices will experience declining sales
volumes
z Firms that are slow to increase price will experience declining gross margins
93-248
Example: effect of price inflation
¾ Alfredo, Inc., sells a specialized network component. The firm’s income statement for
the past year is given below
Alfredo, Inc., Income Statement for the Year Ended 20X1
Revenues 1,000 units @ $100 $100,000
COGS 1,000 units @ $100 $ 40,000
Gross profit 1,000 units @ $40 $ 60,000
SG&A $ 30,000
Operating profit $ 30,000
For 20X2, the input costs(COGS) will increase by $5 per unit.

1. Calculate the gross margin and operating margin for Alfredo, Inc., for 20X1.
2. Calculate the 20X2 gross margin and operating margin assuming that
a. Entire increase in input cost is passed on to the customers through an equal
increase in selling price. The number of units sold is not affected.
b. Selling price is increased by 5% and the number of units sold decreases by
5%
c. Selling price is increased by 5% and the number of units sold decreases by
10%
94-248

¾ Answer:
1. 20X1:
Gross margin Gross profit/sales 60%
Operating margin Operating profit/sales 30%
2. a 20X2, given an increase in unit price by $5 and no change in units sold:
Revenues 1,000 units @ $105 $ 105,000

COGS 1,000 units @ $45 $ 45,000
Gross profit $ 60,000
SG&A $ 30,000
Operating profit $ 30,000
Gross margin 57%
Operating margin 29%
95-248

¾ Answer:
b 20X2, given an increase in unit price by $5 and a decrease of 50 in units sold:
Revenues 950 units @ $105 $ 99,750

COGS 950 units@ $45 $42,750
Gross profit $57,000
SG&A $30,000
Operating profit $27,000
Gross margin 57%
96-248
¾ Answer:
c 20X2, given an increase in unit price by $5 and a decrease of 100 in units sold:
Revenues 900 units @ $105 $ 94,500

COGS 900 units@ $45 $40,500
Gross profit $54,000
SG&A $30,000
Operating profit $24,000
Gross margin 57%
97-248
Effects of technological development
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98-248
Considerations in the choice of an explicit forecast horizon
¾ For buy-side analyst, the appropriate forecast horizon may simply be

the expected holding period of a stock
¾ Highly cyclical companies present difficulties when choosing a forecast
horizon
z Long enough that the effects of the current phase of the economic
cycle are not driving above-trend or below-trend earnings effects
z Long enough to include the middle of a business cycle
z Normalized earnings are expected mid-cycle earnings, or ,
alternatively, expected earnings when the current effects of events or
cyclicality are no longer affecting earnings
z Long enough to include the perceived benefits from events such as
acquisitions, mergers, or restructurings
99-248
Projections beyond the short-term forecast horizon
¾ Assume that a trend growth rate of revenue over the previous period will
continue
¾ Estimating Pro forma financial results based on projection of each future
period’s revenue
¾ Using earnings or some measure of cash flow over forecast period
¾ Estimating terminal value
z Relative valuation approach
9 Price multiples approach: ensure that the multiple used is
consistent with the estimate of the company’s growth rate and
required rate of return
E.g. using the average P/E ratio over the last 10 years,
presupposes that the growth in earnings and required rate of
return of the stock will be the same over the previous 10 years
100-248
Projections beyond the short-term forecast horizon
z Discounted cash flow approach

9 Two key inputs: cash flow or earnings measure and an expected
future growth rate
Expected earnings/cash flow should be normalized to a mid-
cycle value that is not affected by temporary initiatives and
events
Small changes in the estimated (perpetual) growth rate of future
earnings/cash flow can have large effects on estimated terminal
values and current stock value
9 Recognizing Inflection points: those instances when the future will
not be like the past, due to changes in a company’s or an industry’s
competitive environment or changes in the overall economy
Changes in Overall economic environment
Changes in Business cycle stages
Changes in government regulations
Technology
101-248
Sales-based pro forma company model
¾ Use segment information and create segment forecasts when the

subject company has business or geographical segments that differ from
each other in important respects
¾ Use sensitivity analysis or scenario analysis to estimate a range of
possible outcomes and their probabilities when appropriate
102-248
¾ Steps in developing a sales-based pro forma model:

z Estimate revenue growth and future expected revenue (using market
growth plus market share, trend growth rate, or growth relative o GDP
growth)
z Estimate COGS (based on a percentage of sales, or on a more
detailed method based on business strategy or competitive
environment)
z Estimate SG&A (as either fixed, growing with revenue, or using some
other estimation technique)
z Estimate financing costs (using interest rates, debt levels, and the
effects of any large anticipated increases or decreases in capital
expenditures or anticipated changes in financial structure)
z Estimate income tax expense and cash taxes (using historical
effective rates and trends, segment information for different tax
jurisdictions, and anticipated growth in high- and low-tax segments)
103-248
z Estimate cash taxes, taking into account changes in deferred tax

items
z Model the balance sheet based on items that flow from the income
statement [working capital accounts (i.e. account receivable,
accounts payable, and inventory)]
z Use depreciation and capital expenditures (for maintenance and for
growth) to estimate capital expenditures and net PP&E for the
balance sheet
z Use the completed pro forma income statement and balance sheet to
construct a pro forma cash flow statement
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104-248

SS 10
SS 11
SS 12
105-248
DDM formula
Basic formula:
f
Dt
V0 ¦ (1 r )
t 1
t
¾One-period DDM:
D1 P1
V0
1 r
¾Two-period DDM:
D1 D P
V0 2 22
1 r (1 r )
¾Multi-period DDM:
D1 D2 D P
V0 ... n nn
1 r (1 r ) 2 (1 r )
106-248
The Gordon Growth Model

¾ Assumptions
z The firm expects to pay a dividend, D, in one year
z dividends will grow at a constant rate, g, forever.
z The growth rate (g) is less than the required rate (r)
¾ The formula is as follows:
D1
V0
rg
¾ Limitations
z Very sensitive to estimates of r and g
z Difficult with non-dividend stocks
z Difficult with unpredictable growth patterns (use multi-stage model)
107-248
¾ The value of a firm’s equity has two components

1)The present value of a perpetual cash flow of equity
2)The present value of its present value of growth opportunities (PVGO)
V 0 = E0 /r + PVGO
where: E=no-growth earnings level
r=required return on equity
¾ Justified P/E
z leading P/E = P 0 /E 1 = (1 – b) / (r – g)
z trailing P/E = P 0 /E 0 = (1 – b)*(1 + g) / (r – g)
108-248
¾ Strengths
z Applicable to stable, mature, dividend paying companies
z Applicable for valuing market indices
z Easily communicated and explained
z Used to determine price-implied growth rates, required rates of return, and
value of growth opportunities.
z Supplement other, more complex valuation methods.
¾ Weaknesses
z Calculate values are very sensitive to the assumed growth rate and required
rate of return
z Not applicable to non-dividend paying stocks
z Inapplicable to unstable growth, dividend-paying stocks
109-248
Discounted cash flow models

¾Valuing Preferred Stock
z The preferred stock holders are promised to receive a stated dividend for an
infinite period.
z Preferred stock is perpetuity since it has no maturity.
z Valuation model of a preferred stock:
Dp Dp Dp Dp
Vp = + 2
+ + N
=
1+k p 1+k p 1+k p kp
110-248
Multistage Dividend Discount Models

¾Two-stage DDM: the growth rate starts at a high level for a relatively short
period of time, then reverts to a long-run perpetual level
111-248
¾ Two-stage DDM
Example: Calculating value with a two-stage DDM
Sea Island Recreation currently pays a dividend of $1.00. An analyst forecasts
growth of 10 percent for the next three years, followed by 4 percent growth in
perpetuity thereafter. The required return is 12 percent. Calculate the current value
per share.
112-248

¾ H-Model : the growth rate starts out high, and then declines linearly over
the high-growth stage until it reaches the long-run average growth rate
Vo
> D0 u (1 g L )@ > D0 u H ( g s g L )@
r gL
t
H
2
113-248

H-Model
¾Example: Calculating value with the H-model
Omega Foods currently pays a dividend of €2.00. The growth rate, which is
currently 20 percent, is expected to decline linearly over the next 10 years to a
stable rate of 5 percent thereafter. The required return is 12 percent. Calculate
the current value of Omega.
¾Answer: 10
2 u ( ) u (0.2 0.05)
2 u1.05 2
V0 30 21.43 51.43
0.12 0.05 0.12 0.05
Remember that the H-model provides only an approximation of the value of
Omega shares. To find the exact answer, we’d have to forecast each of the first
ten dividends, applying a different growth rate to each, and then discount them
back to the present at 12 percent. In general, the H-value approximation is
more accurate the shorter the high-growth period, t, and/or the smaller the
spread between the short-term and long-term growth rates, gS-gL
114-248
¾Three-stage DDM: the growth rate fits the three growth stages
1. R&M has a current dividend of $1.00 and a
required rate of return of 12 percent. A dividend
growth rate of 15 percent is projected for the
next two years, followed by a 10 percent growth
rate for the next four years before settling down
to a constant 4 percent growth rate thereafter.
Calculate the current value of R&M.
2. As an analyst, you have gathered the following
information on a company you are tracking. The
current annual dividend is 0.75. Dividends are
expected to grow at a rate of 12 percent over the
next three years, decline linearly to 4 percent
over the next six years, and then remain at a
long-term equilibrium growth rate of 4 percent in
perpetuity. The required return is 9 percent.
Calculate the value of the company.
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¾Answer 1:
Relevant Cash Flows for R&M Example
Time Value Calculation D t or V t
1 D1 $1.00(1.15) $1.150
2 D2 $1.150(1.15) $1.323
3 D3 $1.323(1.10) $1.455
4 D4 $1.455(1.10) $1.600
5 D5 $1.600(1.10) $1.760
Now we enter the cash flows into our calculator, noting that the total cash flow at Time
6 is $1.936+ $25.168 = $27.104: CF0 = 0;C01 = 1.150; C02 = 1.323;C03 = 1.455;
C04= 1.600;C05= 1.760; C06= 27.104; I= 12;CPTNPV= 18.864.
According to the three-stage model, R&M is worth $18.864 today. This question is tedious,
but it is not a question to be feared, as long as your calculator batteries hold tip.
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¾Answer 2:
Let’s start by valuing the last two stages using the H-model. We know that:
V3 ¬ª D3 u 1 g L ¼º ¬ª D3 u H g S g L ¼º
r gL
D3 3 D0 1 ! g S 3 $0.751.12 3 $1.0537
3 3
It follows that:
ª 6 º
ª¬ $1.0537 u 1.04 º¼ « $1.0537 u u 0.12 0.04 »
V3 ¬ 2 ¼ $26.9747
0.09 0.04
Now we have a series of three cash flows to discount in order to find the current
value of the stock, and our financial calculator does the rest of the work.
CF0 = 0; C01 = D1 = $0.75(1.12) = $0.84; C02 = D2= $0.75(1.12)2 = $0.9408;
and C03 = D3 + V3= $ 1.0537 + $26.9747 = $28.0284; I = 9;
CPT NPV = 23.2056.
The price of the stock is $23.2056.
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¾Spreadsheet modeling
z In practice we can use spreadsheets to model any pattern of dividend
growth we’d like with different growth rates for each year because the
spreadsheet does all the calculations for us.
z It can involve a great deal of information and can project different growth
rates for differing periods.
z The reason for this is the inherent flexibility and computational accuracy
of spreadsheet modeling.
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Growth phase, Transitional phase, and Maturity phase
Growth Phase
Variable
Initial Growth Transition Maturity
Earnings
• Very high • Above average but falling • Stable at long-run level
Growth
Capital • Significant
• Decreasing • Stable at long-run level
Investment requirements
Profit Margin • High • Above average but falling • Stable at long-run level
• May be positive and

FCFF • Negative • Stable at long-run level
growing
ROE Vs.
Required • ROE > r • ROE approaching r • ROE = r
Return
Dividend payout • Low or zero • Increasing • Stable at long-run level
Appropriate
• Three-stage • Two-stage • Gordon growth
Model
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The Financial Determinants of Growth Rates

¾ SGR (sustainable growth rate) : the rate at which earnings can continue to grow
indefinitely.
SGR = b * ROE b: (1 – dividend payout rate)
¾ PRAT Model: where SGR is a function of the profit margin (P), the retention rate
(R), the asset turnover (A), and the degree of financial leverage (T).
g = ((net income – dividends)/net income) * profit margin * the asset turnover *

financial leverage
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Equity analysis
¾Ratio analysis
z From global industry points of view: analysts should make the comparisons
of each firm in the industry against the benchmark industry average
¾DuPont model
z is commonly used to analyze past performance
z NI NI EBT EBIT Sales assets
ROE u u u u
equity EBT EBIT Sales assets equity
z ROE = tax retention rate * interest burden * operating margin * asset
turnover * leverage
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¾ Example: Calculating value with a two-stage DDM
Given the following partial balance sheets and income statement for Horizons
Company, calculate three components of the ROE (using the DuPont model) and
the sustainable growth rate for 2008 based on beginning balance sheet values.
Assume the dividend payout ratio is 30%. All values are in millions of USD.
Far Horizons Income Statement

Income statement for fiscal year 2008
Sales $40.0
Net income $1.8
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Far Horizons Balance Sheet
Balance sheet fiscal year end 2007 and 2008
2007 2008 2007 2008

Liabilities $10.0 $20.0
Assets $30 $50
Equity 20.0 30.0
Total $30.0 $50.0 Total $30.0 $50.0
¾ Answer:
$1.80
profit margin= 0.045 4.5%
$40.00
$40.00
asset turnover= 1.333
$30.00
$30.00
financial leverage= 1.5
$20.00
ROE=0.045 u1.333 u1.5 0.09 9.0%
g=ROE u b 0.09 u 1 0.30 6.3%
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SS 10
SS 11
SS 12
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Introduction to Free Cash Flows

¾The reason for Using Free Cash Flow(FCFF/FCFE):
z Many firms pay no, or low, cash dividends.
z Dividends are paid at the discretion of the board of directors. It may,
consequently, be poorly aligned with the firm’s long-run profitability.
z 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 (control perspective).
z Free cash flows may be more related to long-run profitability of the firm as
compared to dividends.
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¾The Choice of using FCFF or FCFE
z FCFE is easier and more straightforward to use in cases where the
company’s capital structure is not particularly volatile.
z If a company has negative FCFE and significant debt outstanding, FCFF
is generally the best choice
Equity value=Firm value – Market value of debt
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FCFF and FCFE Valuation Approaches

¾ 1)
FCFF: the cash flow available to all of the firm’s investors (stock holders
and bondholders) after all operating expenses (including tax) have been
paid and necessary investments in working capital and fixed capital have
been made.
z The value of the firm is estimated as the present value of the expected future
z FCFF discounted at the WACC:
FCFFt = FCFFt-1 h (1+g)
z Constant Growth Valuation Model
Firm Value=FCFF1 / (WACC-g) = FCFF0(1+g) / (WACC-g)
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FCFF and FCFE Valuation Approaches

¾ 2)
FCFE: the cash flow from operations minus capital expenditures minus
payments to (and plus receipts from) debt-holders.
z The value of equity: the present value of the expected future FCFE discounted at
the required return on equity(r).
FCFEt = FCFEt-1 h (1+g)
z The methods to estimate r:
CAPM, APT, the Gordon growth model, and a build-up method
z Constant Growth Valuation Model
Equity Value=FCFE1 / (r-g)
=FCFE0(1+g) / (r-g)
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FCFF and FCFE Valuation Approaches-Summary
¾ FCFF
z From NI: FCFF = NI NCC - WCINV Int u (1- T ) - FCINV
z From EBIT: FCFF =EBIT u 1- T Dep - FCINV - WCINV
z From EBITDA: FCFF =EBITDA u 1- T Dep u T - FCINV - WCINV
z From CFO: FCFF =CFO Int u 1 T - FCINV
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FCFF and FCFE Valuation Approaches-Summary

¾ FCFE
z From NI: FCFE NI (1 DR) u ( FCINV Dep) (1 DR) u WCINV
z From EBIT: F C F E E B IT u 1 - T - Int u (1 - T ) D ep
- F C IN V - W C IN V + N et B orrow ing
z From EBITDA: FCFE EBITDA u 1- T - Int u (1- T ) Dep u T

- FCINV - WCINV Net Borrowing
z From CFO: FCFE CFO FCINV Net Borrowing
z From FCFF: FCFE FCFF Int u (1- T ) Net Borrowing
z Given Debt ratio: FCFE = NI+Dep -WC Inv -FC Inv + WC Inv +FC Inv -Dep u DR
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Calculating FCFF From EBIT and EBITDA

1. From NI:
FCFF = NI NCC - WCINV Int u (1- T ) - FCINV
2. From EBIT:
FCFF =EBIT u 1- T Dep - FCINV - WCINV
3. From EBITDA:
FCFF =EBITDA u 1- T Dep u T - FCINV - WCINV
NI = (EBIT - Int)(1 - T) = EBIT h(1-T) - Int h(1-T)

= (EBITDA – Dep – Int)(1-T)
= EBITDA h(1-T) – Dep h (1-T) – Int h (1-T)
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Calculating FCFF From CFO
4. Relationship between FCFF and CFO
¾From CFO:
CFO = NI +NCC - WCInv
FCFF= CFO + Interest expense * (1- tax rate) - Investment in fixed capital
or FCFF = CFO + Inth(1 - T) - FCInv

¾Attentions:
Whether interest expense was taken out of net income and out of CFO
If yes, add it back
If no, keep it in and avoid double calculation.
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NCC (Non-cash charges) Adjustments

Issue #1: NCC (Non-cash charges) adjustments for FCFF
z The most significant noncash charge is usually depreciation (add back).
z Amortization of intangibles should be added back to net income, much like
depreciation.
z Provisions for restructuring charges and other noncash losses should be
added back to net income. If the firm is accruing these costs to cover future
cash outflows, then the forecast of future free cash flow should be reduced
accordingly. Gains and losses on sale of long-term assets are also removed
(they would be accounted for under fixed capital investment).
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NCC (Non-cash charges) Adjustments

Issue #1: NCC (Non-cash charges) adjustments for FCFF
z Income from restructuring charge reversals and other noncash gains
should be subtracted from net income.
z The amortization of a bond discount should be added back to net income,
and the accretion of the bond premium should be subtracted from net
income to calculate FCFF.
z Deferred taxes, which result from differences in the timing of reporting
income and expenses for accounting versus tax purposes, must be carefully
analyzed.
9 Over time, differences between book and taxable income should offset
each other and have no significant effect on overall cash flows.
9 If, however, the analyst expects deferred tax liabilities to continue to
increase (i.e., not reverse), increases in deferred tax liabilities should be
added back to net income.
9 Increases in deferred tax assets that are not expected to reverse should
be subtracted from net income.
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Example: NCC (Non-cash charges) Adjustments
¾ Example: use the following information to answer Questions 17 through 19.
Meyer Henderson, CFA, is analyzing the financials of Roth Department Stores.
He intends to use a free cash flow to the firm (FCFF) model to value Roth's
common stock. In the 2007 financial statements and footnotes he has identified
the following items:
z Item #1: Roth reported depreciation and software amortization of $23 million
in 2007.
z Item #2: The deferred tax liability increased by $17 million in 2007.
z Item #3: Roth reported income of $6 million in 2007 from the reversal of
previous restructuring charges related to store closings in 2006.
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Example: NCC (Non-cash charges) Adjustments

¾ Example: use the following information to answer Questions 17
through 19.
z Item #4: Net income totaled $173 million in 2007.
z Item #5: The net increase in noncash net working capital accounts was $47 million in
2007.
z Item #6: Net capital spending totaled $86 million in 2007.
z Item #7: Roth reported interest expense of $19 million.
¾ Answer
z Henderson estimated Roth's marginal tax rate to be 35%. He also expects Roth to be
profitable for the foreseeable future, so he does not expect the deferred tax liability to
reverse. As the base-year projection for his FCFF valuation, Henderson calculates
FCFF for 2007 as:
FCFF2007 = $173 + $23 - $6 + $17 + [$19(1- 0.35)] - $86 - $47 =

$86.35 million
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WC Calculation
INV
Issue #2: Calculation WCInv
z The investment in net working capital is equal to the change in

working capital.
WCINV =WCt WCt 1
z Excluding cash, cash equivalents, notes payable, and current
portion of long-term debt.
z + sign in front of a reduction in working capital
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FC Calculation
INV
Issue #3: Calculation FCInv

z Fixed capital investment is a net amount: It is equal to the difference between
capital expenditures (investments in long-term fixed assets) and the proceeds
from the sale of long-term assets:
FCInv = Capital Expenditure – Proceeds from sales of long-term assets
z Both capital expenditures and proceeds from long-term asset sales (if any)
are likely to be reported on the firm’s statement of cash flows.
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FC Calculation
INV
Pay attention to FCINV :

¾ If no long-term assets were sold during the year, then capital
expenditures will also equal the change in the gross PP&E account
from the balance sheet:
z FCInv = Capital Expenditure =gross PP&Et – gross PP&Et-1
z FCInv = net PP&Et – net PP&Et-1+ depreciation
¾ The difference between gross PP&E and net PP&E is depreciation
z gross PP&Et = net PP&Et + accumulate depreciation
z “depreciation” defines to the depreciation from time t-1 to time t
z Does “depreciation” equal to “accumulate depreciation” ?
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Forecasting Free Cash Flow

Pay attention to FCINV :
¾If long-term assets were sold during the year:
z Items in the cash statement
9 “Purchase of fixed assets”
9 “Purchase of PP&E”
9 “Proceeds from disposal of fixed assets”
FCInv = Capital Expenditure – Proceeds from sales of long-term assets
z Not given directly, find gain (loss) on asset sales from the income
statement and PP&E figures from balance sheet:
FCInv = ending gross PP&E – beginning gross PP&E – gain on sale
FCInv = ending net PP&E – beginning net PP&E + depreciation – gain

on sale
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Example: Calculating FCINV with no long-term asset sales
¾ Example (1): Airbrush, Inc. financial statements for 2009 include the following
information:
2009 2008
Gross PP&E 5,000 4,150
Accumulated depreciation 1,500 1,200
Net PP&E 3,500 2,950
There were no sales of PP&E during the year; depreciation expense was $300.
Calculate Airbrush’s FCINV for 2009.
¾ Answer:
FCINV =ending gross PP&E-beginning gross PP&E =capital expenditures =
$5,000 - $4,150 = $850
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Example: Calculating FCINV with long-term asset sales
¾ Example (2): Calculating FCINV with long-term asset sales

Use the same information for Airbrush, Inc. as in the previous example, but now
also suppose that the company reports capital expenditures of $1,400, long-term
asset sales of $600, and depreciation expense of $850. The long-term assets
sold were fully depreciated. Calculate Airbrush’s revised FCINV for 2009.
¾ Answer:
Revised FCINV = capital expenditures – proceeds from sales of long-term
assets = $1,400 -$600 =$800
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Example: Calculating FCFF

¾ Example (3): Given the following information, calculate FCFE:
z Net income = $50.
z Working capital investment = $4.
z Beginning gross fixed assets = $90; ending gross fixed assets = $136.
z Beginning accumulated depreciation = $30; ending accumulated depreciation = $40.
z Depreciation expense = $27.
z Capital expenditures = $65.
z Net borrowing = $0.
z In addition, a piece of equipment with an original book value of $19 was sold for $10.
The equipment had a book value at the time of the sale of $2. The gain was classified
as unusual. Free cash flow to equity is closest to:
A. $6 B. $10 C. $18
¾ Answer:
z B Recognize that the firm generated $10 in cash and a noncash $8 gain on the sale of
the equipment. Then calculate FCFE as NI plus depreciation minus the noncash gain
minus FCInv minus WCInv + net borrowing:
FCFE = $50 + $27 - $8 - ($65-$10) - $4 + $0 = $10
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Calculating FCFE
Issue #4: net borrowing
FCFE:
z From FCFF: FCFE FCFF Int u (1- T ) Net Borrowing
z From CFO: FCFE CFO FCINV Net Borrowing
z From NI: FCFE NI Dep FCINV WCINV Net Borrowing
z Preferred Stock: FCFE FCFF - Int u (1- T ) - Div pre Net Borrowing
¾Net Borrowing = long- and short-term new debt

– long- and short-term debt repayments
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Calculating FCFE
Issue #5: Free Cash Flow with Preferred Stocks

¾ Remember to treat preferred stock just like debt, except preferred
dividends are not tax deductible.
z Preferred Stock:
FCFF = NI NCC - WCINV Int u (1- T ) Div pre - FCINV

FCFE FCFF - Int u (1- T ) - Div pre Net Borrowing
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Example: Calculating FCFF with Preferred Stock
¾ An analyst following Barlow Energy has compiled the following information in preparation for
additional analysis she has to include in a report she has been asked to produce (data is in
hundreds of millions of $):
Security Type Market Value Before-Tax Required Return
Preferred stock 200 7.0%
Bonds 600 7.5%
Common Stock 700 14.0%
Total 1500
• Bondsare trading at par.
• Preferred
share dividends: $14
• Net income available to common: $125
• Investment in working capital: $30
• Investment in fixed capital: $100
• Net new borrowing: $40
• Depreciation: $50
• Tax rate: 40%
The current FCFF for Barlow Energy is closest to:
A. $36 B. $62 C.$86
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Example: Calculating FCFF with Preferred Stock
¾Answer:
Solution: C
z C With the bonds trading at par, the interest expense is based on the
before-tax yield:
interest = $600 h 0.075 = $45

z Addback preferred dividends to net income available to common to get
FCFF:
FCFF = NI (available to common) + NCC + [Int h (1- tax rate)] + preferred

dividends -FCInv - WCInv
FCFF= 125 +50+[45h(1- 0.40)]+14-100-30=$86
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Calculating FCFE with Target Capital Structure

Issue #6: Target Debt Ratio
z If a target debt ratio exists, Net borrowing = (WCInv+ FCInv- Dep) h
DR
z To calculate historical FCFE and apply some constant growth rate.
z To forecast the components of free cash flow. e.g. one popular
method is to forecast: the individual components of free cash flow –
EBIT (1-T), net noncash charges, investment in fixed capital,
investment in working capital, and net borrowing.
¾Estimating net borrowing
FCFE = NI + Dep – WCInv – FCInv + (WCInv + FCInv - Dep) h DR
DR: target debt ratio
Net borrowing = (WCInv + FCInv - Dep) h DR
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Forecasting Free Cash Flow
¾ Dividends, share repurchases, and share issues have no effect on FCFF

and FCFE; leverage changes have only a minor effect on FCFE and no
effect on FCFF
¾ Net income is a poor proxy for FCFE, and EBITDA is a poor proxy for
FCFF
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Example: Calculating FCFF and FCFE
¾ Anson Ford, CFA, is analyzing the financial statements of Sting’s Delicatessen. He has a
2009 income statement and balance sheet, as well as 2010 income statement, balance
sheet, and cash flow from operations forecasts (as shown in the tables below). Assume
there will be no sales of long-term assets in 2010. Calculate forecasted free cash flow to the
firm (FCFF) and free cash flow to equity (FCFE) for 2010.
Income Statement
2010 Forecast 2009 Actual
Sales $300 $250
Cost of goods sold 120 100
Gross profit 180 150
SG&A 35 30
Depreciation 50 40
EBIT 95 80
Interests expense 15 10
Pre-tax earnings 80 70
Taxes (at 30%) 24 21
Net income $56 $49
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Balance Sheet
2010 Forecast 2009 Actual
Cash $10 $5
Accounts receivable 30 15
Inventory 40 30
Current assets 80 50
Gross property, plant and
400 300
equipment
Accumulated depreciation -190 -140
Total assets 290 210
Accounts payable 20 20
Short-term debt 20 10
Current Liabilities 40 30
Long-term debt 114 100
Common stock 50 50
Retained earnings 86 30
Total liabilities and owners’
290 210
equity
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Cash Flow From Operations Forecasts for 2010
Net income $56
+ depreciation 50
- WCINV 25
Cash flow from operations $81
¾Answer
z Fixed capital investment is equal to capital expenditures (because there are
no asset sales), which is equal to the change in gross PP&E:
FCInv = 400 - 300 = 100
z Working capital investment is the change in the working capital accounts,
excluding cash and short-term borrowings:
WCInv = (AcctsRec2010 + Inv2010 - AcctsPay2010) - (AcctsRec2009 +

Inv2009 – AcctsPay2009)
WCInv= (30 + 40 - 20) - ( 15 + 30 - 20) = 50 – 25 = 25
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z Given that depreciation is the only noncash charge, we can calculate FCFF
from net income:
FCFF = NI + NCC + [lnt x (1 - tax rate)] - FCInv - WCInv

= 56 + 50+ [15 x (1 - 0.3)] – 100 – 25 = -8.5
= 56 +50 + 10.5 - l00 – 25 = -8.5
z Its entirely possible that FCFF can be negative in the short term. Well talk
more later about how to value firms with negative FCFF.
z Net borrowing is the difference between the long-term and short-term debt
accounts:
Net Borrowing = (114 + 20) - (100 + 10) = 24

FCFE = FCFF - [lnt x (1 - tax rate)] + net borrowing
= -8.5 - 10.5 + 24 = 5
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Free Cash Flow Model Variations

¾ Single-Stage Model
FCFF1
For FCFF valuation: Vo Firm Value
WACC g
FCFE1
For FCFE valuation: Vo Equity Value
rg
z The importance of various forecasting errors can be assessed through comprehensive
sensitivity analysis
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Example (1): Single-Stage Model
¾Example: Calculating firm value with a single-stage FCFF model

Knappa Valley Winery’s (KVW) most recent FCFF is $5,000,000. KVW’s target
debt-to-equity ratio is 0.25. The market value of the firm’s debt is $10,000,000, and
KVW has 2,000,000 shares of common stock outstanding. The firm’s tax rate is 40
percent, the shareholders require a return of 16 percent on their investment, the
firm’s before-tax cost of debt is 8 percent, and the expected long-term growth rate
in FCFF is 5 percent. Calculate the value of the firm and the value per share of the
equity.
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¾Answer:
Note that the problem gives the FCFF in the most recent year (FCFF0). Therefore, you
need to increase FCFF0 at the growth rate by one year (at the 5% rate) to get FCFF1.
let’s calculate the WACC. The target debt-to-equity ratio is 0.25. This implies that for every
$1 of debt, there is $4 of equity, for total capital of $5. Since total assets equals total capital,
it follows that the target debt-to-asset ratio is 1/5, or 20%, and the target equity-to-asset
ratio is 4/5, or 80%.The WACC is: WACC (0.8 u 0.16) > 0.20 u 0.08(1 0.40) @ 0.1376 13.76%
5, 000, 000 u1.050
We can now calculate the value of the firm as: Value of firm $59,931,507
0.1376 0.050
Given that debt is worth $10,000,000θthe implied total value of the equity is:
Value of equity $59,931,507 $10, 000, 000 $49,931,507
$49,931,507
With 2,000,000 shares outstanding, the value of the equity per share is: $24.97
2, 000, 000
Notice that the actual debt-to-equity ratio (10,000,000/49,931,507 = 0.20) does not equal
the target ratio of 0.25. There is nothing inconsistent in this example. WACC is usually
calculated using target capital weights.
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¾Example: Calculating value with a single-stage UCUE model
Ridgeway Construction has an FCFE of 2.50 Canadian dollars (C$) per share
and is currently operating at a target debt-to-equity ratio of 0.4. The expected
return on the market is 9 percent, the risk free rate is 4 percent, and Ridgeway has
a beta of 1.5. The expected growth rate of FCFE is 4.5 percent. Calculate the value
of Ridgeway stock.
¾Answer:
Begin by computing the required return on equity with the CAPM:
r = 0.04 + [1.50 * (0.09-0.04)] = 0.115 = 11.5%

Note that the problem gives FCFE in the most recent year (FCFE0). The model
calls for the FCFE next year, witch is FCFE1. Therefore, you need to multiply
FCFE0 by one plus the growth rate to get FCFE1. The equity value per share is:
C $2.50 u1.045
Equity value per share C $37.32
0.115 0.045
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¾ Two-Stage Model
z Step 1: Calculate FCF in high-growth period
z Step 2: Use single-stage FCF model for terminal value at end of high-growth
period
FCFFt 1
terminal value =
WACC g
z Step 3: Discount interim FCF and terminal value to time zero to find stock
value; use WACC for FCFF, r for FCFE
FCFF1 FCFF2 FCFFt terminal value
Value of the firm
1 WACCh 1 WACCh 2
1 WACCh
t
FCFE1 FCFE2 FCFEt terminal value

Value of equity
1 rh 1 rh
2
1 rh
t
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Example: Two-Stage Model
¾ Example:
The Prentice Paint Company earned a net profit margin of 20% on revenues of $20
million this year. Fixed capital investment was $2 million, and depreciation was $3
million. Working capital investment equals 7.5% of sales every year. Net income,
fixed capital investment, depreciation, interest expense, and sales are expected to
grow at 10% per year for the next five years . After five years, the growth in sales,
net income, fixed capital investment, depreciation , and interest expense will
decline to a stable 5% per year. The tax rate is 40%, and Prentice has 1 million
shares of common stock outstanding and long-term debt paying 12.5% interest
trading at its par value of $32 million. Calculate the value of the firm and its equity
using the FCFF model if the WACC is 17% during the high-growth stage and 15%
during the stable stage.
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¾ Answer:
The components of FCFF are calculated in the following table.
FCFF for Years 0 Through 6 (in per-share amounts of $)
0 1 2 3 4 5 6
Sales($) 20.00 22.00 24.20 26.62 29.28 32.21 33.82
Net Income 4.00 4.40 4.84 5.32 5.86 6.44 6.76
Interest(1-T) 2.40 2.64 2.90 3.19 3.51 3.87 4.06
Depreciation 3.00 3.30 3.63 3.99 4.39 4.83 5.07
FCInv 2.00 2.20 2.42 2.66 2.93 3.22 3.38
WCInv 1.50 1.65 1.82 2.00 2.20 2.42 2.54
FCFF $5.90 $6.49 $7.13 $7.84 $8.63 $9.50 $9.97
Step 2
Let’s demonstrate the calculation of FCFF in Year 0:
net income =$20.00h0.20=$4.00
interest =$32.00h0.125=$4.00
interest(1-T) =$4.00h(1-0.40)=$2.40 Step 1
WCInv =$20.00h0.075=$1.50
FCFF =$4.00+$2.40+$3.00-$2.00-$1.50=$5.90
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¾ Answer:
z In Year 1, sales grow by 10% to $22.00 per share. Following five years of
10% growth, the growth of each component falls to 5%.
z The terminal value (as of Year 5, discounted at the stable WACC of 15%) is:
FCFF6 $9.97
z Terminal value = $99.70 Step 3
WACC g 0.15 0.05
z We can place the cash flows to be evaluated on a time line, such as the one
in the following figure, to get a clearer picture of what we need to evaluate.
z FCFF Timeline
Step 4
$6.49 $7.13 $7.84 $8.63 $9.50+99.70=$109.20
0 1 2 3 4 5
z Notice that WACC in the high-growth stage(17%) is different than the stable
stage(15%)
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¾ Answer:
z We calculated terminal value in Year 5 using 15%, but we’ll calculate the
present value today of the high-growth cash flows and the terminal value at
17%. The total of the firm today is:
$6.49 $7.13 $7.84 $8.63 $109.20
z value of firm= $70.06 Step 5
1.171 1.17 2 1.173 1.17 4 1.175
z Since, in all likelihood, we would want to use our financial calculators to
perform this calculation more quickly and accurately, the appropriate
keystrokes are: Step 6
CF0 =0; C01=6.49; C02=7.13; C03=7.84; C04=8.63; C05=109.20; I=17;
CPTNPV=70.06
z Thus, given that the value of the firm’s debt is $32 per share, the value of
equity per share is $70.06 - $32.00=$38.06
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Three-Stage Model
z Step1: Calculate FCF in high-growth and transitional period
z Step2: Discount each FCF to PV, notice the different discount rate in High-
FCFEn
Growth period, Transitional period: PV of FCFE n n
(1+Required return high )
FCFEt
z For example: PV of FCFE t
(1+Required return high ) n u (1 Required return transitional )t n
z Step 3: Use single-stage FCF model for terminal value at end of transitional
period: FCFE t 1
Terminal value =
Required rate of return long trem g
z Step 4: Calculate terminal value to PV, using the same method as Step 2
z Step 5: Added all PV together
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Example : Three-Stage FCFE Model

¾ Medina Classic Furniture, Inc. is expected to experience growth in three
distinct stages in the future. Its most recent FCFE is 0.90 Canadian
dollars (C$) per share. The following information has been compiled:
High-growth period:
zDuration=3 years
zFCFE growth rate =30%
zShareholder’s required return= 20%
Transitional period:
zDuration= 3 years
zFCFE growth will decline by 9% per year down to indicated stable growth rate
zShareholder’s required return = 15%
Stable-growth period:
zFCFE growth rate = 3%
zShareholder’s required return = 10%
Calculate the value of the firm’s equity using the three-stage FCFE model.
165-248
¾ Answer:
z The annual FCFE and the associated present value are presented in the
table:
FCFE and PV
High-Growth
Year 1 Year 2 Year 3
Period
Growth rate 30% 30% 30%
FCFE C$1.170 C$1.521 C$1.977
PV(@ 20%) C$0.975 C$1.056 C$1.144
Transitional
Year 4 Year 5 Year 6
Period
Growth rate 21% 12% 3%
FCFE C$2.393 C$2.680 C$2.760
PV C$1.204 C$1.173 C$1.050
166-248

z The transitional present values are computed using a combination of the 20%
initial discount rate and the transitional 15% rate. For example, the present
value of FCFE, is computed as:
C $2.680
C $1.173
1.203 u1.152
z We can calculate the terminal value of the stock as of Year 6 using the FCFE
projected for Year 7. Notice that we use the stage 3 required return of 10%.
$2.760 u1.03
terminal value = $40.611
0.10 0.03
z The value of Medina stock is :
§ 40.611 ·
value per share =0.975+1.056+1.144+1.204+1.050+ ¨ 3 ¸
C $22.055
© 1.20 u 1.15 ¹
3
z The changing discount rates were important here for a couple of reasons.
First, the terminal value in Year 6 had to be discounted for three years at 20%
and for was not as helpful as it was in other multiple cash flow calculations. It
simply cannot handle the changing discount rates in one easy set of
calculations.
167-248
Sensitivity Analysis in FCFF and FCFE
¾ Sensitivity analysis shows how sensitivity analyst’s valuation results are to

changes in each of a model’s inputs.
¾ Two major sources are:
z Estimating the future Growth rate in the FCFF and FCFE.
z The chosen base year for the FCFF or FCFE growth forecasts.
168-248
Approaches for Calculating the Terminal Value
¾ Two major valuation approaches:
z Single-stage
z Multiple approach
terminal value in year n=(trailing P/E) u (earnings in year n)

terminal value in year n=(leading P/E) u (forecasted earnings in year n+1)
169-248

SS 10
SS 11
SS 12
170-248
Price Multiples
¾ Introduction to Price Multiples
¾ P/E
¾ P/B
¾ P/S
¾ P/CF
¾ EV/EBITDA
¾ Dividend Yield
¾ Momentum Valuation Indicators
171-248
Introduction to Price Multiples
¾ The method of comparables is perhaps the most widely used approach

for analysts reporting valuation judgments on the basis of price multiples
¾ The economic rationale for the method of comparables is the Law of One
Price.
¾ A justified price multiple for the stock is the estimated fair value of
multiples.
¾ We can justify a multiple based on the method of comparables or the
method based on forecasted fundamentals
¾ The justified price multiple is also called the warranted price multiple or
the intrinsic price multiple
172-248
P/E
¾Advantages & Disadvantages
z Advantages:
9 Earning power is the primary determinant of value;
9 P/E ratio is popular;
9 P/E differences are related to long-run average stock returns
z Disadvantage:
9 Earnings might be negative;
9 volatile earning;
9 management discretion distorts
¾Justified P/E
z Leading 1 b
P / E1
rg
z Trailing (1 b)(1 g )
P / E0
rg
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Normalizing EPS
¾Two methods for

z The method of historical average EPS
9 Normal EPS is calculated as average EPS over the most recent full
cycle
9 one of several possible statistical approaches to the problem of cyclical
earnings
9 the method does not account for changes in the business’s size
however
z The method of average ROE
9 Normal EPS is calculated as the average return on equity from the most
recent full cycle, multiplied by current book value per share
9 by using recent book value per share, reflects more accurately the effect
on EPS of growth or shrinkage in the company’s size
9 For that reason, the method of average ROE is sometimes preferred
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Example: Normalizing EPS
z Using the data in the following figure, calculate normalized earnings using the
method of historical average EPS and the method of average return on equity
for Magnolia Enterprises.
z Data for Magnolia Enterprises [amounts in Canadian dollars (C$)]
Year 2006 2007 2008 2009
EPS 4.20 3.75 4.75 4.30
BVPS 26.02 27.78 29.25 32.29
ROE 14.0% 12.0% 16.0% 14.0%
z Answer:
4.20 3.75 4.75 4.30
Normalized earnings (average EPS approach)= 4.25
4
0.14 0.12 0.16 0.14
Average ROE = 0.14 14.00%
4
z Normalized earnings are C$4.25 based on the method of historical average
EPS and C$4.52 based on the method average return on equity.
Normalized earnings (average ROE approach) = Average ROE u BVPS2009
0.14 u 32.29 4.52
175-248
P/E to growth (PEG) ratio
¾P/E to growth (PEG) ratioφ

P/E Ratio
PEG ratio=
g
z One metric that appears to address the impact of earnings growth on P/E
ratios.
z Calculated as the stock’s P/E divided by the expected earnings growth rate.
The ratio in effect calculates a stock’s P/E per unit of expected growth.
z Stocks with lower PEGs are more attractive than stocks with higher PEGs,
all else equal.
z The PEG ratio must be used with care for several reasons:
9 Assumes a linear relationship between P/E ratios and growth. The
model for P/E in terms of DDM shows that in theory the relationship is
not linear.
9 Does not factor in differences in risk, a very important component of
P/E ratios.
9 Does not account for differences in the duration of growth.
176-248
P/B
¾ The measure of value in the P/B ratio, book value per share, is a stock or
level variable coming from the balance sheet.
¾ Book value per share attempts to represent the investment that common
shareholders have made in the company, on a per-share basis.
¾ The computation of book value:
z Common shareholders’ equity = (Shareholders’ equity) - (the total
value of equity claims that are senior to common stock)
z (Common shareholders’ equity)/(number of common stock shares
outstanding) = book value per share
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P/B
¾Advantages:
z BV almost always>0,
z BV more stable than EPS.
z Measures NAV per share, more fit for valuing companies composed
chiefly of liquid assets, such as finance institutions.
z Differences in P/Bs may be related to differences in long-run average
returns, according to empirical research.
¾Disadvantages:
z Size differences cause misleading comparisons.
z Influenced by accounting choices.
z BVMV due to inflation/ technology.
z Other assets besides those recognized in accounting may be critical.
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P/B
Justified P/B
¾use fundamental forecasts to estimate a stock’s justified P/B ratio
P/B=(ROE-g) / (r-g)
z The P/B increases as ROE increases.
z It also increases as the spread between ROE and r increases.
¾Common adjustments to the book value include:
z Excluding intangible assets such as goodwill.
z Since the book value forecasts are not widely disseminated like EPS
forecasts, analysts typically use trailing BV when calculating P/Bs.
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P/S
¾Advantages:
z Meaningful even for distressed firms.
z Sales revenue not easily manipulated.
z Not as volatile as P/E ratios.
z Useful in valuing mature, cyclical, and start-up firms.
z Differences in P/Ss may be related to differences in long-run average
returns.
¾Disadvantages:
z High sales do not imply high profits and cash flows.
z Does not capture cost structure differences.
z Revenue recognition practices still distort sales.
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P/S
Justified P/S
P0 ( E0 / S 0 )(1 b )(1 g )
S0 rg
z E/S is the business’s profit margin PM,
z Justified P/S is an increasing function of its profit margin and earning
growth rate.
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P/CF
¾Advantages
z Cash flow less subject to manipulate than EPS.
z More stable than P/E
z Handles the problem of differences in the quality of reported earning
z Empirical evidence supported
¾Disadvantages
z Difficult to estimate true CFO
z FCFE better but more volatile and more frequently negative.
182-248
P/CF
Cash flow definition
¾Earning-plus-noncash-charges
z CF = net income + depreciation + amortization
z limitation: ignore some items that influence cash flow (such as, noncash
revenue and changes in net working capital)
¾Adjusted CFO
z adjusted CFO = CFO +[(net cash interest outflow) * (1- tax rate)]
z limitation: includes the items related to financing and investing activities
¾FCFE
z FCFE = CFO – FCInv + net borrowing
¾EBITDA
z used in enterprise value-to-EBITDA ratio
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EV/EBITDA
z Enterprise value (EV) is total company value, not equity.
z EV = market value of common stock + market value of preferred
equity + market value of debt + minority interest – cash and
investments
¾ Advantage
z Useful for comparing firms with different degrees of financial
leverage
z EBITDA is useful for valuing capital-intensive business EB
z EBITDA is usually positive even when EPS is not.
¾ Disadvantages
z If working capital is growing, EBITDA will overstate CFO
z FCFF is more strongly linked with valuation theory than EBITDA
184-248
Dividend Yield
z For practical purposes, dividend yield, D/P is preferred over P/D. (zero
dividends are a problem)
z Trailing dividend yield is generally calculated as four times the most recent
quarterly per-share dividend divided by the current market price per share.
(The most recent quarterly dividend times four is known as the dividend rate.)
4 u m ost recent qu aterly d ivid end

trailin g D /P =
m ark et price p er share
z The leading dividend yield is calculated as forecasted dividends per share

over the next year divided by the current market price per share.
forecasted dividends over next four quarters

L eading D /P =
m arket price per share
z The justified dividend yield in a Gordon model is:

D/P = r-g / 1+g
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Comparable Method Using Price Multiples

zBasic idea of the method of comparables: to compare a stock’s price multiple to
the benchmark
multiples < benchmark the stock’s value is undervalued
multiples > benchmark the stock’s value is overvalued
zMore importance about the method of comparables:
9 the fundamentals of stock and benchmark both should be the
similar
¾Details for each of price multiples
zP/E ratio (assuming that P/E < benchmark)
9 stock: undervalued
9 stock: properly valued, but the stock has a lower expect growth rate
than the benchmark lower P/E
OR it has higher required rate of return than benchmark lower P/E
9 Therefore, to sure that the expected growth, risk and return of stock
and those of benchmark are the similar.
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Comparable Method Using Price Multiples
zP/B
9 mostanalystsusetrailingbookvaluesincalculatingP/Bs
9 relativeP/BvaluationmustconsiderdifferencesinROE,risk,and
expectedgrowthwhentodocomparisonsamongstocks
zP/S
9
usually,iscalculatedbasedontrailingsales
9
shouldcontrolforprofitmargin,expectedgrowth,risk,andthe
qualityofaccountingdatawhentomakecomparison
zEV/EBITDA(elseareequal)
9 lowerraothanpeer rmsundervalued
9 higherraothanpeer rmsovervalued
zDividendyield
9 toidentifiedonthebasisofcomparableriskandexpectedgrowth
9 elseareequalrelativetopeerfirms
Higherraoundervalued
Lowerraoovervalued
187-248
Momentum Valuation Indicators

¾Momentum indicators
zrelate either price or a fundamental such as earnings to the time series
of their own past values, or in some cases to the fundamental’s
expected value.
¾Growth/momentum investment strategies
zuses positive momentum in various senses as a selection criterion.
¾Unexpected Earnings
zUnexpected earnings (also called earnings surprise) is the difference
between reported earnings and expected earnings
UEt = EPSt – E(EPSt)
zwhere UEt is the unexpected earnings per share for quarter t, EPSt is
the reported earnings per share for quarter t, and E(EPSt) is the
expected earnings per share for the quarter.
188-248

¾Standardized Unexpected Earnings
zThe same rationale lies behind standardized unexpected earnings
(SUE)
EPSt E (EPSt )
SUE t
> EPSt E (EPSt ) @
zwhere the numerator is the unexpected earnings for t and the

denominator, [EPSt – E(EPSt)], is the standard deviation of past
unexpected earnings over some period prior to time t, for example the
20 quarters prior to t as in Latané and Jones (1979), the article that
introduced the SUE concept.
189-248
¾Relative strength (RSTR) indicators
zRelative strength (RSTR) indicators compare a stock’s performance
during a period either
9 to its own past performance
9 or to the performance of some group of stocks.
zThe simplest relative strength indicator of the first type is the stock’s
compound rate of return over some specified time, such as six months
or one year.
zA simple relative strength indicator of the second type is the stock’s
performance divided by the performance of an equity index.
9 This indicator may be scaled to 1.0 at the beginning of the study
period.
9 If the stock goes up quickly (slowly) than the index, then relative
strength will be above (below) 1.0
190-248
Central tendency of a group of multiples

¾Portfolio or index P/E is best calculated as the weighted harmonic mean
P/E
1
weighted harmonic mean
n
¦ WX
i 1
I
i
¾When there are outliers
z Harmonic mean put more weights on smaller values, therefore
median or weighted harmonic mean with the outliers excluded may be
more appropriate measures.
191-248

SS 10
SS 11
SS 12
192-248
Residual Income Valuation
¾Concept of Residual Income
¾Residual Income Valuation Model
¾Accounting Issues
¾Single-stage Model
¾Multistage Models
193-248
Concept of Residual Income

¾ Residual income (economic profit): is net income less a charge for
common stockholder’s opportunity cost of capital.
RI = net income – equity capital * cost of equity
¾ EVA (economic value added): measures the value added to shareholders
by management during a given year
EVA = NOPAT – WACC * invested capital
= EBIT*(1 – t) - $WACC
Total capital = book value of long-term debt + book value of equity
= net working capital + net fixed assets
¾ Market value added (MVA) = market value – total capital
194-248

¾Example 1
z Madeira Fruit Suppliers, Inc. (MFS) distributes fruit to grocery stores 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 percent, and its marginal tax rate is 34 percent. MFS has a cost of equity
of 12.3 percent. MFS’s abbreviated income statement is shown in Following:
EBIT $142,000,000
Less: Interest expense (20,000,000)
Pretax income 122,000,000
Less: Income tax expense (41,480,000)
Net income $80,520,000
z Determine whether MFS is profitable by calculating residual income and
explaining its relationship to reported accounting income.
195-248
¾Answer:
z While the accounting net income of $80,520,000 indicates that MFS is profitable, it
remains to be seen whether the firm is profitable after deducting a charge for equity. The
dollar-based equity charge is:
equity charge = equity capital hcost of equity= $800 million h 0.123

= $98,400,000
RI is calculated as
Net income $80,520,000
— Equity charge 98,400,000
Residual income —$17,880,000
z Even though MFS is profitable in the traditional accounting sense, it is economically
unprofitable after taking into account the necessary charge to meet stockholders’
opportunity cost of supplying capital to the company.
196-248

¾Example 2
z VBM Inc. reports NOPAT of $2,100, a WACC of 14.2%, and invested capital of
$18,000. The market price of the firm’s stock is $25 per share, and VBM has
800 shares outstanding. The market value of the firm’s long-term debt is $4,000.
Calculate VBM’s economic value added (EVA) and market value added (MVA).
¾Answer:
z First calculate EVA:
$WACC = 0.142x$18,000 = $2,556
EVA = $2,100-$2,556 = -$456
z The market value of the company is the market value of the equity plus the
market value of the debt:
MV of company = ($25x800)+$4,000 = $24,000
The firm’s MVA is: MVA = $24,000-$18,000 = $6,000
197-248
Calculation of Residual Income
RI t EPSt re u Bt 1 ( ROE re ) u Bt 1
Bt 1 Bt
Et Et 1
Dt Et (1 b) Dt 1
Bt Bt 1 Et Dt Bt 1
re u Bt 1 re u Bt
RI t Et re u Bt 1 RI t 1 Et 1 re u Bt
Clean surplus relation: ending BV = beginning BV + earnings - dividend
198-248
Residual Income Valuation Model
¾ Residual income model of valuation breaks the intrinsic value of
equity into two components:
zAdjusted current book value of equity
zPresent value of expected future RI
¾ Under the residual income model, the intrinsic value of the stock can
be expressed as:
V0 = B0 + (RI1/(1+r) + RI2/(1+r)^2 + RI3/(1+r)^3….)
zRI model is relatively less sensitive to terminal value estimates than
dividend discount and free cash flow models. This is because intrinsic
values estimated with residual income models include the firm’s current
book value, which usually represents a substantial percentage of the
estimated intrinsic value
199-248
¾ Difference with DDM & FCFE

zThe assumptions are difference
zResidual income model starts with a book value and adds to this the
PV of the expected stream of residual income
zHowever, DDM & FCFE measure value by discounting a stream of
expected cash flows
200-248
Relationship with justified P/B

¾ Relationship with justified P/B
z residual income models can be used to estimate justified price multiples
z mostly closely to P/B, due to justified P/B directly links with expected future
residual income
( ROE re ) P ROE re
V0 B0 u B0 0 1
re g B0 re g
ROE ! re P0 ! B0 P ! 1
° B
°
® ROE re P0 B0 P B 1
°
°̄ ROE re P0 B0 P B 1
201-248
Single-Stage Residual Income Valuation Model
¾ Single-Stage Valuation
V0 = B0 + [(ROE – r) * B0]/(r – g)
z Ifreturn on equity = the required return on equity, the justified market value of a
share of stock is equal to its book value
z The single-stage model assumes constant ROE and constant earnings
growth, which implies that residual income will persist indefinitely.
z [(ROE – r) * B0]/(r – g) is the additional value generated by the 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.
¾ Residual income implied growth rate
B0 u ( ROE r )
g r [ ]
V0 B0
z Assumption: intrinsic value = market price
202-248
Continuing residual income
¾ Continuing residual income

zProblem about the forecasting residual income: difficult to calculate PV
of residual income and implement the residual income model
zSolution
9simply use DDM or FCFE

9forecast over the short term, like 5 years, then follow the pattern of
RI growth
zContinuing residual income is …
9the residual income expected over the long term
203-248
Multistage Residual Income Model
zAssumptions (One of the four)

9 residual income is expected to persist at its current level forever
9 residual income is expected to drop immediately to zero
9 residual income is expected to decline to a long-run average level
consistent with mature industry
9 residual income is expected to decline over time as ROE falls to
the cost of equity
204-248
z Justify an estimate of continuing residual income
9 reason: economic profits reduction to the point at which firms begin to
leave the industry and ROE stabilizes at a long term normal level by the
industry competition
z Persistent factors
9 Higher persistent factors
Associated with low dividend payouts
historically high residual income persistence in the industry
9 Lower persistent factors
high return on equity
significant levels of nonrecurring items
high accounting accruals
205-248

z In the residual income model, intrinsic value is the sum of three components:
intrinsic value = book value + (PV of interim high-growth residual income)
+ (PV of continuing residual income)
z Step 1: Calculate the current book value per share.
z Step 2: Calculate residual income in each year 1 to T-1 during the interim high-
growth period and discount them back to today at the required return on equity.
z Step 3: Calculate continuing residual income that begins at the end of the
high-growth period starting in year T, and then calculate the present value of
continuing residual income as of the end of year T-1 using the following formula
(Four Assumptions):
PV of continuing residual income in year T -1 = RIT/(1 + r – )
0 d Z d1
Where = persistence factor,
206-248
Assumptions
¾Residual income persists at the current level forever
PV of continuing residual income in year T-1 = RIT /r
¾Residual income drops immediately to zero
PV of continuing residual income in year T-1 = RIT /(1+r)
¾Residual income declines to long-run level in mature industry after year t:
PV of continuing residual income in year T-1 =[(PT – BT )+ RIT ]/(1+r)
¾Residual income declines over time after year T as ROE falls to the cost of
equity capital, then the persistence factor, , is between zero and one:
PV of continuing residual income in year T -1 = RIT/(1 + r – )
207-248
Example: Multistage Residual Income Model (1)
¾Example:
zJava Metals is expecting an ROE of 15 percent over each of the next five
years. Its current book value is $5.00 per share, it pays no dividends, and
all earnings are reinvested. The required return on equity is 10 percent.
Forecasted earnings in years one through five are equal to ROE times
beginning book value. Calculate the intrinsic value of the company using
a residual income model, assuming after five years that continuing
residual income falls to zero.
208-248

¾ Answer:
z The following table provides an estimate of the present value of residual
income. Java Metals Residual Income Forecast
Ending Book Equity Charge Residual Income

Year Et ROE
Value (Bt-1 ) (r x Bt-1) [E- (r x Bt-1)]
0 $5.00
1 $0.75 5.75 0.15 $0.50 $0.25
2 0.86 6.61 0.15 0.57 0.29
3 0.99 7.60 0.15 0.66 0.33
4 1.14 8.74 0.15 0.76 0.38
5 1.31 10.05 0.15 0.87 0.44
209-248

z Under the assumption that residual income after five years is zero (i.e., w
= 0), the terminal value (the present value of continuing residual income)
at the end of Year 4 is $0.44/1.10 = $0.40. Intrinsic value today is:
$0.25 $0.29 $0.33 $0.38 $0.40

5.00 [ ] $6.25
1.10 1.102 1.103 1.104
z Remember, you can also use your calculator to solve for the answer: CFO
= 5, CO1 = 0.25, CO2 = 0.29, CO3 = 0.33, CO4 = 0.38 + 0.40 = 0.78, I =
10, CPT -> NPV = $6.25.
210-248
¾Example:
z Suppose we change our assumption regarding Java’s residual income after five
years to assume instead that it remains constant at $0.44 forever. Calculate the
new intrinsic value of Java.
¾Answer:
z The intrinsic value of Java is higher than the first case because we assume the
residual income persists at the same level forever, so RI = RI = . . . = $0.44, and Z = 1
5 6
z The $0.44 perpetuity beginning in Year 5 is worth $4.40 ($0.44/0.10) in Year 4.
The intrinsic value is:
$0.25 $0.29 $0.33 $0.38 $4.40

V0 $5.00 [ ] $8.98
1.10 1.102 1.103 1.104
211-248

¾Example:
z Now let’s make the more realistic assumption that after year five Java’s residual
income will decay over time to zero with a persistence factor of 0.4. Calculate the
new intrinsic value of Java.
¾Answer:
z Residual income begins to decline after Year 5, so the terminal value in Year 4
includes the present value of Year 5 residual income.
$0.44
z terminal value in year 4 = $0.63
1 0.10 0.40
z The intrinsic value today is book value plus the present value of years 1 through
4 residual income plus the present value of the terminal value in Year 4.
$0.25 $0.29 $0.33 $0.38 $0.63
V0 $5.00 [ ] $6.40
1.10 1.102 1.103 1.104
z more conservative assumption of a lower persistence factor reduces the intrinsic
value of the stock.
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¾Example:
z Suppose instead that a the end of year five we assume that Java’s ROE falls to a
long-run average level and the price-to-book ratio falls to 1.2. Calculate Java’s
intrinsic value.
¾Answer:
z The book value per share at the end of Year 5 is $10.05, which means the market
price is expected to be $10.05 x 1.2 = $12.06. The present value of continuing
residual income is:
($12.06 $10.05) $0.44 $2.45
z PV of continuing residual income in year 4 = $2.23
1.10 1.10
z Then intrinsic value is: V $5.00 [
$0.25 $0.29 $0.33 $0.38 $2.23
0 ] $7.50
1.10 1.102 1.103 1.104
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¾ Strengths
z terminal value does not dominate the intrinsic estimate;
z accounting data, which is easy to find;
z applicable to firms that do not pay dividends or do not have positive
expected free cash flows in the short run or have volatile cash flows;
z Applicable even when cash flows are volatile;
z focus on economic profitability rather than just on accounting profitability.
¾ Weaknesses
z rely on accounting data that can be manipulated by management;
z reliance on accounting data requires numerous and significant adjustments;
z assume that the clean surplus relation holds or that its failure to hold has
been properly taken into account.(i.e., ending BV = beginning BV + earnings -
dividend)
214-248
¾ Appropriate for:
z Not pay dividends, or the stream of payments is too volatile to be
sufficiently predictable;
z Free cash flows are negative for the foreseeable future;
z Terminal value forecast is highly uncertain;
¾ Not appropriate
z Clean surplus accounting relation is violated significantly;
z Significant uncertainty concerning the estimates of book value and return
on equity.
215-248
Clean Surplus Violations

¾ The clean surplus relationship
z The clean surplus relationship can be expressed as:
Bt Bt 1 Et Dt
z The clean surplus relationship may not hold when items are charged directly
to shareholders’ equity and do not go through the income statement. Items
that can bypass the income statement include:
9Foreign currency translation gains and losses that flow directly to
retained earnings under the all-current method;
9The minimum liability adjustment in pension accounting;
9Changes in the market value of debt and equity securities classified as
available-for-sale.
z If the clean surplus relation doesn’t hold, the ROE forecast will not be
accurate.
216-248
Variations form Fair Value
¾ The accrual method of accounting causes many valance sheet items to
be reported at book values that are significantly different than their market
values, which include the following:
z Operating leases: should be capitalized by increasing assets and liabilities;
z Special purpose entities (SPEs): assets and liabilities are not reflected;
z Reserves and allowances: should be adjusted.
z Inventory for companies: that use LIFO should be adjusted to FIFO;
z Pension asset or liability: should be adjusted to reflect the funded status;
z Deferred tax liabilities: should be eliminated and reported as equity if the
liability is not expected to reverse.
¾ Intangible asset effects on book value: goodwill and productivity R&D should
include;
¾ Nonrecurring Items and Other Aggressive Accounting Practices should be
adjusted;
¾ International Accounting Differences should be considered.
217-248

SS 10
SS 11
SS 12
218-248
Public & Private Company Valuation

¾Company-specific factors
z Stage of life-cycle: typically less mature than public firms;
z Size: less capital, fewer assets, and fewer employees than public firms, can be
riskier;
z Quality and depth of management: not be able to attract as many qualified
applicants;
z Management/shareholder overlap: management has a substantial ownership
position;
z Short-term investor: managers are long-term holders of significant equity
interests;
z Quality of financial and other information: less information;
z Taxes: more concerned with taxes.
¾Stock-specific factors
z Liquidity: less liquid;
z Restrictions on Marketability: prevent shareholders from selling;
z Concentration of control: high control concentration in the hands of a few
shareholders.
219-248
Reasons for Valuation
¾ Transaction-related valuation: selling or financing a firm

zVC financing: for capital investment;
zIPO: public sale of the firm’s equity;
zSale in an acquisition: development-stage or mature private firms be sold;
zBankruptcy proceedings: firms in bankruptcy;
zPerformance-based managerial compensation: firm compensates employees.
¾ Compliance-related valuation: legal & regulatory reasons
zFinancial reporting
zTax purposes
¾ Litigation-related valuation: shareholder suits, damage claims, lost
profits claims, or divorce settlements.
220-248
6 kinds of values
¾ 6 kinds of values
z Fair market value: used for tax purpose in the USA, characterized by: 1)
hypothetical willing and able seller sells the asset or a willing and able buyer;
2) arm’s length transaction in free market; 3) well-informed buyer and seller.
z Fair value for financial reporting: used in financial reporting, characterized
by: 1) arm’s length transaction; 3) well-informed buyer and seller.
z Fair value for litigation: in the jurisdiction of the litigation.
z Market value
z Investment value: the value to a particular buyer
z Intrinsic value
¾ Value definition will have the effect on the estimated value
221-248
Private Company Valuation Methods
¾ 3 methods for private company valuation

z Income approach: value a firm as the present value of its expected future
income.
z Market approach: value a firm using the price multiples based on recent
sales of comparable assets.
z Asset-based approach: values a firm’s assets minus its liabilities.
¾ 3 issues of the financial statement adjustments

z Normalized earnings
z Strategic and nonstrategic buyers
z Estimating cash flows
222-248
Normalized Earnings
¾ Normalized earnings
z Exclude nonrecurring and unusual items;
z In the case of private firms with a concentrated control, there may be
discretionary or tax-motivated expenses that need to be adjusted
when calculating normalized earnings.
z Real estate owned by the firm may merit treatment separate from that
firm operations.
223-248
Example: Normalized Earnings

¾ Tim Groh is the principal shareholder, CEO, and founder of Arbutus
Generators. Arbutus reports the following:
z Groh's compensation of $2,500,000 is included in the firm's selling, general,
and administrative (SG&A) expenses.
z Arbutus leases a warehouse for $100,000 a year from one of its largest
suppliers.
z Arbutus owns a vacant office building with reported SG&A expenses of
$150,000 and $25,000 of depreciation expense.
z Arbutus's capital structure has too little leverage.
z An analyst determines that a market-based compensation figure for Groh's
position is $1,000,000 and that the office building is not needed for core
operations. The market lease rate of the warehouse is $130,000.
z Based on 1-4 above, what adjustments should the analyst make to Arbutus's
reported income to estimate normalized earnings (earnings), assuming the
firm will be acquired?
224-248
Example: Normalized Earnings

¾ Answer:
z Because the market rate is $1,500,000 less, SG&A expenses should be
reduced by $1,500,000 to reflect a normalized compensation expense.
z Because the market lease rate is $30,000 higher than reported, SG&A
expenses should be increased by $30,000 to reflect a normalized lease rate.
z Because the office building is non-core, SG&A expenses should be reduced
by $150,000, and depreciation expense should be reduced by $25,000.
z Because the capital structure is non-optimal, the analyst will drop interest
expense from the calculation of operating income under the assumption that
the capital structure will be changed if the firm is acquired. As we will see,
interest expense is added back when calculating free cash flow to the firm.
225-248
Strategic and Nonstrategic Buyers
¾ Strategic transaction, valuation of the firm is based in part on the
perceived synergies with the acquirer’s other assets.
¾ A financial transaction (nonstrategic) transaction assumes no synergies,
as when one firm buys another in a dissimilar industry.
¾ When estimating normalized earnings for a strategic transaction, the
analyst should incorporate any synergies as an increase in revenues or
as a reduction in costs.
226-248
Example: Strategic and Nonstrategic Buyers

¾ Example:
z An analyst is valuing a firm for two different buyers. Buyer A is a firm, in the same
industry as the target firm, which expects to reduce costs at the target firm by
eliminating redundancies. Buyer B is a firm in another industry.
z Calculate the normalized EBITDA for each buyer given the information below.
Reported EBITDA $4,800,000

Current executive compensation $900,000
Market-based executive compensation $600,000
Current SG&A expenses $8,000,000
SG&A expenses after synergistic savings $7,600,000
¾ Answer:
z Both strategic (Buyer A) and nonstrategic (Buyer B) buyers will attempt to reduce
executive compensation to market levels. So the adjustment for both buyers to
generate normalized EBITDA is $4,800,000 + ($900,000 — $600,000) = $5,100,000.
z However, only Buyer A will be able to realize synergistic savings of $400,000
($8,000,000 — $7,600,000). So normalized EBITDA for Buyer A is $5,500,000 and for
Buyer B it is $5,100,000.
227-248
Estimating Cash Flow

¾ Estimating Cash Flow
z The valuation of equity depends on the definition of value used. Also,
controlling and no controlling equity interests will have quite different
values. These differences should be accounted for in cash flow estimates and
assumptions.
z When there is significant uncertainty about a private company’s future
operations, the analyst should examine several scenarios when estimating
future cash flows.
z Weighted average of these values is used to estimate firm value, weighted
average scenario cash flow may be discounted using a single discount rate
to arrive at an estimate of firm value.
z The analyst should be aware of the potential bias in management estimates.
z FCFF is usually more appropriate when the significant changes in the firm’s
capital structure.
228-248
Income Approach
¾The free cash flow method
z2-stage model
¾The capitalized cash flow method
zsingle-stage model: a single measure of economic benefit is divided by
a capitalization rate to arrive at firm value, where the capitalization rate
is required rate of return minus a growth rate.
FCFF1
Value of firm
WACC g
Value of equity Value of firm MVD
FCFE1
Value of equity
rg
229-248
Example: The Capitalized Cash Flow Method

¾ Example:
z Given the following figures, calculate the value of the firm and equity using the
CCM.
FCFF in one year $12,100,000
Growth rate of FCFF 4.0%
WACC 15.0%
Market value of debt $4,000,000
¾ Answer:
z Step 1: Calculate the value of the firm.
Using the FCFF formula:
value of firm = ($12,100,000) / (0.15 - 0.04) = $110,000,000
z Step 2: Calculate the value of the equity.
Subtract the debt value from firm value:
value of equity = $110,000,000 - $4,000,000 = $106,000,000
Note that the capitalization rate in this example is 11% (15% - 4%). The WACC
will be greater when more (relatively expensive) equity and less debt are used,
resulting in lower estimates of firm and equity values.
230-248
Income Approach
¾Residual income or The excess earnings method

zEE = firm earnings – the earnings required to provide the required rate of
return on working capital and fixed asset
¾4 steps of EEM
zStep 1 Calculate the required return for working capital and fixed assets
zStep 2 Calculate the excess earnings
zStep 3 Value the intangible assets
zStep 4 Sum the asset values to arrive at the total firm value
231-248
Example: EEM
¾ Example:
z Given the following figures, calculate the value of the firm using the EEM.
Working capital $300,000

Fixed assets $1,000,000
Normalized earnings (year just ended) $130,000
Required return for working capital 6%
Required return for fixed assets 10%
Growth rate of residual income 5%
Discount rate for intangible assets 14%
¾ Answer:
z Step 1: Calculate the required return for working capital and fixed assets.
Based on the required rates of return for working capital and fixed assets, the
required earnings are:
working capital: $300,000 x 6% = $18,000
fixed assets: $1,000,000 x 10% = $100,000
232-248
Example: EEM
z Step 2: Calculate the excess earnings.
excess earnings = $130,000 - $18,000 - $100,000 = $12,000

z Step 3: Value the intangible assets.
Using the formula for a growing perpetuity, the discount rate for intangible
assets, and the growth rate for excess earnings:
value of intangible assets = ($12,000 x 1.05) / (0.14 - 0.05) = $140,000

z Step 4: Sum the asset values to arrive at the total firm value.
Firm value = $300,000 + $1,000,000 + $140,000 = $1,440,000

z Professor's Note: In the excess earnings method, the FCFF may be given in
place of the normalized earnings. The growth rate in free cash flow may be
given in place of the growth rate of residual income. After these substitutions,
the calculations are identical to those above.
233-248
Estimating The Discount Rate For Private Companies

¾Estimating the discount rate
zSize premium
9 Size premiums are often added to the discount rates for small private
companies.
zAvailability and cost of debt
9 A private firm may have less access to debt financing than a public firm.
zAcquirer versus target
9 When acquiring a private firm, some acquirers will incorrectly use their own
(lower) cost of capital, rather than the higher rate appropriate for the target.
zProjection risk
9 Because of the lower availability of information from private firms and
managers
zLifecycle stage
9 It is particularly difficult to estimate the discount rate for firms in an early
stage of development.
234-248
Estimating The Discount Rate For Private Companies
¾3 models to estimate the discount rate
zCAPM
9
Beta is estimated from public firm data, and this may not be appropriate
for private firms that have little chance of going public or being acquired by
a public firm.
zExpanded CAPM
9 This version of the CAPM includes additional premiums for size and firm-
specific (unsystematic) risk.
zBuild-up method
9 When it is not possible to find comparable public firms for beta estimation,
the build-up method can be used. Beginning with the expected return on
the market (beta is implicitly assumed to be one), premiums are added for
small size, industry factors, and company specific factors.
235-248
Market Approach Methods
¾Using price multiples and data from previous public and private transaction
z Guideline Public Company Method (GPCM)
z Guideline Transactions Method (GTM)
z Prior Transaction Method (PTM)
z Private forms may have risks not common to public firms, such as greater
company risk and illiquidity. Therefore, it is important that the public
comparables be chosen carefully.
¾Market Multiples
z Large size: EBIT/EBITDA multiples
z Small size: net income multiples
236-248
Guideline Public Company Method (GPCM)

¾GPCM:
z Usingprice multiples from trade data for public companies, with
adjustments to the multiples to account for differences between the subject
firm and the comparables.
¾To estimate a control premium
z Transaction type: A financial transaction typically has a smaller price
premium.
z Industry conditions: there is a flurry in industry acquisition activity, driving
up acquisition prices, share prices of public companies may already reflect
some premium for control.
z Type of consideration: estimates of the control premium when acquisitions
are made with shares that are at higher temporary or “bubble” values will
be overstated.
z Reasonableness: the use of control premiums and price multiples can quickly
result in significant differences in valuations from historical pricing.
237-248
Example: Guideline Public Company Method (GPCM)
z An analyst, Natalie Hoskins, is valuing a private firm, Rensselaer Components,
using the GPCM and MVIC to EBITDA multiples. Hoskins has gathered data for
comparable public firms; however they are larger in size than Rensselaer.
Hoskins decided to deflate the average public company multiple by 20% to
account for the higher risk of Rensselaer.
z A premium of 30% was paid for a firm by an acquiring firm in the same industry.
The acquirer exchanged stock for the target.
z Other data are as follows:
Market value of debt $1,100,000

Normalized EB1TDA $12,800,000
Average MVIC/EBITDA multiple 8.0
1. Comment on the relevance of the information above for the valuation of

Rensselaer.
2. Calculate the equity value of Rensselaer using the GPCM.
238-248
¾Answer to question 1:
z The application of control premiums is difficult and requires subjective
judgment. The control premium of 30% is probably not relevant for the
valuation of Rensselaer. The premium for the prior acquisition likely
contained some value for synergies since it was a strategic transaction,
and because stock was used for the purchase, there is also the
possibility that the stock value at the time was inflated, adding to the
estimated premium.
z The adjustment to the public company multiple of 20% is appropriate
because growth and risk may differ between public comparables and
private firms.
239-248
¾Answer to question 2:
z The adjustment to the MVIC/EBITDA multiple for the higher risk of
Rensselaer is:
8.0 x (1 - 0.20) = 6.4
z No control premium is applied.
z The adjusted multiple is applied against the normalized EBITDA:
6.4 x $12,800,000 = $81,920,000
z Subtracting out the debt results in the equity value:
$81,920,000 - $1,100,000 = $80,820,000
240-248
Guideline Transactions Method
¾GTM:
z Prior acquisition values for entire (public and private) companies that
already reflect any control premiums are used, so no additional
adjustment for a controlling interest is necessary.
z When using multiples from historical transactions, several issues
should be considered:
9 Transaction type: If the subject transaction is nonstrategic, the
analyst may need to adjust the historical multiple.
9 Contingent consideration: transactions with contingent
consideration should be scrutinized before they are compared to
transactions without such contingencies.
9 Type of consideration: some transactions are for stock rather than
cash, comparing transactions of different consideration type may
not be relevant.
241-248
Prior Transaction Method

9 Availability of data: the historical data for comparables that are
relevant and accurate may be limited.
9 Date of data: data from very long ago, the prices and estimated
premiums may not be relevant.
¾PTM:
z Using transactions data from the stock of the actual subject company.
z PTM is most appropriate when valuing minority (non-controlling)
interests.
242-248
Asset-based Approach
¾ABA:
z Itestimates the value of firm equity as the firm value of its assets minus
the fair value of its liabilities. It is generally not used for going
concerns.
z The asset-based approach generally results in the lowest valuation
because the use of a firm’s assets in combination usually results in
greater value creation than each of its parts individually.
z Appropriate in the following circumstances:
9 Firms with minimal profits and little hope for better prospects.
9 Finance firms, with asset and liability based on the market price and
factors
9 Investment companies such as REITs and CEICs
9 Small companies or early stage companies
9 Natural resource firms
243-248
Discount / Premium in Private Company Valuation
¾Adjustments are required when the liquidity or control position of an
acquisition differs from that of the comparable companies. We would need
to apply discounts for both a lack of control and a lack of marketability
(liquidity).
¾Discount of lack of control

1
DLOC 1 [ ]
1 control premium
Scenario Comparable data Subject Valuation Adjustment
1 Controlling Interest Controlling Interest None
2 Controlling Interest Noncontrolling Interest DLOC
3 Noncontrolling Interest Controlling Interest Control Premium
4 Noncontrolling Interest Noncontrolling Interest None
244-248
Discount / Premium in Private Company Valuation
¾Discount of lack of marketability

z Method 1: using price of restricted shares
z Method 2: the price of pre-IPO shares is compared to that of post-IPO
shares
z Method 3: estimate DLOM as the price of a put option divided by the
stock price, where the put is at the money.
¾Total Discount
Total discount 1 [(1 DLOC )(1 DLOM )]
245-248
Example: Discount / Premium
z An analyst determines that a control premium of 18% is included in the

acquisition prices of the comparable firms used for valuing a minority
interest in a private company. If she also determines that a discount for
lack of marketability of 22% is appropriate for the private company
interest, what is the total adjustment she will make to the value of the
comparables when valuing the private company interest?
z A. 33.9%.
z B. 36.0%.
z C. 40.6%.
246-248
Valuation Standards
¾Number of valuation standards have been developed, include:

z Uniform Standards of Professional Appraisal Practice (USPAP);
z International Valuation Standards;
z Statement of Standards on Valuation Services (SSVS)
¾There are many challenges involved with the implementation of
appraisal standards:
z most buyers are still unaware of them.
z Most valuation reports are private.
z It is necessarily limited due to the heterogeneity of valuations.
z Valuation will depend on the definition of value used.
247-248
It’s not the end but just beginning.
Always believe that good things are possible, and remember that
mistakes can be lessons that lead to discoveries. Take your fear and transform
it into trust; learn to rise above anxiety and doubt. Turn your "worry hours"
into "productive hours". Take the energy that you have wasted and direct it
toward every worthwhile effort that you can be involved in. You will see
beautiful things happen when you allow yourself to experience the joys of
life. You will find happiness when you adopt positive thinking into your daily
routine and make it an important part of your world.
䈧ඊؑˈ㖾ྭⲴ䱽Ѥᒦ䶎нਟ㜭ˈཡ䈟ҏ䇨ᱟᡀ࣏ⲴࡽཿǄሶᜦ 
ॆ֌ؑԫˈᆖՊ䎵䎺ᣵᘗ઼⯁㲁Ǆ䇙Ā䈊ᜦ䈊 āⲴᰦ‫ݹ‬ਈᗇĀᇼᴹᡀ
᭸āǄн㾱ᥕ䴽⎚䍩㋮࣋ˈሶᆳᣅࡠᴹ᜿ѹⲴһᛵѝ৫Ǆᖃ֐л᜿䇶૱
ቍ⭏ભⲴ⅒᜹ᰦˈ㖾ྭቡՊࠪ⧠Ǆᖃ֐〟ᶱൠⴻᖵ⭏⍫ˈᒦԕ↔֌Ѫ֐
Ⲵᰕᑨ߶ࡉᰦˈ֐ቡՊ᢮ࡠᘛҀⲴⵏ䉋Ǆ
248-248
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CFAӂ
Session NO. Content Weightings

Study Session 1-2 Ethics & Professional Standards 10-15
Study Session 3 Quantitative Methods 5-10
Study Session 4 Economic Analysis 5-10
Study Session 5-7 Financial Statement Analysis 15-20
Study Session 8-9 Corporate Finance 5-15
Study Session 10-12 Equity Analysis 15-25
Study Session 13 Alternative Investments 5-10
Study Session 14-15 Fixed Income Analysis 10-20
Study Session 16-17 Derivative Investments 5-15
Study Session 18 Portfolio Management and Wealth Planning 5-10
Total: 100
2-157
Frameworkofalternativeinvestments
Introduction
IncomeApproach
PrivateReal Valuation CostApproach

Estate SalescomparisonApproach
Investment AnalysisandEvaluation
Types
WhyPublicTraded Advantages&Disadvantages
PublicTraded
Characters&Risks
RealEstate
Alternative Securities REITs Subtypes
Investments
NAVPS,P/FFO,P/AFFO,DCF
Investment
PEFundsCharacters
PrivateEquity Terms,feesandvaluation
Valuation BuyoutFunds
NPVmethod
VentureCapital
IRRmethod
APrimeronCommodityInvesting
3-157
FormsofRealEstate
Therearefourbasicformsofrealestateinvestmentthatcanbedescribedinterms
ofatwodimensionalquadrant:
Firstdimension: investmentcanbedescribedintermsofpublicorprivatemarkets.
¾Privateinvestments
zDirectinvestmentscanbesolelyowned,Indirectlyownedthrough
partnershipsorcommingledrealestatefunds(CREF)
¾Publicmarketinvestments
zNotinvolvedirectinvestment;
zIncludesownershipofunderlyingassets:
9Realestateinvestmenttrust(REIT)
9Realestateoperatingcompany(REOC)
9Mortgagebackedsecurities
4-157
FormsofRealEstate
Seconddimension:whethertheinvestmentsisstructuredasequityordebt.
zDebt:alenderthatownsamortgageormortgagesecurities.Usually,the
mortgageiscollateralized(secured)bytheunderlyingrealestate.Thelender
hasasuperiorclaimoveranequityinvestorintheeventofdefault.
zEquity:hasanownershipinterestinrealestateorsecuritiesofanentitythat
ownsrealestate.Equityinvestorscontroldecisionssuchasborrowingmoney,
propertymanagement,andtheexitstrategy.
5-157
FormsofRealEstate
BasicFormsofRealEstateInvestment
Debt Equity
•Directinvestmentssuchassole
ownership
Private •Mortgages
•Partnerships
•Otherformsofcommingledfunds
Public •Mortgagebackedsecurities •SharesofREITsandREOCs
¾Privateinvestmentsareusually largerthanPublicmarketinvestments;
¾Publicmarketinvestmentsmoreliquidandenableinvestorstodiversify;
¾Privateinvestmentspropertymanagementexpertise needs
¾Publicmarketinvestmentsnopropertymanagementexpertiseneeds
6-157
FrameworkofAlternativeInvestment
SS13
¾R38 PrivateRealEstateInvestments
¾R39PubliclyTradedRealEstateSecurities
¾R40 PrivateEquityValuation
¾R41APrimeronCommodityInvesting
7-157
ExamFocuses
¾Investmentcharacteristicsandrisks
¾Threevaluationapproachesusedforappraisalpurposes
¾Incomeapproach
¾DirectcapitalizationmethodandtheDiscountedcashflowmethod
¾Relationshipbetweenthecapitalizationrateandthediscountrate
8-157
FormsofRealEstate
¾RealEstateCharacteristics:
zHeterogeneity:notwopropertiesareexactlythesame.
zHighunitvalue:unitvalueissignificantlyhigherthanstocksandbonds.
zActivemanagement:Privaterealestateinvestmentrequiresactiveproperty
managementbytheownerorapropertymanagementcompany.
zHightransactioncosts:appraisers,lawyers,brokers,andconstruction
personnel.
zDepreciationanddesirability:wearoutovertimeandlessdesirablebecause
oflocation,design,orobsolescence.
9-157
FormsofRealEstate
¾RealEstateCharacteristics:
zCostandavailabilityofdebtcapital:highcoststoacquireanddevelopreal
estate,propertyvaluesareimpactedbythelevelofinterestratesand
availabilityofdebtcapital.
zLackofliquidity:Realestateisilliquid.
zDifficultyindeterminingprice:heterogeneity andlowtransactionvolume,
appraisalsareusuallynecessarytoassessrealestatevalues.
¾REITs hasexpandedtoovercomemanyoftheproblems:
zSharesofaREITareactivelytradedandaremorelikelytoreflectmarket
value.
zInvestinginaREITcanprovideexposuretoadiversifiedrealestateportfolio.
zInvestorsdon'tneedpropertymanagement.
10-157
PropertyClassifications
¾Residentialproperties:
zSinglefamily(owneroccupied)houses
zMultifamilyproperties
zResidentialrealestatepropertiespurchasedwiththeintenttolet,lease,or
rent(inotherwords,produceincome)aretypicallyincludedinthecategory
ofcommercialrealestateproperties (sometimescalledincomeproducing
realestateproperties).
¾Nonresidentialrealestateproperties:
zCommercialpropertiesotherthanmultifamilyproperties
zFarmland
zTimberland
¾Mixedusedevelopment
11-157
AnotherPropertyClassifications
¾CommercialRealEstateproperties:purchasedwithintenttoproduceincome.
zMultifamilyproperties
zOffice;
zIndustrial/warehouse;
zRetail;
zHospitality;
zParkingfacilities,restaurantsandrecreationalproperties,etc.
¾Noncommercialrealestate:singlefamilyhouses
¾Uniquecategories:separatefromcommercialrealestate.
zFarmland
zTimberland
12-157
CommercialRealEstate
¾Office:
zDemanddependenton:
9Employmentgrowth
9Spaceusedperemployee
9Averageamountofspaceperemployee
zLength:Variesglobally
9Desirabilityoftheproperty
9Financialstrengthofthetenant
9Provisionsforfuturerentchanges
9Optionstoextendthelease
13-157
¾Office:
zOperatingExpenses:
9Grosslease:requirestheownertopaytheoperatingexpenses.
9Netlease:requiresthetenanttoberesponsibleforpayingoperating
expensesθtenantbearstherisk iftheactualoperatingexpensesare
greaterthanexpected.Rentunderanetleaseislowerthanagrosslease.
9Expensesreimbursement:leasebestructuredsothatinthefirstyearof
thelease,theownerisresponsibleforpayingtheoperatingexpensesand
foreveryyearoftheleaseafterthat,theownerpaysforexpensesupto
theamountpaidinthefirstyear.Anyincreaseinexpensesabovethat
amountis“passthrough”tothetenantasan“expensesreimbursement.”
zLeasestructure:
9Lengthfallenglobally
9Needdetailedcost(expense)analysis
14-157
¾Retail:
zDemanddependenton:
9Trendsinconsumerspending
9Healthoftheeconomy
9Jobgrowth,populationgrowth,andsavingsrates
zLength:
9Qualityoftheproperty
9Importanceofthetenant
zUniqueaspect:
9 Retailtenantsareoftenrequiredtopayadditionalrentoncesalesreach
acertainlevel.Thisuniquefeatureisknownasapercentageleaseor
percentagerent.
15-157
¾Industrialandwarehouse:
zHeavilydependentontheoverallstrengthoftheeconomyandeconomic
growth
¾MultiFamily
zDemanddependenton:
9 Populationgrowth
9 Populationdemographics
9 Propensitytorentintheculture
9 Costofrent—ratioofhomepricestorents
9 Interestrates
9 Operatingexpenses
16-157
RiskstoInvestinRealEstate
¾ReasonstoInvestinRealEstate:
zCurrentincome:Investorsmayexpecttoearnincomefromcollectingrents
andafterpayingoperatingexpenses,financingcosts,andtaxes.
zCapitalappreciation:Investorsusuallyexpectpropertyvaluestoincrease
overtime,whichformspartoftheirtotalreturn.
zInflationhedge:Duringinflation,bothrentsandpropertyvaluesexpectto
rise.
zDiversification:Realestate,especiallyprivateequityinvestment,islessthan
perfectlycorrelatedwiththereturnsofstocksandbonds.
zTaxbenefits:Insomecountries,realestateinvestorsreceivefavorabletax
treatment.
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¾RiskstoInvestinRealEstate:
zBusinessconditions:Numerouseconomicfactorssuchasgrossdomestic
product(GDP),employment,householdincome,interestrates,andinflation
affecttherentalmarket.
zNewpropertyleadtime:Marketconditionscanchangesignificantlywhile
approvalsareobtained,whilethepropertyiscompleted,andwhenthe
propertyisfullyleased.
zCostandavailabilityofcapital:Realestatemustcompetewithother
investmentsfordebtandequitycapital.
zUnexpectedinflation:Someleasesprovideinflationprotectionbyallowing
ownerstoincreaserentorpassthroughexpensesbecauseofinflation.Real
estatevaluesmaynotkeepupwithinflationwhenmarketsareweakand
vacancyratesarehigh.
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zDemographicfactors:Thedemandforrealestateisaffectedbythesizeand
agedistributionofthelocalmarketpopulation,thedistributionof
socioeconomicgroups,andnewhouseholdformationrates.
zLackofliquidity:Aquicksalewilltypicallyrequireasignificantdiscount.
zEnvironmentalissues:Realestatevaluescanbesignificantlyreducedwhena
propertyhasbeencontaminatedbyapriorowneroradjacentproperty
owner.
zAvailabilityofinformation:Alackofinformationwhenperformingproperty
analysisincreasesrisk.
19-157
zManagementexpertise:Propertymanagersandassetmanagersmustmake
importantoperationaldecisions.
zLeverage:HigherLTVresultsinhigherleverageand,thus,higherriskbecause
lendershaveasuperiorclaimintheeventofdefault.
zOtherfactors:Otherriskfactors,suchasunobservedpropertydefects,
naturaldisasters,andactsofterrorism,maybeunidentifiedatthetimeof
purchase.
20-157
Valuations
¾Differenttypesofvalue:
zMarketvalue:themostprobablesalespriceatypicalinvestoriswillingto
pay
zInvestmentvalue:thevalueorworththatconsidersaparticularinvestor's
motivations
zValueinuse:thevaluetoaparticularisusingthepropertyasapartofits
business
zAssessedvalue:usedbyataxingauthority
zMortgagelendingvalue:Forpurposesofvaluingcollateral,lenders
sometimesuseamoreconservativemortgagelendingvalue.
¾Realestateinvestmenthasbothbondlikeandstocklikecharacteristics
zBondlike:intheleasetime,similartothecouponpaymentsofbond.
zEquitylike:whenaleaseexpires,thereisuncertaintyregardingrenewaland
futurerentalrates.
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Example:Valuations
¾ ApropertythatwasdevelopedtwoyearsagoatacostofА60.0million,
includingland,isputonthemarketforthatprice.ItsellsquicklyforА50.0
million.Aftertheclosing,thepurchaseadmitshewouldhavepaiduptoА65.0
millionforthepropertybecauseheownedvacantlandnexttotheproperty
purchased.Averysimilarproperty(approximatelythesamesize,age,etc.)
recentlysoldforА55.0million.
1.Thepurchaserismostlikelya:
A.typicalinvestorB.particularinvestorC.shortterminvestor
2.Themarketvalueofthepropertyiscloserto:
A.А50.0millionB.А55.0millionC.А65.0million
3.Theinvestmentvalueofthepropertytothebuyerisclosestto:
A.А50.0millionB.А60.0millionC.А65.0million
22-157
Solutions
¾Solutionto1:
Biscorrect.Thisinvestormaybewillingtopaymorethanthetypicalinvestor
becauseofhisparticularcircumstances.
¾Solutionto2:
B is correct. The purchase paid А50.0 million rather than the А65.0 million he
was willing to pay for the property. However, we have to be careful about using
a transaction price as an indication of market value because the market may
have been thin and the seller may have been distressed and willing to accept
less than the property would have sold for if it had been kept on the market for
a longer period of time. The quick sale suggests that the price may have been
lower than what a typical investor may be willing to pay. There was a
comparable property that sold for А55.0 million. Combining these facts and
23-157
Solutions
basedonlyonthisinformation,itisreasonabletoassumethatthemarket
valueisclosettoА55.0million.Notethatwhatitcosttodeveloptheproperty
twoyearsagoisnotparticularlyrelevant.Marketsmayhavedeterioratedsince
thattime,andnewconstructionmaynotbefeasible.
¾Solutionto3:
Ciscorrect.TheinvestmentvalueofthepropertyisА65.0million.The
purchaserwaswillingtopayuptoА65.0million,suggestingthathis
investmentvaluewashigherthantheamountpaid.Hepaidonlyasmuchashe
hadto,basedonnegotiationswiththeseller.
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Valuations
¾Valuationapproaches:
zIncomeapproach:isthatvalueisbasedontheexpectedrateofreturn
requiredbyabuyertoinvestinthesubjectproperty.
zCostapproach:buyerwouldnotpaymoreforapropertythanitwouldcost
topurchaselandandconstructacomparablebuilding.
zSalescomparisonapproach:isthatabuyerwouldpaynomorefora
propertythanothersarepayingforsimilarproperties.
¾ Highestandbest:useofavacantsiteistheusethatproducesthehighest
impliedlandvalue.
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HighestandBest
¾Solution
Office Apartment
Valueoncompletion $20,000,000 $25,000,000

Costofconstructbuilding (16,000,000) (22,000,000)
Impliedlandvalue $4,000,000 $3,000,000
zAninvestor/developercouldpayupto$4millionforthelandtodevelopan
officebuildingbutonly$3millionforthelandtodevelopanapartment
building.Thehighestandbestuseofthesiteisanofficebuildingwithaland
valueof$4million.Ofcourse,thisanswerassumesacompetitivemarket
withseveralpotentialdeveloperswhowouldbidforthelandtodevelopan
officerbuilding.
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FrameworkofPrivateEquityValuation
CalculateNOI
StabilizedNOI
Income
DirectedCapitalizationMethod Allrisksyield(ARY)
Approach
Grossincome
CostApproach
Multiples
Technique
Sales
Comparison TermandReversion
Approach Approach
DCFMethod
LayerMethod
27-157
Incomeapproach:CalculateNOI
¾CalculateNOI
zCalculationofNOI(NetOperatingIncome)
9NOI=Rentalincomeiffullyoccupied +Otherincome
=Potentialgrossincome– Vacancyandcollectionloss
=Effectivegrossincome– Operatingexpense
=Netoperatingincome
¾Capitalizationrate
Caprate=discountrate– growthrate
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Example:calculateNOI
¾Example:
Aninvestorisconsideringthepurchaseofasmallofficebuildingand,aspartof
hisanalysis,mustcalculatetheNOI.Theinformationonthebuildingisasfollows:
Grosspotentialrentalincome •$250,000
Parkingincome •$50,000
Estimatedvacancyand
• 5%
collectionlossrate
Insurance •$10,000
Taxes •$8,000
UtilitiesandMaintenance •$22,000
Depreciation •$20,000
(Solution:NOI=(250000+50000)(15%)10000800022000)
29-157
Incomeapproach:DirectCapitalizationMethod
¾Incomeapproach:DirectCapitalizationMethod
zStep1:CalculateNOI1,thenetoperatingincomeforthefirstyear.
zStep2:Wecandefinedasthecurrentyield ontheinvestment:
NOI1
Cap rate =
value
9Wecanderivedfromrecentcomparabletransactionsasfollows:
NOI1
cap rate =
comparable sales price
zStep3:Rearrangingthepreviousformula:
NOI1
value = V0 =
cap rate
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Incomeapproach:StabilizedNOI
¾StabilizedNOI
zIfNOIisnotrepresentativeoftheNOIofsimilarpropertiesbecauseofa
temporaryissue,thesubjectproperty’sNOIshouldbestabilized.
¾Example:StabilizedNOI
zOnJanuary1ofthisyear,renovationbeganonashoppingcenter.Thisyear,
NOIisforecastedat€6million.Absentrenovations,NOIwouldhavebeen€10
million.Afterthisyear,NOIisexpectedtoincrease4%annually.Assumingall
renovationsarecompletedbythesellerattheirexpense,estimatethevalue
oftheshoppingcenterasofthebeginningofthisyearassuminginvestors
requirea12%rateofreturn.
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Incomeapproach:StabilizedNOI
¾Solution:
zStep1:Thevalueoftheshoppingcenterafterrenovationis:
Stabilized NOI 10, 000, 000

125, 000, 000
cap rate 12% 4%
zStep2:Usingthefinancialcalculator,thepresentvalueofthetemporary
declineinNOIduringrenovationis:
N=1;I/Y=12,PMT=0;FV=4,000,000;CPTPV=€3,571,429
9(Inthepreviouscomputation,weareassumingthatallrentisreceivedat
theendoftheyearforsimplicity).
zStep3:Thetotalvalueoftheshoppingcenteris:
Valueafterrenovations€125,000,000
Lossinvalueduringrenovations(3,571,429)
Totalvalue€121,428,571
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OtherApproach(1):AllRisksYield(ARY)
¾Allrisksyield(ARY)
zWhentenantsarerequiredtopayallexpenses,thecapratecanbeapplied
torentinsteadofNOI.Dividingrentbycomparablesalesiscalledtheallrisks
yield(ARY).
rent1
value = V0 =
ARY
zIfrentsareexpectedtoincreaseataconstantrateeachyear,theinternal
rateofreturn(IRR)canbeapproximatedbysummingthecaprateand
growthrate.
Internal rate of return (IRR) = Cap rate + Growth rate
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IncomeApproach:DCFMethod
¾DCFmethod
MV0=NOI1/(1+r)1 +NOI2/(1+r)2 +…+NOIn/(1+r)n +MVn/(1+r)n

¾DirectIncomeApproachtocalculateterminalvalue(reversionorresale):
MVn =NOIn+1/(rg)=NOIn+1/R0
9NOIn+1istheNOIoffirstyearownershipforthenextinvestor
9AssumingNOIisgrowingataconstantrate,g,andg<r.
9R0=rgisknownastheterminalcaprate orresidualcaprate
zLimitations:
9Difficulttoselectingtheappropriatecapitalizationrate
9 Incomecapitalizationisnotapplicableforowneroccupied
propertiesthatprovideotherbenefitsoramenities
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OtherApproach(2):GrossIncomemultiplierTechnique
¾Grossincomemultipliertechnique
zThegrossincomemultipliercanbederivedfromcomparabletransactions
justlikewedidearlierwithcaprates.
sales price
gross income multiplier =
gross income
zOnceweobtainthegrossincomemultiplier,valueisestimatedasamultiple:
Value = gross income u gross income multiplier
¾Limitations
zIgnoresvacancyrates
zIgnoresoperatingexpenses
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GrossIncomemultiplierTechnique
¾Example:Valuationusingthegrossincomemultipliertechnique
zAssumeyouareconsideringthepurchaseofanurbanofficebuildingwithan
estimatedgrossannualincomeof$2,500,000.Furtherassumethatthe
averagegrossincomemultiplierofseveralcomparableurbanofficebuildings
is2.7times.Computethevalueofthesubjectpropertyusingthegross
incomemultipliertechnique.
¾Answer:
z MV=grossincomeh incomemultiplier=$2,500,000h2.7=$6,750,000
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¾Indiscountedcashflowmethod,theterminalvalueis
NOI n+1 NOI n+1
Terminal Value = MVn = =
R0 r-g
¾Relationshipbetweendiscountratesandcapitalizationrates
zThediscountrate(r):therequiredrateofreturnontherealestate
investment.
zThecapitalizationrate(R0=rg):therequiredrateofreturnlessthe
expectedgrowthinNOI(increaseordecreaseinvalue)
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¾Relationshipbetweendiscountratesandcapitalizationrates
zTheterminalcaprate isnotnecessarilythesameasthegoingincaprate.
Goingincaprate=PMT/PV
zTheterminalcapratecouldbehigher ifinterestratesareexpectedto
increaseinthefutureorifthegrowthrateisprojectedtobelower because
thepropertywouldthenbeolderandmightbelesscompetitive.Also,
uncertaintyaboutfutureNOImayresultinahigherterminalcaprate.
zTheterminalcapratecouldbelower ifinterestratesareexpectedtobe
lowerorifrentalincomegrowthisprojectedtobehigher.
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ValuationwithDifferentLeaseStructure
¾ IntheU.K.thepropertyissaidtohavereversionarypotentialwhenthecontract
rentexpires
¾Method1:TermandReversionApproach
zOnewayofdialingwiththeproblemisknownasthetermandreversion
approach,wherebythecontract(term)rentandthereversionareappraised
separatelyusingdifferentcaprates.
zForexample:
zAsingletenantofficebuildingwasleasedsixyearsagoat£200,000peryear.
Thenextrentreviewoccursintwoyears.Theestimatedrentalvalue(ERV)in
twoyearsbasedoncurrentmarketconditionsis£300,000peryear.Theall
risksyield(caprate)forcomparablefullyletpropertiesis7%.Becauseof
lowerrisk,theappropriateratetodiscountthetermrentis6%.Estimatethe
valueoftheofficebuilding.
39-157
TermandReversionApproach
¾Answer:
zStep1:Usingthefinancialcalculator,thepresentvalueofthetermrentis:
N=2;I/Y=6,PMT=200,000;FV=0;CPTPV=£366,679
zStep2:ThevalueofreversiontoERVis:
ERV3 300, 000
V2 = 4, 285, 714
ERV cap rate 7%
zStep3:ThepresentvalueofthereversiontoERVis:
N=2;I/Y =7,PMT=0;FV=4,285,714;CPTPV=£3,743,309
zStep4:Thetotalvalueoftheofficebuildingtodayis:
PVoftermrent£366,679
PVofreversiontoERV£3,743,309
Totalvalue£4,109,988
40-157
¾Method2:Layermethod
zAvariationofthetermandreversionapproachistheLayermethod,one
source(layer)ofincomeisthecontract(term)rentthatisassumedto
continueinperpetuity.Thesecondlayeristheincreaseinrentthatoccurs
whentheleaseexpiresandtherentisreviewed.
¾Forexample:
zLet'sreturntotheexampleofthetermandreversionvaluationapproach.
Assumethecontract(term)rentisdiscountedat7%,andtheincremental
rentisdiscountedat8%.
41-157
¾Answer:
zStep1:Thevalueoftermrent(bottomlayer)intoperpetuityis:
term rent 200, 000
2,857,143
term rent cap rate 7%
zStep2:Thevalueofincrementalrentintoperpetuity(attimet=2)is:
ERV 300, 000 200, 000

1, 250, 000
ERV cap rate 8%
zStep3:Usingthefinancialcalculator,thepresentvalueoftheincremental
rent(toplayer)intoperpetuityis:
N=2;1/Y=8,PMT=0;FV=1,250,000;CPTPV=1,071,674
zStep4:Thetotalvalueoftheofficebuildingtodayis:
Total value = 2,857,143 1, 071, 674 3,928,817
42-157
EstimatesandAssumptions
¾ Usingthediscountedcashflowmethodrequiresthefollowingestimatesand
assumptions,especiallyforpropertieswithmanytenantsandcomplicatedlease
structures:
zProjectincomefromexistingleases:totrackthestartandenddatesandthe
variouscomponentsofeachlease
zLeaserenewalassumptions:theprobabilityofrenewal
zOperatingexpenseassumptions:beclassifiedasfixed,variable,orahybrid
ofthetwo
zCapitalexpenditureassumptions:expendituresforcapitalimprovements
zVacancyassumptions:howlongbeforecurrentlyvacantspaceisleased
zEstimateresaleprice:howlongtheinitialinvestorwillholdthepropertyis
important
zAppropriatediscountrate:someanalystsusebuyersurveysasaguide
43-157
AllocationofOperatingExpenses
¾Example:Allocationofoperatingexpenses
zTotaloperatingexpensesforamultitenantofficebuildingare30%fixedand
70%variable.Ifthe100,000squarefootbuildingwasfullyoccupied,
operatingexpenseswouldtotal$6persquarefoot.Thebuildingiscurrently
90%occupied.Ifthetotaloperatingexpensesareallocatedtotheoccupied
space,calculatetheoperatingexpenseperoccupiedsquarefoot.
¾Answer:
zIfthebuildingisfullyoccupied,totaloperatingexpenseswouldbe$600,000
(100,000SFhА6perSF).Fixedandvariableoperatingexpenseswouldbe:
Fixed$180,000(600,000h30%)
Variable$378,000(600,000h70%h90%)
Total$558,000
So,operatingexpensesperoccupiedsquarefootare$6.20(558,000total
operatingexpenses/90,000occupiedSF).
44-157
ComparethedirectcapitalizationandDCFmethods
¾ComparethedirectcapitalizationandDCFmethods
Directcapitalization DCF
Numerator FirstyearNOI Futurecashflow
•Needtoforecastwhatwillhappenedinfuture.
Inputsrequired •Lesscomplex
•Notdoingadetailedleasebyleaseanalysis.
Comparabletransactions Yes No
Choosingdiscountrate No Yes
zCommonerrorsmadeusingtheDCFmethod:
9 Thediscountratedoesnotadequatelycapturerisk.
9 Incomegrowthexceedsexpensegrowth.
9 Theterminalcaprateandthegoingincapratearenotconsistent.
9 TheterminalcaprateisappliedtoNOIthatisatypical.
9 Thecyclicalityofrealestatemarketsisignored.
45-157
CostApproach
¾ Costapproachinvolvesestimatingthemarketvalueoftheland,estimatingthe
replacementcostofthebuilding,adjustingfordepreciation andobsolescence.
Thecostapproachissometimesconsideredtheupperlimitofvalue.
¾Replacement&Reproduction
zReplacementcost:tothecostofabuildinghavingthesameutilitybut
constructedwithmodernbuildingmaterials.
zReproductioncost:thecostofreproducinganexactreplica ofthebuilding
usingsamebuildingmaterials,architecturaldesign,andqualityofconstruction.
zThereplacementcost estimateforthepropertyassumesitisanewbuilding
thathasnoobsolescence.
¾Curableandincurable
zCurable:fixingtheproblemwilladdvaluethatisatleastasgreatasthecost.
zIncurable:fixingproblemmaycostmoretocurethantheamountthatitwould
increasethevalueoftheproperty.
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CostApproach
¾Stepsinvolved:
zStep1:Estimatethemarketvalueoftheland
zStep2:Estimatethebuilding’sreplacementcost
zStep3:Deductdepreciationincludingphysicaldeterioration,functional
obsolescence,locational obsolescence,andeconomicobsolescence.
9 physicaldeterioration:relatedtothebuilding’sageandoccursasa
resultofnormalwearandtearovertime.
Costoffixingcurable itemsissubtractedfromreplacementcost.
Anitemisincurable iftheproblemisnoteconomicallyfeasibleto
remedy.Depreciationcanbeestimatebasedontheeffectiveageof
thepropertyrelativetoitstotaleconomiclife.
47-157
CostApproach
¾Stepsinvolved:
zStep3:Deductdepreciationincludingphysicaldeterioration,functional
obsolescence,locational obsolescence,andeconomicobsolescence.
9 Functionalobsolescence:isthelossinvalueresultingfromdefectsin
designthatimpairsabuilding’sutility.
9 Locational obsolescence:occurswhenthelocationisnolongeroptimal.
9 Economicobsolescence:occurswhennewconstructionisnotfeasible
undercurrenteconomicconditions.
48-157
Example:CostApproach
¾Example:CostApproach
z HeavenlyTowersisa200,000squarefoothighriseapartmentbuildinglocatedinthe
downtownarea.
z Thebuildinghasaneffectiveageof10years,whileitstotaleconomiclifeisestimatedat40
years.Thebuildinghasastructuralproblemthatisnotfeasibletorepair.Thebuildingalso
needsanewroofatacostof€1,000,000.Thenewroofwillincreasethevalueofthe
buildingby€1,300,000.
z Thebedroomsineachapartmentaretoosmallandthefloorplansareawkward.Asaresult
ofthepoordesign,rentsare€400,000ayearlowerthancompetingproperties.
z WhenHeavenlyTowerswasoriginalbuilt,itwaslocatedacrossthestreetfromapark.Five
yearsago,thecityconvertedtheparktoasewagetreatmentplant.Thenegativeimpacton
rentsisestimatedat€600,000ayear.
z Duetorecentconstructionofcompetingproperties,vacancyrateshaveincreased
significantlyresultinginalossofanestimatedvalueof€1,200,000.
z ThecosttoreplaceHeavenlyTowersisestimatedat€400persquarefootplusbuilder
profitof€5,000,000.Themarketvalueofthelandisestimatedat€20,000,000.An
appropriatecaprateis8%.Usingthecostapproach,estimatethevalueofHeavenlyTowers.
49-157
Example:CostApproach
¾Answer:
zReplacementcostincludingbuilderprofit85,000,000
[(200,000SFh €400perSF)+5,000,000]
zCurablephysicaldeteriorationι newroof(1,000,000)
zReplacementcostaftercurablephysicaldeterioration84,000,000
zIncurablephysicaldeteriorationι structuralproblem(21,000,000)
[(10yeareffectiveage/40yearlife)h 84,000,000]
zIncurablefunctionalobsolescenceι poordesign(5,000,000)
400,000lowerrent/8%caprate
zLocational obsolescenceι sewageplant(7,500,000)
[600,000lowerrent/8%caprate]
zEconomicobsolescenceι competingproperties(1,200,000)
zMarketvalueofland20,000.000
zEstimatedvalueusingthecostapproach€69,300,000
50-157
SalesComparisonApproach
¾ SalesComparisonApproach:buyerwouldpaynomoreforapropertythan
othersarepayingforsimilarpropertiesinthecurrentmarket.
¾Example:Salescomparisonapproach
Anappraiserhasbeenaskedtoestimatedthevalueofawarehouseandhas
collectedthefollowinginformation:
ComparableTransaction
UnitofComparison SubjectProperty 1 2 3
Size,insquarefeet 30,000 40,000 20,000 35,000
Age,inyear 5 9 4 5
Physicalcondition Average Good Average Poor
Location Prime Prime Secondary Prime
Saledate,months
6 18 12
ago
Salesprice $9,000,000 $4,500,000 $8,000,000
51-157
¾ Theappraiser’sadjustmentsarebasedonfollowing:
z Eachadjustmentisbasedontheunadjustedsalespriceofthecomparable.
z Propertiesdepreciateat2%perannum.Sincecomparable#1isfouryearsolder
thanthesubject,anupwardadjustmentof$720,000ismade
[$9,000,000h2%h4year]
z Conditionadjustment:Good:+5%,average:none;poor:ι5%.Because
comparable#1isinbetterconditionthanthesubject,adownwardadjustment
of$450,000ismade[$9,000,000h5%].Similarly,anupwardadjustmentismade
forcomparable#3tothetuneof$400,000[$8,000,000h5%].
z Locationadjustment:Prime– none,secondary– 10%.Becausebothcomparable
#1andthesubjectareinaprimelocation,noadjustmentismade.
z Overthepast24months,salespriceshavebeenaappreciating0.5%permonth.
z Becausecomparable#1wassoldsixmonthsago,anupwardadjustmentof
$270,000ismade[$9,000,000h0.5%h6months]
52-157
¾Answer:
zOncetheadjustmentsaremadeforallofthecomparabletransaction,theadjusted
salespricepersquarefootofthecomparabletransactionsareaveragedandapplied
tothesubjectpropertyasfollows:
ComparableTransactions
Adjustment SubjectProperty 1 2 3
Salesprice $9,000,000 $4,500,000 $8,000,000
Age +720,000 90,000 ˉ
Condition 450,000 ˉ +400,000
Location ˉ +450,000 ˉ
Saledate +270,000 +405,000 +480,000
Adjustedsalesprice $9,540,000 5,265,000 $8,880,000
Sizeinsquarefeet 30,000 40,000 20,000 35,000
AdjustedsalespriceperSF $238.50 $263.25 $253.71
AveragesalespriceperSF $251.82
Estimatedvalue $7,554,600
53-157
CompareCostandSalesComparisonApproaches
¾ComparetheCostandSalesComparisonApproaches
CostApproaches SalesComparisonApproaches
•Upperlimitonthevalue
Advantages •Ifmarketisactive,quitereliable
(tothebuyer.)
•Unreliable,whenmarketisweak
•Difficulttofindcomparables
Disadvantages •Difficulttoestimate
•Investors’behavingrationally,
misleadingin“Bubble”market.
54-157
RECONCILIATIONOFVALUE
¾RECONCILIATIONOFVALUE
zBecauseofdifferentassumptionsandavailabilityofdata,thethreevaluation
approachesarelikelytoyielddifferentvalueestimates.
zAnimportantpartoftheappraisalprocessinvolvesdeterminingthefinal
estimateofvaluebyreconcilingthedifferencesinthethreeapproaches.
zAnappraisermayprovidemore,orlessweight toanapproachbecauseof
thepropertytypeormarketconditions.
55-157
RealEstateinvestmentindices
¾ Anumberofrealestateindicesareusedtotracktheperformanceofrealestate
including:
zAppraisalbasedindices:combinevaluationsofindividualpropertiesthatcan
beusedtomeasuremarketmovements.
NOI-capital expenditures+(end market value-begin market value)
return =
beginning market value
9Quarterlydata
9Valueweighted baseonthereturnoftheseparateproperties.The
returnisknownasaholdingperiodreturnandisequivalenttoasingle
periodIRR.
9Appraisalbased Indices
9Drawbacks:
Marketvaluemustincreasebymorethanthecapitalexpenditures
LagactualtransactionsLowcorrelation
Smooth
56-157
RealEstateinvestmentindices
zTransactionbasedindices
9 Repeatsalesindex:reliesonrepeatsalesofthesameproperty.A
changeinmarketconditionscanbemeasuredonceapropertyissold
twice.Accordingly,aregressionisdevelopedtoallocatethechangein
valuetoeachquarter.
9 Hedonicindex:requiresonlyonesale.Aregressionisdevelopedto
controlfordifferencesinpropertycharacteristicssuchassize,age,
location,andsoforth.
57-157
FinancialRatiosUsedtoAnalysis——Debt
¾ Lendersoftenusethedebtservicecoverageratio(DSCR)andtheloantovalue
(LTV)ratiotodeterminethemaximumloanamountonaspecificproperty.The
maximumloanamountisbasedonthemeasurethatresultsinthelowestdebt.
zDebtservicecoverageratio(DSCR)
First-year NOI
DSCR =
debt service
9Debtservice(loanpayment)includesinterestandprincipal
zLoantovalue(LTV)ratioiscalculatedasfollows:
loan amount
LTV =
appraisal value
58-157
FinancialRatiosUsedtoAnalysis
¾Example(1):Maximumloanamount
zArealestatelenderagreedtomakea10%interestonlyloanonaproperty
thatjustappraisedfor€1,200,000aslongasthedebtservicecoverageratio
isatleast1.5andtheloantovalueratiodoesnotexceed80%.Calculatethe
maximumloanamountassumingtheproperty’sNOIis€135,000.
¾Answer:
zUsingtheLTVratio,thepropertywillsupportaloanamountof€960,000
[1,200,000valueh80%LTVratio].UsingtheDSCR,thepropertywillsupport
adebtservicepaymentof€90,000[135,000NOI/1.5].Thus,theloan
amountwouldbe€900,000[90,000payment/10%interestrate].Inthiscase,
themaximumLoanamountisthe€900,000,whichisthelowerofthetwo
amounts.At€900,000,theLTVis75%[900,000loanamount/1,200,000
value]andtheDSCRis1.5[135,000NOI/90,000payment].
59-157
¾ Equitydividendrate(cashoncashreturn) iscalculatedasfollows,which
measuresthecashreturnontheamountofcashinvested:
first year cash flow
equity dividend rate =
equity
¾LeveragedIRR
zConsiderthecashflowsovertheentireholdingperiodincludingthechange
invalueoftheoriginalinvestment.
zAttheendoftheholdingperiod(i.e.,netsalesproceeds)arereducedbythe
outstandingmortgagebalance.
¾UnleveragedIRR
zTheinitialcashoutflowishigherbecausenodebtisincurred.Theannualcash
flowsarehigherbecausethereisnodebtservice,andtheterminalcashflow
ishigherbecausenomortgagebalanceisrepaidattheendoftheholding
period.
60-157
¾Example(2):Equitydividendmaximumloanamount
zReturningtothepreviousexample,calculatetheequitydividendrate(cash
oncashreturn)assumingthepropertyispurchasedfortheappraisedvalue.
¾Answer:
zThe€1,200,000propertywasfinancedwith€ 900,000debtand€ 300,000
equity.Firstyearcashflowis€ 45,000(135,000NOI– 90,000debtservice
payment).Thus,theequitydividendrateis15%(45,000firstyearcashflow/
300,000equity).
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¾Example(3):LeveragedIRRandunleveragedIRR
zReturningtothelastexample,calculatetheIRRifthepropertyissoldatthe
endofsixyearsfor€1,500,000.
¾Answer:
zOvertheholdingperiod,annualcashflowsof€45,000arereceivedand,at
theendofsixyears,thesaleproceedsof€1,500,000arereducedbythe
outstandingmortgagebalanceof€900,000.Recallthattheloanwasinterest
onlyand,hence,theentireoriginalmortgageamountof€900,000was
outstandingattheendoftheholdingperiod.Usingthefinancialcalculator,
theleveragedIRRis24.1%asfollows:
N=6;PV=(300,000),PMT=45,000;FV=600,000;CPTI/Y=24.1%
zReturningtothelastexample,theunleveragedIRRis14.2%asfollows:
N=6;PV=(1,200,000),PMT=135,000;FV=1,500,000;CPTI/Y=14.2%
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SS13
63-157
ExamFocuses
¾ Differenttypesofpubliclytradedrealestatesecurities;
¾ Advantagesanddisadvantagesofpubliclytradedrealestatesecurities;
¾ TypesofREITs,economicvalue,characteristic,principlerisks,duediligence
considerations;
¾ VariousapproachestoREITvaluation
¾ CalculatethevalueofaREITshare
64-157
TypesofPubliclyTradedRealEstateSecurities
¾Equity
zEquityREITs(Realestateinvestmenttrusts):
9 Taxadvantagedcompanies(trusts):themostpartexemptfrom
corporateincometax.
9 EquityREITsareactivelymanaged,ownincomeproducingrealestate,
andseektoprofitbygrowingcashflows,improvingexistingproperties,
andpurchasingadditionalproperties.
9 REITsoftenspecializeinaparticularkindofproperty,whilestill
diversifyingholdingsbygeographyandotherfactors.
zREOCs(Realestateoperatingcompanies)
9REOCsarenottaxadvantaged
9AbusinesswillformasaREOCifitisineligibletoorganizeasREIT.
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TypesofPubliclyTradedRealEstateSecurities
¾Debt
zResidentialorcommercialmortgagebackedsecurities(MBS)
9 Residentialorcommercialmortgagebackedsecuritiesarepublicly
tradedassetbackedsecuritizeddebtobligationsthatreceivecashflows
fromanunderlyingpoolofmortgageloans.
9 Commercialproperties(CMBS)
9 ResidentialProperties(RMBS)
zMortgageREITs
9 MortgageREITsinvestprimarilyinmortgages,mortgagesecurities,or
loansthataresecuredbyrealestate.
¾HybridREITs
zOwnandoperateincomeproducingrealestate,asdoequityREITs,butinvest
inmortgagesaswell.
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AdvantagesandDisadvantagesofPublicTradedSecurities
¾Advantages
zSuperiorliquidity:REITandREOCsharestradedailyonastockexchange.
zLowerminimuminvestment:sharestradeformuchsmallerdollaramounts.
zLimitedliability:liabilityofaREITinvestorislimitedtotheamountinvested.
zAccesstopremiumproperties:caninvestindifficultenteredproperties.
zActiveprofessionalmanagement:REITsandREOCsemployprofessional
management.
zProtectionsaccordedtopubliclytradedsecurities:mustmeetthesame
requirementsapplicabletootherpubliclytradedcompanies.
zGreaterpotentialfordiversification:ThroughREITsaninvestorcandiversify
acrosspropertytypeandgeographicallocation.
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¾REITspecificadvantages
zExemptionfromtaxation:Aslongascertainrequirementsaremet,REITs
enjoyfavorabletaxation,becauseamajorpartofREITdistributionsare
treatedasareturnofcapitalandarethusnottaxable.
zPredictableearnings:TheearningsofREITstendtoberelativelyconsistent
overtime,becauseREITs'rentalincomeisfixedbycontracts.
zHighyield:Becauseofthishighincomepayoutratio,theyieldsofREITsare
higherthantheyieldsonmostotherpubliclytradedequities.
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¾Disadvantages
zTaxesversusdirectownership:REITsorREOCsnotavailabletodeductlosses
onrealestatefromtaxableincomeorreplaceonepropertyforasimilar
property("likekindexchange"intheU.S.)withouttaxationonthegains.
zLackofcontrolREIT:littleinputintoinvestmentdecisions
zCostsofapubliclytradedcorporatestructure:costsmaynotbeworthwhile
forsmallerREITs.
zPriceisdeterminedbythestockmarket:marketdeterminedpriceofaREIT
shareislikelytobemuchmorevolatile.
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¾Disadvantages
zStructuralconflictsofinterest:differenttaximplicationsforREIT
shareholdersandforthegeneralpartners,conflictofinterest.
zLimitedpotentialforincomegrowth:highratesofincomepayoutlimitREITs'
abilitytogeneratefuturegrowththroughreinvestment.
zForcedequityissuance:REITsfrequentlyparticipateinbondmarketsto
refinancematuringdebt.Whencreditisdifficulttoobtain(e.g.,duringthe
2008creditcrisis),aREITmaybeforcedtoissueequityatadisadvantageous
price.
¾ThefollowingdisadvantageappliestoREITs,butnottoREOCs:
zLackofflexibility:REITsarepreventedfrommakingcertainkindsof
investmentsandfromretainingmostoftheirincome.
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SUBTYPESOFEQUITYREITS
Economic
Investment
REITType Value PrincipalRisks DueDiligenceConsideration
Characteristics
Determinant
•Retailsales •Stablerevenue
growth •Dependson •Persquarefootsalesandrental
Retail streamoverthe
consumerspending rates
•Jobcreation shortterm
•Jobcreation •Long(525years) •Newspaceunderconstruction
leaseterms •Changesinoffice
Office •Newspace vacancyandrental •Qualityofofficespace(location,
supplyvs. •Stableyeartoyear rates
demand income conditionofbuilding,andsoon)
•Competition
•Demographicsandincometrends
•Population •Inducements
Reside •Oneyearleases •Ageandcompetitiveappeal
growth •Regionaleconomy
ntial •Stabledemand •Costofhomeownership
•Jobcreation •Inflationinoperating
•Rentcontrols
costs
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EconomicValue Investment
REITType PrincipalRisks DueDiligenceConsideration
Determinant Characteristics
•Constructionofnewcompetitive
facilities
•Spaceisrented •Trendsinhousingsales
•Population •Easeofentrycan
growth undergross •Demographictrends
Storage leadto
leasesandona
•Jobcreation overbuilding •Newbusinessstartupactivity
monthlybasis
•Seasonaltrendsindemandfoe
storagefacilitiesthatcanbe
significantinsomemarkets
•Demographics
•Operatingtrends
•REITslease •Government
•Population •Governmentfundingtrends
facilitiestohealth binding
growth
Health careproviders •Litigationsettlements
•Newspace •Constructioncycles
care •Leasesare •Insurancecosts
supplyvs. •Financialcondition
usuallynet
demand ofoperators •Competitors’newfacilitiesvs.
leases.
demand
•Tenantlitigation
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EconomicValue Investment
REITType PrincipalRisks DueDiligenceConsideration
Determinant Characteristics
•Lesscyclicalthan
someotherREIT •Trendsintenants’requirements
•Retailsales types •Shiftsinthe
compositionof •Obsolescenceofexistingspace
growth •525yearnet
Industrial localandnational •Needfornewtypesofspace
•Population leases industrialbases
growth •Proximitytotransportation
•Changeinincome andtrade
andvaluesare •Trendsinlocaltypeanddemand
slow
•Occupancy,roomrates,and
operatingprofitmarginsvs.
•Exposedto
businesscycle industryaverages
•Variableincome
•Jobcreation •Revenueperavailableroom
•Sectoriscyclical •Changesin
Hotel •Newspace businessand (RevPAR)
becauseitisnot
supplyvs. leisuretravel
protectedbylong •Trendsinforwardbookings
demand
termleases •Exposuretotravel •Maintenanceexpenditures
disruptions
•Newconstructioninlocalmarkets
•Financialleverage
73-157
EconomicvalueDeterminantsofREITs
zNationalGDPgrowthisthelargestdriver ofeconomicvalueforallREITtypes.
zPopulationgrowth
zJobcreation
zNewspacesupplyVs.Demand
zRetailsalesGrowth
National NewSpace
RetailSales Population
REITType GDP JobCreation Supplyvs.
Growth Growth
growth Demand
Shopping/Retail 1 3 2 4 4
Office 1 2 5 4 3
Healthcare 1 4 5 2 3
Industrial 1 5 2 3 4
Hotel 1 2 5 4 3
Storage 1 3 5 2 4
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InvestmentCharacteristicsofREITs
¾InvestmentCharacteristicsofREITs.
z Exemptionfromcorporatelevelincometaxes:thedefiningcharacteristicof
REITsisthattheyareexemptfromcorporatetaxation.
z Highdividendyield:REITs'dividendyieldsaregenerallyhigherthanyieldson
bondsorotherequities.
z Lowincomevolatility:REITs'revenuestreamstendtoberelativelystable.
z Secondaryequityofferings:SinceREIT’sarelikelytofinanceadditionalreal
estateacquisitionsbysellingadditionalshares.
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InvestmentCharacteristicsofREITs
¾PrincipalRisksofREITs
zSignificantmismatchesbetweensupplyanddemand.
zOccupancyratesaremostlikelytofluctuateforshortperiodoftime.
zProperties'financingproblems,whentheleasesthatareinplace.
zProperties'locationsandquality
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DueDiligenceconsiderationsofREITs
¾DueDiligenceconsiderationsofREITs
zRemainingleaseterms:evaluatethelengthofremainingleasetermsin
conjunctionwiththeoverallstateoftheeconomy
zInflationprotection:levelofcontractualhedgingagainstrisinggeneralprice
levels
zInplacerentsversusmarketrents:comparetherentsthataREIT'stenants
arecurrentlypaying(inplacerents)withcurrentrentsinthemarket.
zCoststoreleasespace:thecostsoftenantdemandedimprovements,and
brokercommissions.
zTenantconcentrationintheportfolio:payspecialattentiontoanytenants
thatmakeupahighpercentageofspacerentedorrentpaid.
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DueDiligenceconsiderationsofREITs
¾DueDiligenceconsiderationsofREITs
zTenants'financialhealth:itisimportanttoevaluatethefinancialpositionof
theREIT'slargestrenters.
zNewcompetition:evaluatetheamountofnewspacethatisplannedor
underconstruction.
zBalancesheetanalysis:anindepthanalysisoftheREIT'sbalancesheet,with
specialfocusontheamountofleverage,thecostofdebt,andthedebt's
maturity.
zQualityofmanagement:Seniormanagement'sperformancerecord,
qualifications,andtenurewiththeREITshouldbeconsidered.
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NAVPSinREITValuation
¾ NAVPSisthe(pershare)amountbywhichassetsexceedliabilities,usingcurrent
marketvaluesratherthanaccountingbookvalues.
zGenerallyconsideredthemostappropriatemeasure.
zCapitalizationrate(“caprate”)frommarket
net operating income
capitalization rate =
property value
zPropertyvalue
net operating income
property value =
capitalization rate
zNetoperatingincomeistheexpectedincomeinthecomingyear.
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NAVPSinREITValuation
¾NAVPS
EstimatedcashNOIthisyear 1
*(1+g)
=CashNOIinthecomingyear 2
/Assumedcaprate
=Estimatedvalueofoperatingrealestate 3
+Cashandaccountsreceivable
Debtandotherliabilities
=Netassetvalue 4
/Sharesoutstanding
5
=NAV/share
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Example:NAVPSinREITValuation
¾Example:ComputingNAVPS
z Vinny Cestonc,CFA,isundertakingavaluationoftheAnyco ShoppingCenterREIT,Inc.
GiventhefollowingfinancialdataforAnyco,estimateNAVPSbasedonforecastedcashnet
operatingincome.
z SelectAnyco ShoppingCenterREIT,Inc.FinancialInformation(inmillions)
Last12monthsNOI$80
Cashandequivalents$20
Accountsreceivable$15
Totaldebt$250
Otherliabilities$50
Noncashrents$2
Fullyearadjustmentforacquisitions$1
Landheldforfuturedevelopment$10
Prepaid/Otherassets(excludingintangibles)$5
Estimateofnext12monthsgrowthinNOI1.25%
Capratebasedonrecentcomparabletransactions8.0%
Sharesoutstanding15
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Example:NAVPSinREITValuation
¾Answer:
Last12monthsNOI$80
Noncashrents(1)$2
+Fullyearadjustmentforacquisitions(2)$1
=ProformscashNOIforlast12months$79
+Next12monthsgrowthinNOT(@1.25%/yr)(3)$1
=Estimatednext12monthscashNOI$80
+Caprate(4)8.0%
Estimatedvalueofoperatingrealestate(5)$1,000
+Cashandequivalents(6)$20
+Landheldforfuturedevelopment$10
+Accountsreceivable$15
+Prepaid/otherassets(excludingintangibles)$5
=Estimatedgrossassetvalue$1,050
Totaldebt(7)$250
Otherliabilities$50
Netassetvalue$750
+Sharesoutstanding15
=Netassetvaluepershare(8)$50.00
82-157
FFOandAFFOinREITValuation
¾FFO
Accountingnetearnings
+Depreciationexpense
+Deferredtaxexpenses(i.e.,deferredtaxexpenses)
Gainsfromsalesofpropertyanddebtrestructuring
+Lossesfromsalesofpropertyanddebtrestructuring
=Fundsfromoperations
83-157
FFOandAFFOinREITValuation
¾ AFFO,alsoknownascashavailablefordistribution(CAD)orfundsavailablefor
distribution(FAD).
FFO(fundsfromoperations)
Noncash(straightline)rentadjustment
Recurringmaintenancetypecapitalexpendituresandleasingcommissions
=AFFO(adjustedfundsfromoperations)
zNoncash(straightline)rentadjustment:refersnottothecashrentpaid
duringtheleasebutrathertotheaveragecontractualrentoveralease
period.
zRecurringmaintenancetypecapitalexpendituresandleasingcommissions:
representcoststhatmustbeexpendedinordertomaintainthevalueofthe
properties.
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NAVPS,Relativevalue,andDCFtoREITValuation
¾NAVPS:anindicationofaREIT’sassetstoabuyerintheprivatemarket.
¾ Relativevalue(pricetoFFOandpricetoAFFO):Therearethreekeyfactorsthat
impactpricetoFFOandpricetoAFFO:
9Expectationsforgrowth ofFFOorAFFO.
9Thelevelofrisks inherentintheunderlyingrealestate.
9Risk relatedtothefirm'sleverageandaccesstocapital.
zPricetoAFFObettermeasureofeconomicincomethanPricetoFFO
zPricetoFFOismorefrequently citedinpractice
¾ Discountedcashflowapproach:typicallydevelopnearterm,mediumterm,and
longtermgrowthforecastsandthenusethesevaluesasthebasisfortwo or
threestagedividenddiscountmodels.
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CalculationtheValueofaREITshare
¾Example:CalculatingthevalueofaREITshare
zLucindaCrabtree,CFA,isanassetmanagerthatisinterestedindiversifying
theportfolioshemanagesthroughaninvestmentinanofficebuildingREIT.
zCrabtreewantstovaluethepotentialinvestmentusingfourdifferent
approachesasoftheendof2O13,asfollows:
Approach1:Netassetvalue
Approach2:PricetoFFO
Approach3:PricetoAFFO
Approach4:Discountedcashflow
SelectedREITFinancialInformation
86-157
Allamountin$million
Estimated12monthscashnetoperatingincome(NOI)$80
Fundsfromoperations(FF0)$70
Cashandequivalents$65
Accountsreceivable$35
Debtandotherliabilities$400
Noncashrents$5
Recurringmaintenancetypecapitalexpenditures$15
Sharesoutstanding10millionshares
Expectedannualdividendnextyear(2014)$5.00
Dividendgrowthratein2015and20162%
Dividendgrowthrate(from2017intoperpetuity)1%
Assumedcaprate8%
OfficesubsectoraverageP/FFOmultiple10%
OfficesubsectoraveragePIAFFOmultiple14%
Crabtree’sapplicablecostofequitycapital9%
Riskfreerate2%
87-157
¾ApproachI:ValueofaREITshareusingnetassetvalueapproach
ThevaluepershareforthisREITusingnetassetvaluevaluationiscomputedasfollow:
EstimatedcashN0I80
Assumedcaprate8%
Estimatedvalueofoperatingrealestate(80/08)1,000
Pluscash+accountsreceivable100
Lessdebtandotherliabilities400
Netassetvalue700
Sharesoutstanding10
NAV/share$70.00
TheREITsharevalueusingthenetassetvalueapproachisthus$70.
¾Approach2:ValueofaREITshareusingpricetoFFOapproach
ThevaluepershareforthisREITusingpricetoFFOvaluationiscomputedasfollows:
Sharesoutstanding(millions)10
FFO/share=$70million110millionshares$7.00
88-157
ApplyingtheofficesubsectoraverageP/FFOmultipleofl0h yieldsavaluepershareof:
$7.00h 10=$70.00
TheREITsharevalueusingthepricctoFF0approachisthus$70.
¾Approach3:ValueofREITshareusingpricetoAFFOapproach
Subtractnoncashrents$5
Subtractrecurringmaintenancetypecapitalexpenditures$15
EqualsAFFO$50
Sharesoutstanding(million)10
2
AFFOIshare$50million110millionshares$5
PropertysubsectoraveragePIAFFOmultiple14h
ApplyingtheofficesubsectoraveragePIAFFOmultipleofl4xyieldsavaluepershareof
$55h 14=$70.
TheREITsharevalueusingthepricetoAFFOapproachisthus$70.
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¾Approach4:ValueofREITshareusingdiscountedcashflowapproach
2014 2015 2016 2017

Dividendspershare $5.00 $5.10 $5.20 $5.25
Presentvaluein2016ofdividendsstreambeginningin2017=5.25/(0.090.02)=75.06
Thesedividendsarediscountedatarateof9%.
valueofaREITshare
=PV(dividendsforyears1throughn)+PV(terminalvalueattheendofyearn)
= PV2014 dividend +PV2015 dividend +PV2016 dividend +PV2017 and later dividends (terminal value)
$5.00 $5.10 $5.20 $75.06
70.85
(1.09) (1.09) 2 (1.09)3 (1.09)3
TheREITsharevalueusingthediscountedcashflowapproachisthus$70.85.
NotethatthecalculatedvalueofaREITshareislikelytovary,sometimesgreatly,
dependingonwhichoftheseapproachesisused.
90-157
SS13
91-157
FrameworkofPrivateEquityValuation
ThreeSourcesofValueCreation
PEFundsCharacters Risks,Costs,Structure,Terms
Managementfee,Carryinterest
NAV,PIC,DPI,RVPI,TVPI
PrivateEquity
Valuation Diversofreturns
BuyoutFunds
Valuation
Diversofreturns
VentureCapital
NPVandIRRmethods
92-157
IntroductiontoPE
¾PEinvestmenttransaction
zPEinvestor:denotetheoutsideinvestorwhomakesaninvestmentinafund
offeredbythePEfirm.
zPrivateequityfirm(PEfirm):todenotetheintermediaryintheillustrated
transaction.
zPortfoliocompany:denotethecompaniesthatprivateequityfirmsinvestin.
¾ClassificationofPrivateEquity
zVentureCapital(VC):workingwithearlystagecompaniesthatinmanycases
havenorevenuesbuthavepotentiallygoodideasortechnology.
zBuyout:theprivateequityfirmbuystheentirecompany.
zSpecialsituations:investedindistressedsecurities,onetimeopportunities,
orothers
93-157
ValuationtechniquesinPEvaluation(1)
¾ValuecreationinPE
zReengineerthefirmandoperateitmoreefficiently
zObtaindebtfinancingonmoreadvantageterms
zBetteralignmentofinterestsbetweenmanagementandPEownership
¾ControlMechanismsinPEtransactions
zCompensation&Tagalong,dragalongclauses
9 Compensation:Managersoftheportfoliocompaniesreceive
compensationthatiscloselylinkedtothefirm’sperformance,andthe
compensationcontractcontainsclausesthatpromotetheachievement
ofthefirm’sgoals.
9 Tagalong,dragalongclauses:Anytimeanacquireracquirescontrolof
thecompany,theymustextendtheacquisitionoffertoall
shareholders,includingfirmmanagement.
94-157
ValuationtechniquesinPEvaluation
zBoardrepresentation&Noncompeteclauses
9 Boardrepresentation:Theprivateequityfirmisensuredcontrol
throughboardrepresentationifthefirmexperiencesamajorevent
suchasatakeover,restructuring,initialpublicoffering(IPO),
bankruptcy,orliquidation.
9 Noncompete clauses:Companyfoundersmustsignsuchclausesthat
preventthemfromcompetingagainstthefirmwithinaprespecified
periodoftime.
95-157
zPriorityinclaims,Requiredapprovals,&Earnouts
9 Priorityinclaims:Privateequityfirmsreceivetheirdistributionsbefore
otherowners,oftenintheformofpreferreddividendsandsometimes
specifiedasamultipleoftheiroriginalinvestment.Theyalsohave
priorityonthefirm’sassetsiftheportfoliocompanyisliquidated.
9 Requiredapprovals:Changesofstrategicimportance(e.g.,acquisitions,
divestitures,andchangesinthebusinessplan)mustbeapprovedbythe
privateequityfirm.
9 Earnouts:Theseareusedpredominantlyinventurecapital
investments.Earnoutstietheacquisitionpricepaidbytheprivate
equityfirmtotheportfoliocompany’sfutureperformanceovera
specifiedtimeperiod.
96-157
¾ValuationCharacteristics:VCvs.Buyout
z Cashflows&Productmarket
z Product&Assetbase
z Financialleverage&Riskassessment
z Goalsetting&Investmentreturns
z Capitalmarketpresence&Exit
z Workingcapitalrequirement&Abilitytogrowthroughsubsequentfunding
z Managementteam,Operation&Salestransaction
z DueDiligencePerformedbyPEfirms
z Sourceofgeneralpartner’svariablerevenue
97-157
Characteristic VentureCapitalInvestments BuyoutInvestments
CashFlows • Lowpredictabilitywithpotentially • Stableandpredictablecashflows

unrealisticprojections
ProductMarket • Newproductmarketwithuncertain • Strongmarketpositionwitha
future possiblenicheposition
Products • Productisbasedonnewtechnology • Establishedproducts
withuncertainprospects
AssetBase • Weak • Substantialbasethatcanserveas
collateral
Management • Newteamalthoughindividual
Team memberstypicallyhaveastrong • Strongandexperienced
entrepreneurialrecord
• Highamountsofdebtwithalarge
Financial • Lowdebtusewithamajorityof percentageofseniordebtand
Leverage equityfinancing substantialamountsofjuniorand
mezzaninedebt
• Riskisdifficulttoestimateduetonew • Riskcanbeestimatedduetoindustry
RiskAssessment technologies,markets,andfirm andfirmmaturity
history
Exit • ExitviaIPOorfirmsaleisdifficultto • Exitispredictable
forecast
Operations • Highcashburnraterequireddueto • Potentialexistsforreductionin

firmandproductimmaturity inefficiencies
98-157
Characteristic VentureCapitalInvestments BuyoutInvestments
WorkingCapital • Increasingrequirementsdueto • Lowrequirements
Required growth
DueDiligence • Privateequityfirmsinvestigate
Performedby technologicalandcommercial • Privateequityfirmsperform
PrivateEquityFirms prospects;investigationoffinancials extensiveduediligence
islimitedduetoshorthistory
GoalSetting • Goalsaremilestonessetinbusiness • Goalsreferencecashflows,strategic
planandgrowthstrategy plan,andbusinessplan
PrivateEquity • Highreturnscomefromafewhighly • Lowvariabilityinthesuccessof
Investment successfulinvestmentswithwriteoffs investmentswithfailuresbeingrare
Returns • fromlesssuccessfulinvestments
CapitalMarket • Generallynotactiveincapitalmarkets • Activeincapitalmarkets
Presence
• Mostfirmsaresoldasaresultofthe • Firmsaretypicallysoldinanauction
SalesTransactions relationshipbetweenventurecapital typeprocess
firmandentrepreneurs
AbilitytoGrow
Through • Firmsarelessscalableassubsequent • Strongperformerscanincrease
Subsequent fundingistypicallysmaller subsequentfundingamounts
Funding
SourceofGeneral • Carriedinterestismostcommon, • Carriedinterest,transactionfees,and
Partner’s transactionandmonitoringfeesare monitoringfees
VariableRevenue lesscommon
99-157
PrivateEquityFundStructure
¾LimitedPartnership
¾EconomictermsofaPEfund
z Managementfees&Transactionfees
9 Managementfees:ThesearefeespaidtotheGPonanannualbasisas
apercentofpaidincapitalinvestedandusuallyrangefrom1.5%to
2.5%.
9 Transactionfees:ThesearepaidtotheGPforfundinvestmentbanking
services,suchasarrangingamerger.Thesefeesareusuallysplitevenly
withtheLPsand,whenpaid,aredeductedfrommanagementfees.
100-157
z Carriedinterests,Ratchet,&Hurdlerate
9 Carriedinterest:ThisistheGP’sshareofthefundprofitsandisusually
20%aftermanagementfees.
9 Ratchet:Thisspecifiestheallocationofequitybetweenstockholders
andmanagementoftheportfoliofirmandallowsmanagementto
increasetheirallocation,dependingonfirmperformance.
9 Hurdlerate:ThisistheIRthatthefundmustmeetbeforetheGPcan
receivecarriedinterest.Itusuallyvariesfrom7%to10%and
incentivizestheGP.
101-157
z Targetfundsize,Vintage,&Termofthefund
9 Targetfundsize:ThestatedtotalmaximumsizeofthePEfund,
specifiedasanabsolutefigure.ItsignalstheGP’sabilitytomanageand
raisecapitalforafund.Itisanegativesignalifactualfundsultimately
raisedaresignificantlylowerthantargeted.
9 Vintage:Thisistheyearthefundwasstartedandfacilitates
performancecomparisonswithotherfunds.
9 Termofthefund:Asdiscussedpreviously,thisisthelifeofthefirmand
isusuallytenyears.
102-157
¾CorporateGovernancetermsofaPEfund
z Keymanclause&performancedisclosureandconfidentiality
9 Keymanclause:Ifakeynamedexecutiveleavesthefundordoesnot
spendasufficientamountoftimeatthefund,theGPmaybe
prohibitedfrommakingadditionalinvestmentsuntilanotherkey
executiveisselected.
9 Performancedisclosureandconfidentiality:Thisspecifiesthefund
performanceinformationthatcanbedisclosed.Notethatthe
performanceinformationforunderlyingportfoliocompaniesistypically
notdisclosed.
103-157
z Clawback&distributionwaterfall
9 Clawback:Ifafundisprofitableearlyinitslife,theGPreceives
compensationfromtheGP’scontractuallydefinedshareofprofits.
Underaclawback provision,ifthefundsubsequentlyunderperforms,
theGPisrequiredtopaybackaportionoftheearlyprofitstotheLPs.
Theclawback provisionisusuallysettledatterminationofthefundbut
canalsobesettledannually(alsoknownastrueup).
104-157
z Clawback&distributionwaterfall
9 Distributionwaterfall:Thisprovisionspecifiesthemethodinwhich
profitswillflowtotheLPsandwhentheGPreceivescarriedinterest.
Twomethodsarecommonlyused.Inadealbydealmethod,carried
interestcanbedistributedaftereachindividualdeal.
Dealbydealmethod:carriedinterestcanbedistributedaftereach
individualdeal.
Totalreturnmethod:carriedinterestiscalculatedontheentire
portfolio.
OnlyaftertheentirecommittedcapitalisreturnedtoLPs
Exceedssomeminimumamount
105-157
z Tagalong,dragalongclause&Removeforcause
9 Tagalong,dragalongclauses:Anytimeanacquireracquirescontrolof
thecompany,theymustextendtheacquisitionoffertoall
shareholders,includingfirmmanagement.
9 Nofaultdivorce:ThisclauseallowsaGPtobefiredifasupermajority
(usually75%ormore)oftheLPsagreetodoso.
z Nofaultdivorce&Investmentrestrictions
9 Removalforcause:Thisprovisionallowsforthefiringofamanageror
theterminationofafundgivensufficientcause(e.g.,afelony
convictionofaseniormanager).
9 Investmentrestrictions:Thesespecifyleveragelimits,aminimum
amountofdiversification,etc.
106-157
z Coinvestment
9 Coinvestment:ThisprovisionallowstheLPstoinvestinotherfundsof
theGPatlowornomanagementfees.ThisprovidestheGPanother
sourceoffunds.TheprovisionalsopreventstheGPfromusingcapital
fromdifferentfundstoinvestinthesameportfoliocompany.Aconflict
ofinterestwouldariseiftheGPtakescapitalfromonefundtoinvestin
atroubledcompanythathadreceivedcapitalearlierfromanother
fund.
107-157
CostofInvestinginPE
¾CostofInvestinginPE
zTransactioncost:thesecostsincludethosefromduediligence,bank
financing,legalfeesfromacquisitions,andsalestransactionsinportfolio
companies.
zInvestmentvehiclefundsetupcost:thelegalandothercostsofsettingup
thefundareusuallyamortizedoverthelifeofthefund.
zAdministrativecost:thesearechargedonayearlybasisandinclude
custodian,transferagent,andaccountingcosts.
zAuditcost:thesearefixedandchargedannually.
108-157
CostofInvestinginPE
¾CostofInvestinginPE
zManagement&performancecost:thesearetypicallyhigherthanthatfor
otherinvestmentsandarecommonly2%forthemanagementfeeanda20%
feeforperformance.
zDilutioncost:Asdiscussedpreviously,additionalroundsoffinancingand
stockoptionsgrantedtoportfoliocompanymanagementwillresultin
dilution.Thisisalsotrueforoptionsissuedtotheprivateequityfirm.
zPlacementfees:Placementagentswhoraisefundsforprivateequityfirms
maychargeupfrontfeesasmuchas2%orannualtrailerfeesasapercentof
fundsraisedthroughlimitedpartners.
109-157
RiskofInvestinginPE
¾RiskofInvestinginPE
zLiquidityrisk:Becauseprivateequityinvestmentsarenotpubliclytraded,it
maybedifficulttoliquidateaposition.
zUnquotedinvestmentrisk:Becauseprivateequityinvestmentsdonothavea
publiclyquotedprice,theymayberiskierthanpubliclytradedsecurities.
zCompetitiveenvironmentrisk:Thecompetitionforfindingreasonablypriced
privateequityinvestmentsmaybehigh.
zAgencyrisk:Themanagersofprivateequityportfoliocompaniesmaynotact
inthebestinterestsoftheprivateequityfirmandinvestors.
zCapitalrisk:Increasesinbusinessandfinancialrisksmayresultina
withdrawalofcapital.Additionally,portfoliocompaniesmayfindthat
subsequentroundsoffinancingaredifficulttoobtain.
110-157
RiskofInvestinginPE
¾RiskofInvestinginPE
zRegulatoryrisk:Theportfoliocompanies’productsandservicesmaybe
adverselyaffectedbygovernmentregulation.
zTaxrisk:Thetaxtreatmentofinvestmentreturnsmaychangeovertime.
zValuationrisk:Thevaluationofprivateequityinvestmentsreflectssubjective,
notindependent,judgment.
zDiversificationrisk:Privateequityinvestmentsmaybepoorlydiversified,so
investorsshoulddiversifyacrossinvestmentdevelopmentstage,vintage,and
strategyofprivateequityfunds.
zMarketrisk:Privateequityissubjecttolongtermchangesininterestrates,
exchangerates,andothermarketrisks.Shorttermchangesareusuallynot
significantriskfactors.
111-157
Exit,Risk,&Cost
¾Typeofexitroutes
zIPO(InitialPublicOffering):InanIPO,afirm’sequityisofferedforpublicsale.
AnIPOusuallyresultsinthehighestexitvalueduetoincreasedliquidity,
greateraccesstocapital,andthepotentialtohirebetterqualitymanagers.
However,anIPOislessflexible,morecostly,andamorecumbersome
processthantheotheralternatives.
zSecondaryMarketSale:Inasecondarymarketsale,thefirmissoldto
anotherinvestorortoanotherfirminterestedinthepurchaseforstrategic
reasons(e.g.,afirminthesameindustrywishestoexpanditsmarketshare).
Secondarymarketsalesfromoneinvestortoanotherarequitefrequent,
especiallyinthecaseofbuyouts.VCfirmsaresometimesexitedviaabuyout
toanotherfirm,butVCfirmsareusuallytooimmaturetosupportalarge
amountofdebt.Secondarymarketsalesresultinthesecondhighestfirm
valuationsafterIPOs.
112-157
Exit,Risk,&Cost
¾Typeofexitroutes
zMBO(ManagementBuyout):thefirmissoldtomanagement,whoutilizea
largeamountofleverage.Althoughmanagementwillhaveastronginterest
inthesubsequentsuccessofthefirm,theresultinghighleveragemaylimit
management’sflexibility.
zLiquidation:theoutrightsaleofthefirm’sassets,ispursuedwhenthefirmis
deemednolongerviableandusuallyresultsinalowvalue.Thereispotential
fornegativepublicityasaresultofdisplacedemployeesandfromthe
obviousimplicationsofthefirm’sfailuretoreachitsobjectives.
113-157
Exit,Risk,&Cost
¾Exittiming
z Thetimingoftheexitisalsoveryimportantforfirmvalue,andtheventure
capitalfirmshouldbeflexibleinthisregard.Forexample,ifafirmcannotbe
soldduetoweakcapitalmarkets,theventurecapitalfirmmaywantto
considerbuyinganotherfirmatdepressedprices,mergingthetwofirms,
andwaitinguntilcapitalmarketconditionsimprovetosellbothasonefirm.
z Whenanexitisanticipatedinthenextyearortwo,theexitvaluation
multiplecanbeforecastedwithouttoomucherror.Beyondthistime
horizon,however,exitmultiplesbecomemuchmoreuncertainandstress
testingshouldbeperformedonawiderangeofpossiblevalues.
114-157
¾NetAssetValue
z WhyusetheNAV
z WaystodetermineNAV
9
Atcost,adjustingforsubsequentfinancinganddevaluation
9
Theminimumofcostormarketvalue
9 Revaluingaportfoliocompanyanytimethereisanewfinancing
9 Atcostwithnoadjustmentuntilexit
9 Bydiscountingforrestrictedsecurities
9 Lessfrequently,applyingilliquiditydiscountstopubliccomparables
z FiveissuesincalculatingNAV
z DuediligenceofPEfundinvestment
115-157
¾NetAssetValue
9 First,iftheNAVisonlyadjustedwhentherearesubsequentroundsof
financing,thentheNAVwillbemorestalewhenfinancingsare
infrequent.
9 Second,thereisnodefinitivemethodforcalculatingNAVforaprivate
equityfundbecausethemarketvalueofportfoliocompaniesisusually
notcertainuntilexit.
9 Third,undrawnLPcapitalcommitmentsarenotincludedintheNAV
calculationbutareessentiallyliabilitiesfortheLP.Thevalueofthe
commitmentsdependsonthecashflowsgeneratedfromthem,but
thesearequiteuncertain.WhenaGPhastroubleraisingfunds,this
impliesthatthevalueofthesecommitmentsislow.
116-157
¾NetAssetValue
9 Fourth,theinvestorshouldbeawarethatfundswithdifferent
strategiesandmaturitiesmayusedifferentvaluationmethodologies.In
theearlystages,aventurecapitalinvestmentistypicallyvaluedatcost.
Inthelaterstages,amethodbasedoncomparablesmaybeused.
Maturefundsmayusemarketcomparablesfortheirinvestmentsthat
arenearexit.Assetpricebubbleswouldinflatethevalueofthesefirms.
9 Finally,itisusuallytheGPwhovaluesthefund.LPsareincreasingly
usingthirdpartiestovalueprivateequityfunds.
117-157
¾NetAssetValue
z DuediligenceofPEfundinvestment
9 First,privateequityfundshavereturnsthattendtopersist.Hence,a
fund’spastperformanceisusefulinformation.Inotherwords,
outperformerstendtokeepoutperformingandunderperformerstend
tokeepunderperformingorgooutofbusiness.
9 Second,thereturndiscrepancybetweenoutperformersand
underperformersisverylargeandcanbeasmuchas20%.
9 Third,privateequityinvestmentsareusuallyilliquid,longterm
investments.Thedurationofaprivateequityinvestment,however,is
usuallyshorterthanexpectedbecausewhenaportfolio.
118-157
¾PEvaluationMethodologies
z DCF
9
Discountedcashflow(DCF)analysisismostappropriateforcompanies
withasignificantoperatinghistorybecauseitrequiresanestimateof
cashflows.
z RelativevalueorMarketapproach
9 Arelativevalueormarketapproachappliesapricemultiple,suchasthe
priceearningsratio,againstthefirm’searningstogetanestimateof
thefirm’svaluation.
z Realoptionanalysis
9 Realoptionanalysisisapplicableforimmaturefirmswithflexibilityin
theirfuturestrategies.
119-157
¾PEvaluationMethodologies
z Replacementcost
9
Replacementcostofthebusiness.Itisgenerallynotapplicableto
maturefirmswhosehistoricalvalueaddedwouldbehardtoestimate.
z VCmethod&leveragebuyoutmethod
120-157
¾Otherconsiderations
z Controlpremiums
z Countryrisks
z Marketabilityandilliquiditydiscounts
z Otherconsiderationsforvaluingprivateequityportfoliocompaniesare
controlpremiums,countryrisk,andmarketabilityandilliquiditydiscounts.In
buyouts,theprivateequityinvestorstypicallyhavecompletecontrol.In
venturecapitalinvestments,however,theseinvestorsusuallyhavea
minorityposition,andtheircontrolofthefirmsdependsonthealignmentof
theirinterestswiththatofcontrollingshareholders.Whenvaluingfirmsin
emergingmarkets,countryriskpremiumsmaybeadded,therebyincreasing
thediscountrateappliedtothefirm’scashflows.Illiquidityand
marketabilitydiscountsrefertotheabilityandrighttosellthefirm’sshares,
respectively.
121-157
¾ValuationIssue:BuyoutVs.VC
ValuationIssue Buyout VC
DCFMethod •Frequently •Lessfrequently
RelativeValueApproach •UsedtocheckDCF •Difficulttouse
UseofDebt •High •Low
• Earninggrowth •Premoneyvaluation
TheDrivenofEquityReturn • increaseinmultipleuponexit •Investment
• reductionindebt •subsequentdilution
122-157
VCValuationIssues
¾Pre andPostMoneyValuation
z Thepostmoneyvaluationofthefirmis
PRE+INV=POST
z TheownershipproportionoftheVCinvestorisINV/POST
123-157
VentureCapitalMethod
¾Forasinglefinancinground
z Step1:PostMoneyValuation
POST=FV/(1+r)N
z Step2:PreMoneyValuation
PRE=POSTINV
z Step3:OwnershipFraction
f=INV/POST
z Step4:No.ofthesharestobeheldbythePEfirm
Spe =Se[f/(1f)]
z Step5:Pricepershare
P=INV/Spe
124-157
¾ Example:CalculationsusingtheNPVventurecapitalmethodandasingle
financinground
z PonderTechnologiesisabiotechfirm,anditsentrepreneurfounders
believetheycansellthefirmfor$40millioninfiveyears.Theyneed$5
millionincapitalnow,andtheentrepreneurscurrentlyhold1million
shares.
z Theventurecapitalfirm,VCInvestors,decidesthatgiventhehighriskof
thisfirm,adiscountrateof40%isappropriate.
z Calculatethepremoneyvaluation,postmoneyvaluation,ownership
fraction,andpricepershareapplyingtheNPVventurecapitalmethodwith
asinglefinancinground.
125-157
¾Answer:
z Step1:Thepostmoney(POST)valuationisthepresentvalueofthe
expectedexitvalue(thisassumestheinvestmentwasmadeinthefirm):
40,000,000
POST 7, 437,377
(1 0.40)5
z Step2:Thepremoney(PRE)valuationiswhatthecompanywould
hypotheticallybeworthwithouttheinvestment:
PRE=7,437,377– 5,000,000=2,437,377
z Step3:Toput$5millioninafirmworth$7.4million,theprivateequityfirm
mustown67.23%ofthefirm:
5, 0 0 0, 0 0 0
f 6 7 .2 3 %
7, 437, 377
126-157
¾Answer:
z NotethatundertheIRmethod,fisthesame:
5million(1.405 )
f 67.23%
40million
z Step4:Iftheentrepreneurswant1millionshares,theprivateequityfirm
mustget2.05millionsharestoget67.23%ownership:
ª 0.6723 º
SVC 1, 000, 000 « » 2, 051, 572
¬ (1 0.6723) ¼
z Step5:Givena$5millioninvestmentand2.05millionshares,thestock
pricepershare(P)mustbe:
5, 000, 000
P $2.44 pershare
2, 051, 572
127-157
¾Formultiplefinancingrounds:
z Step1:thecompounddiscountrate
z Step2:PostMoneyValuation(round2)
POST2=FV/ (1+r2)
z Step3:PreMoneyValuation(round2)
PRE2=POST2– INV2
z Step4:PostMoneyValuation(round1)
POST1=PRE2 / (1+r1)
z Step5:PreMoneyValuation(round1)
PRE1=POST1– INV1
128-157
¾Formultiplefinancingrounds:
z Step6:OwnershipFraction(round2)
f2=INV2 / POST2
z Step7:OwnershipFraction(round1)
f1=INV1/POST1
z Step8:No.ofthesharestobeheldbythePEfirm
Spe1=Se[f1 /(1 f1)]
z Step9:Pricepershareafterfinancing(round1)
P1=INV1 / Spe1
z Step10&11:Pricepershareafterfinancing(round2)
Spe2=(Se+Spe1) [f2 /(1 f2)]
P2=INV2 / Spe2
129-157
¾ Example:Calculatingsharesissuedandsharepriceforasecondroundfinancing
z Supposethatinsteadofasingleroundoffinancingof$5million,thefirm
willneed$3millioninthefirstroundandasecondroundoffinancing
(threeyearslater)of$2milliontofinancefirmexpansiontothesize
expectedatexit.
z Useadiscountrateof40%forthefirstthreeyearsand30%forthelasttwo
years.Thefirmisstillexpectedtobeworth$40millionafterfiveyears,and
founderswillhold1millionshares.
¾ Answer:
z Thevalueofthefirmatthetimeofthesecondroundoffinancing(two
yearsremainingtoexit)is:
exitvalue 40,000,000
POST2 23,668,639
(1 r2 ) n 2 (1.30) 2
130-157
¾Answer:
z ThefractionalVCownershiprequiredforthesecondroundinvestmentof
$2millionis:
INV2 2, 000, 000
f2 0.0845or 8.45%
POST2 23, 668, 639
z Thevalueofthefirmbeforethesecondroundfinancingwouldthenbe:
PRE2 POST2 INV2 23,668,639 2,000,000 21,668,639
z Valueofthefirmatthefirstroundoffinancingis:
PRE 2 21, 668, 639
POST1 7, 896, 734
(1 r1 ) n1 (1.40) 3
131-157
¾Answer:
z ThefractionalVCownershiprequiredforthefirstroundinvestmentof$3
millionis:
INV1 3,000,000
f1 0.38or 38%
POST1 7,896,734
z Numberofsharesissuedatthetimeoffirstroundoffinancingis:
ª f º ª 0.38 º
shareVC1 shareFounders « 1 » 1,000,000 « 612,903
¬1 f1 ¼ ¬1 0.38 »¼
z Thepricepershareatthetimeoffirstroundoffinancingis:
INV1 3,000,000
price1 $4.89
shareVC1 612,903
132-157
¾Answer:
z NumberofsharesissuedtotheVCfirmatthetimeofthesecondroundof
financingis:
§ f ·
shareVC 2 ( shareVC 1 share Founders ) ¨ 2 ¸
© 1 f2 ¹
§ 0.0845 ·
(612,903 1,000,000) ¨ ¸ 148,870
© 1 0.0845 ¹
z Thepricepershareatthetimeofsecondroundoffinancingis:
INV2 2, 000, 000

price2 $13.43
shareVC 2 148,870
133-157
IRRMethod
¾OwnershipFraction
z Step1:Investor’sexpectedfuturewealthW=INVh (1+r)N
z Step2:OwnershipFractionf=W/FV
¾Pricepershare
z Step3:No.ofthesharestobeheldbythePEfirmSpe =Se[f/(1f)]
z Step4:PricepershareP=INV/Spe
¾PostMoney&PreMoneyValuation
z Step5:PostMoneyvaluation
9 POST=INV/forPOST=Ph(Spe+Se)
z Step6:PreMoneyvaluation
9 PRE=POST INVorPRE=PhSe
134-157
AccountingforriskwhenvaluingVC
¾Adjustingthediscountrate
z r*=[(1+r)/(1q)]– 1
9 r*=discountrateadjustedforprobabilityoffailure
9 r=discountrateunadjustedforprobabilityoffailure
9 q=probabilityoffailureinayear
¾Adjustingtheterminalvalue
z UsingtheScenarioanalysis
135-157
Example:Usingscenarioanalysistoarriveatanexpectedterminalvalue
¾ Inthepreviousvaluationexample,weweregivenaterminalvalueof$40
million.Assumethatthescenarioanalysisisperformedandexaminesthree
possiblescenarios:
1. Theexpectedearningsare$4millionandtheexpectedpriceearnings
multipleis10,resultinginthe$40million(asbefore).
2. Thefirmisnotassuccessful,andearningsareonly$2million.Growthis
slower,sotheexpectedpriceearningsmultipleis5.Theexpectedterminal
valueis$10million.
3. Thefirmfails,anditsterminalvalueis$0.
136-157
¾Answer:
z Ifeachscenarioisequallylikely,eachpossiblevalueisweightedbyone
third,andtheexpectedterminalvalueis:
1 1 1
($40) ($10) ($0) $16.7 million
3 3 3
z Theterminalvalueof$16.7millionisthenusedinsteadofthe$40millionin
thevaluationanalysisabove.Thisisanalternativetoadjustingthediscount
ratefortheprobabilityoffailure.
137-157
BuyoutValuationIssues
¾LBOModel
z Targetfirm’sforecastcashflows
z Exceptedreturnstotheprovidersofthefinancing
z Totalamountoffinancing
¾ExitValue
z ExitValue=investmentcost+earningsgrowth+increaseinpricemultiple
+reductionindebt
¾Componentofthereturn
z ThereturnonthepreferencesharesforthePEfirm
z Theincreasemultipleuponexit
z Thereductioninthedebtclaim
138-157
BuyoutValuationIssues
¾CalculatingPayoffMultiplesandIRRsforEquityInvestors
z Calculatingtheexitvalue
z Calculatingtheclaimant’spayoffs:
9 Debt
9 Preferenceshares
9 PEfirms
9 Management
z Calculatingthetotalinvestmentandtotalpayoff,usingthesetwocanget
thepayoffmultiplesforPEfirms
z CalculatingtheIRRsforPEinvestorsandmanagementequity
139-157
Example:BuyoutValuationIssues
¾Example:CalculatingPayoffMultiplesandIRRsforEquityInvestors
SupposeanLBOtransactionisvaluedat$1,000millionandhasthefollowing
characteristics(amountsareinmillionsofdollars):
z Exitoccursinfiveyearsataprojectedmultipleof1.80ofthecompany'sinitialcost.
z Itisfinancedwith60%debtand40%equity.
z The$400equityinvestmentiscomposedof:
9 $310inpreferencesharesheldbytheprivateequityfirm.
9 $80inequityheldbytheprivateequityfirm.
9 $10inequityheldbymanagementequityparticipation(MEP).
z Preferencesharesareguaranteeda14%compoundannualreturnpayableatexit.
z Theequityoftheprivateequityfirmispromised90%ofthecompany'sresidual
valueatexitaftercreditorsandpreferencesharesarepaid.
z Managementequityreceivestheother10%residualvalue.
z Byexit,thecompanywillhavepaidoff$350oftheinitial$600indebtusing
operatingcashflow.
Calculatethepayoffforthecompany'sclaimantsandtheinternalrateofreturn(IRR)
andpayoffmultiplefortheequityclaimants.
140-157
¾Answer:
z Firstcalculatetheexitvalueas:$1,000x1.8=$1,800.
z Nextcalculatetheclaimants'payoffs:
9 Debt:Theclaimofdebtholdersistheirinitialinvestmentminustheamount
thathasbeenpaiddown:$600 $350=$250.
9 Preferenceshares:Earnareturnof14%sotheirclaimis:
$310X(1.14)5=$596.88.
9 Privateequityfirm:Receives90%oftheresidualexitvalue:
0.90(1,800 $250 $596.88)=$857.81.
9 Management:Receives10%oftheresidualexitvalue:
0.10(1,800 $250 $596.88)=$95.31.
z Thetotalinvestmentbytheprivateequityfirmis$310+$80=$390.
z Thetotalpayoffis$596.88+$857.81=$1454.69.
z Thepayoffmultiplefortheprivateequityfirmis:1454.69/390=3.7.
141-157
¾Answer:
z UsingyourTIBAIIPlus,theIRRiscalculatedas:
PV=$390;FV=$1454.69;N=5;CPT1/Y30.1%.
z Forthemanagementequity,theIRRis:
PV=$10;FV=$95.31;N=5;CPT1/Y57.0%.
z Thepayoffmultipleforthemanagementequityprogram(MEP)is:95.31/10=9.5.
z Intheexample,theequityheldbytheprivateequityfirmandmanagement
experiencesasignificantincreaseinvalue.TheIRRforeachisattractiveat30.1%
and57.0%,respectively.
142-157
PerformanceevaluationofPEfund
¾IRR
z GrossIRR
z NetIRR
¾Multiples
z Quantitativemeasures
9 PIC(Paidincapital/committedcapital,OR$utilizedbyGP)
9 DPI(distributedtopaidincapital)
9 RVPI(residualvaluetopaidincapital)
9 TVPI(totalvaluetopaidincapital)
z Qualitativemeasures
z Benchmark
¾ Calculatingtheperformancemeasures
143-157
¾Example:Calculatingperformancemeasures
z TheGPforprivateequityFundCchargesamanagementfeeof2%andcarriedinterestof20%,
usingthefirsttotalreturnmethod.Thetotalcommittedcapitalforthefundwas$150million.
Thestatisticsforyears2004–2009areshowninthefollowingtable(inmillions).
CashFlowsforPrivateEquityFundC
Capital
Paidin Management Operating NAVbefore Carried NAVafter
Called Distributions
Capital Fees Results Distributions Interest Distributions
Down
2004 50 50 1.0 10 39.0 39.0
2005 20 70 1.4 25 32.6 32.6
2006 30 100 2.0 25 85.6 85.6
2007 20 120 2.4 50 153.2 0.6 20 132.6
2008 10 130 2.6 60 200.0 9.4 40 150.6

2009 10 140 2.8 110 267.8 13.6 80 174.2
z Calculatethemanagementfees,carriedinterest,NAVbeforedistributions,NAVafter
distributions,distributedtopaidin(DPI),residualvaluetopaidin(RVPI),andtotalvalueto
paidin(TVPI)ofprivateequityFundC.
144-157
¾Answer:
z Paidincapital:Thisisjustthecumulativesumofthecapitalcalleddown.
Forexample,in2005,itisthesumofthecapitalcalleddownin2004and
2005:
$50+$20=$70.
z Managementfees:Ineachyear,thesearecalculatedasthepercentagefee
(here2%)multipliedbythepaidincapital.Forexample,in2005,itis2%h
$70=$1.4.
z Carriedinterest:CarriedinterestisnotpaiduntiltheGPgeneratesrealized
anunrealizedreturns(asreflectedintheNAVbeforedistributions)greater
thanthecommittedcapitalof$150.
z In2007,theNAVbeforedistributionsexceededthecommittedcapitalfor
thefirsttime.Inthisfirstyear,thecarriedinterestis20%multipliedbythe
NAVbeforedistributionsminusthecommittedcapital:20%h ($153.2–
$150)=$0.6.
z Insubsequentyears,itiscalculatedusingtheincreaseintheNAVbefore
distributions.Forexample,in2008,itis:20%h ($200– $153.2)=$9.4.
145-157
¾Answer:
z NAVbeforedistributions:Thesearecalculatedas:
=NAVafterdistributionsinprioryear+capitalcalleddown– management
fees
+operatingresults
9 Forexamplein2008,NAVbeforedistributionsis:
$132.6+$10– $2.6+$60=$200.
z NAVafterdistributions:Thesearecalculatedas:
=NAVbeforedistributions– carriedinterest– distributions
9 Forexamplein2008,NAVafterdistributionsis:
$200– $9.40– $40=$150.60.
146-157
SS13
147-157
ExamFocuses
¾ Typesofmarketparticipantsincommodityfuturesmarkets
¾ Storabilityandrenewabilityinthecontextofcommodities
¾ Convenienceyield
¾ Distinguishamongcapitalassets,storeofvalueassets,andconsumableor
transferableassetsandexplainimplicationsforvaluation.
¾ Comparewaysofparticipatingincommoditymarkets.
¾ Explainbackwardationandcontango intermsofspotandfuturesprices.
¾ Describethecomponentsofreturntoacommodityfuturesandaportfolioof
commodityfutures.
¾ Rollreturn
¾ Comparetheinsuranceperspective,thehedgingpressurehypothesis,andthe
theoryofstorageandtheirimplicationsforfuturespricesandexpectedfuture
spotprices.
148-157
Marketparticipants
¾Hedgers
z Anentitythathasanexposuretocommoditypricesandtakesonanoffsetting
positioninthefuturesmarkettolowerriskiscalledahedger.
z Commodityproducers(long)e.g.awheatfarmer
z Commodityconsumer(short)e.g.airline
¾Speculators
z Whencommodityhedgersusefuturestolowertheirrisk,itisgenerallythe
Speculatorsthatacceptthisriskbytakingtheoppositeposition.
z Exposedtosignificantriskofloss(orgain)
z Demandapremium
¾Arbitrageurs
z Commodityarbitrageurstrytocreaterisklessprofitsfrompricedifferencesover
timebetweenlocations,orfromdifferencesbetweenfuturesandspotprices.
z E.g.cashandcarryarbitrage
149-157
Storabilityandrenewability
¾Storability
z Acommodityisconsideredtobehighlystorableifitdoesnotdegradeovertimeand
ifthecostofstoringthecommodityisrelativelylowcomparedtoitsvalue.(gold)
¾Renewability
z Arenewablecommoditycanbeproducedwithoutlimit.(wheat)
z Thepriceofrenewablecommoditiesishighlyinfluencedbytheexpectedcostof
futureproductionofthatcommodity.
z Nonrenewablecommoditieshaveafinitesupply.(minerals&crudeoil)
150-157
Convenience yield
¾Convenienceyield
z Amanufacturerthatholdsastorablecommodityinputhasavaluableoptionto
consumethatinputatanytime.Thebenefitfromholdingaphysicalcommodityvs.
beinglongtheequivalentfuturescontractiscalledtheconvenienceyield.
¾Convenienceyieldvs.inventorylevel
z Thetheoryofstorageexplainsthatthereisaninverserelationshipbetween
inventoriesandcommodityfuturesprice:
z Thehigher inventoriesare,thelowertheConvenienceyieldwillbe,andthusthe
lowerthefuturespriceswillbe.
151-157
Capitalassets,storeofvalueassets,andconsumableor
transferableassets
¾ Capitalassets:areexpectedtoprovidecontinuouscashflowsinthefuture,such
asstocksandbonds.Capitalassetsareappropriatelyvaluedbydiscountingthose
expectedfuturecashflows.
¾ Storeofvalueassets:neithergenerateincomenorcantheybeconsumed.
(Artworksandforeigncurrencies)
¾ Consumableortransferable(C/T)assets:donotgeneratecontinuouscashflows
buthaveaneconomicvaluebecausetheycanbeusedasaninput.Commodities
likewheat,oil,orcattlearealmostalwaysclassifiedintheC/Tassetssuperclass.
152-157
Comparewaysofparticipatingincommoditymarkets
Buyingthe Commodity Commodity Commodity Structured

physicalgood. stocks. mutualfunds. futures productson
commodity
futuresindices
Advantage Obviousand Stockmarkets Diversification Convenient, ETF:safe, high
direct respond with low flexible,low liquidity,lowTC.
quicklyand transaction transactions Commodity index
sensibly costs cost,and certificate:cheap,
highly lowinitialcosts&
leveraged managementfee.
nature.
Disadvantage Storageand Low Differencesin Investor must ETF:must
maintaining correlation management continuously carefullyconsider
costs maybe withtheprice style, rollmaturing indexrisk&
impractical ofunderlying allocation contracts return.
commodity strategy Commodityindex
certificate:small
returnpotential.
153-157
Backwardationandcontangointermsofspotandfuturesprices
¾ Backwardation
z Thetermstructurewillhaveanegativetrend
z Futuresprice<Spotprice
¾ Normalbackwardation
z Thefuturespriceislowerthanthecorrespondingexpectedspotpriceinthefuture.Occurs
whenhedgers(producers)areshortinthefuturescontract.
¾ Contango
z Thetermstructurehasapositiveslope
z Futuresprice>Spotprice
¾ Futuresmarketsthataredominatedbyshorthedgers(producersofthe
commoditywhoshortfuturestoprotectagainstpricedecreases)tendtobein
backwardation.
¾ Futuresmarketsthataredominatedbylonghedgers(usersofthecommodity
whobuyfuturestoprotectagainstpriceincreases)tendtobeincontango.
154-157
Returncomponentsofcommodityfuturesinvestments
¾ Wecanbreakdownthereturnofacommodityfuturesinvestmentintoanumber
ofcomponents:
Totalreturn=spotreturn+rollreturn+collateralreturn+rebalancingreturn
Where:
9 Spotreturn:thepercentagechangeinacommodity’sspotprice.
9 Rollreturn:returnfromclosingoutmaturingfuturescontractsandreplacingthem
withnewerfuturescontracts.
9 Collateralreturn:returnonthepostedcollateralthatisinvestedingovernment
securities.
9 Rebalancingreturn(diversificationreturn):additionalreturnonaportfolioof
commodityfuturescontracts(doesnotapplytoindividualcontracts).
155-157
Rollreturn
¾ Rollreturn(orrollyield)representstheprofit(orloss)thatresultsfromthe
continuousconvergenceoffuturespricestowardsspotpricesasafutures
contractapproachesmaturity.
Rollreturn=(St – Ft,T)/St
z Whenthecommodity’stermstructureisinbackwardation,positive rollreturn.
z Whenthecommodity’stermstructureisincontango,negativerollreturn.
156-157
Modelsofexpectedreturns
¾ CAPM:becausecommoditiesarenotcapitalassets,CAPMisnotanappropriate
modelforderivingexpectedreturnsforcommodities.
¾ Insuranceperspective:alongpositionincommoditieswillearnpositivereturns
duetothespeculator’spremiumearnedtosupportshorthedgers.
¾ Hedgingpressurehypothesis:ariskpremiumcanbeearnedoneitherlongor
shortpositionsdependingonthebalanceofhedgersinthemarket.
¾ Theoryofstorage:accordingtothetheoryofstorage,commoditiesthatare
difficulttostorewouldearnapositiveconvenienceyield.
157-157

(CFA) (2015) (L2) 20150314-15+20150321-22 - 权益和其他类投资分析 - 李斯克3

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),'зঃ‫׀‬੟஍ࣹ

Category Observation Example

¾ Forward-looking (Ex ante) estimate – conceptual framework

2. Equity risk premium

Equity Index Price PVrapid (r)+PVtransition (r)+PVmature (r)

z Expected inflation: iˆ (YTM of 20-year T-bonds)-(YTM of 20-year TIPS)

2. Equity risk premium

 precision issues (due to the

2. Equity risk premium

Estimates Strength Weakness

 Popular method;  Change through time and need

Supply-Side  Proven models;  Only appropriate for developed

 Wide disparity from different

¾ In estimating the required return on equity, the analyst can choose

3. Required return on equity

3. Required return on equity

CAPM model—Beta Estimates for Public Companies

Estimating Beta for tiny traded stock or nonpublic companies:

3. Required return on equity

Required Return=RF  RP1  RP2    RPn

z Factor sensitivity is also called the factor beta, it is the asset’s

3. Required return on equity

Required Return RF  E mkt,j u ( Rmkt  RF )

 E iliq (R LL-R HL)

3. Required return on equity

3. Required return on equity

Methods Strength Weakness

 Choosing the appropriate factor.

 higher explanatory power

3. Required return on equity

3. Required return on equity

6. Discount rate selection in relation to cash flow

¾ Being used as discount rates in valuation, required returns need to be

Equity Valuation: The framework

(Discounted by Req. Rate of Return)

> Market Value < Market Value

Buy Sell / Short Sell

Step 1: Global & Country

Industry Analysis: Porter's Five-Forces

¾ 1.Threat of new entrants in the industry

Industry Analysis: Porter's Five-Forces

Industry Analysis: Porter's Five-Forces

཰Differentiation of inputs that are acceptable to the industry;

ཱPresence of substitute inputs is closely related to

the differentiation of inputs.

ཱིImportance of volume to the supplier.

ུThe threat of forward integration.

Industry Analysis: Porter's Five-Forces

Factors Affect an Industry on Temporary Basis

¾ Various factors may affect an industry on a temporary basis but not

¾ Five forces drive an industry’s structural attractiveness and long-term

Example: Analyzing the Competitive Forces for WAL-Mart

Step 3: Stock Analysis

9Discounted Dividend Valuation

9Free Cash Flow Valuation

9Residual Income Valuation

9Market-Based Valuation: Price Multiple

z Private Company Valuation

Compare: dividends, free cash flow, and residual income

Advantages Disadvantages Suitability

Summary of Readings and Framework

Strategy formulation styles

precision issues (due to the

Popular method; Change through time and need

Supply-Side Proven models; Only appropriate for developed

Wide disparity from different

Required Return=RF RP1 RP2 RPn

Required Return RF E mkt,j u ( Rmkt RF )

E iliq (R LL-R HL)

Choosing the appropriate factor.

higher explanatory power